Dollar and U.S. Rates Continue to Rise in Tandem

September 28, 2021
  • U.S. 10-year yield continues to move higher; with the FOMC meeting out of the way, Fed speakers become plentiful but changes at the Fed are afoot; fiscal brinksmanship continues; Fed regional manufacturing surveys will continue to roll out; Brazil central bank minutes will be released
  • BOE continues to beat the hawkish drum; comments by Turkey’s central bank governor Kavcioglu reinforced the dovish bias even as the U.S. is threatening sanctions
  • Reports suggest Japan will lift the state of emergency at the end of this month as planned; Australia reported final August retail sales; China’s industrial profits data slowed down significantly in August; PBOC Governor Yi noted that it has the ability to implement normal monetary policy even as growth is expected to remain around 5-6%; global energy issues continue unabated

The dollar remains firm as U.S. rates continue to climb. DXY is up for the third straight day and is nearing the August 20 high near 93.729. After that is the November high near 94.302. The euro remains heavy and is nearing a test of the August 20 low near $1.1665. Sterling had held up relatively well but is finally playing catch-up despite more hawkish talk from the BOE (see below). We see a test of the July 20 low near $1.3885 soon, followed by the January low near $1.3450. USD/JPY is trading at the highest level since July 2 near 111.40 and is nearing that day’s cycle high near 111.65. After that is the February 2020 high near 112.25. We believe the hawkish Fed, rising U.S. rates, and ongoing China risks will help keep the dollar rally going.

AMERICAS

The U.S. 10-year yield continues to move higher. It traded today at the highest level since June 17 near 1.55%. Of note, a clean break above 1.53% sets up a test of the March 30 high near 1.77%. The real 10-year yield is also higher and at -0.85% is the highest since June 25. Similarly, a break above -0.82% is needed to set up a test of the March 19 high near -0.59%. It’s not just the long end either. The 2-year yield has risen to 0.32% today, the highest in two years. If this broad-based rise in U.S. yields can be sustained, it is yet another dollar-positive factor to consider. Of note, the Fed Funds futures strip now has lift-off in Q4 2022 fully priced in.

Despite the rise in short-dated yields, the U.S. curve has steepened. At 150 bp, the 3-montn to 10-year curve is the steepest since mid-June. This recent curve steepening is to be expected if the previous tapering episode is any guide. Back in 2013, the 3-month to 10-year curve steepened from a low near 160 bp in April to a high near 295 bp in December as tapering discussions progressed. After the official announcement at the December FOMC meeting, the curve proceeded to flatten as markets started to focus on the eventual lift-off. We believe that is the likely dynamic that will be seen this year and next year as the Fed begins to remove emergency accommodation. We will be putting out a longer piece this week with a likely roadmap for the dollar and U.S. rates.

Higher U.S. yields are being seen in a week of heavy issuance. $60 bln of 2-year and $61 bln of 5-year notes were auctioned yesterday and demand was weak. Indirect bidders (mostly foreign accounts) were not as active, taking only 45.3% of the 2-year auction vs. 60.5% at the previous auction and taking only 54.3% of the 5-year auction vs. 62.7% at the previous auction. The bid/cover ratio for the 2-year fell to 2.28 from 2.65 previously, but rose for the 5-year to 2.37 from 2.35 previously. In recent auctions this year, higher yields have been met with strong foreign demand but that does not seem to be working this week. The market will get another chance to test this with the $62 bln auction of 7-year notes today. Indirect bidders took 61.1% of the previous 7-year auction, when the bid/cover ratio was 2.34.

With the FOMC meeting out of the way, Fed speakers become plentiful. Evans, Bowman, Bostic, and Bullard speak today, while Powell and Yellen appear before the Senate Banking Panel. All Fed officials are expected to continue advancing the tapering timeline, with the aim of preparing markets for an official announcement at the November 2-3 FOMC meeting. Even Brainard tilted hawkish yesterday, as she said that the labor market may soon meet her requirement to start tapering. However, she warned that “We had expected a smooth rotation from goods spending to services spending during a complete reopening this fall, but delta has slowed this process. As a result of delta, the September labor report may be weaker and less informative of underlying economic momentum than I had hoped.”

Changes at the Fed are afoot. Yesterday, Boston Fed President Rosengren announced he will retire September 30. Reports suggest this is nine months earlier than planned due to a serious kidney condition. Of note, he is an alternate voter in 2021 and would have become a voter in 2022 and so his replacement will be very important. Later, Dallas Fed President Kaplan announced his retirement effective October 8. He would not become a voter until 2023 and so his replacement won’t have an immediate impact on policymaking. Both came under heavy criticism for reports of carrying out active stock trading. Regional Fed Presidents are chosen by the individual Fed bank boards and not the White House.

Fiscal brinksmanship continues. Yesterday, Republican Senators blocked the bill that would have suspended the debt ceiling until December 2022 and funded the government past September 30. The 48-50 outcome was not a surprise as Majority Leader Schumer switched his vote to no at the last moment in order to retain the option of calling for another vote on the bill later. 60 votes were needed and so the Democrats are left with few options. The most likely one is that the debt ceiling is folded into the human infrastructure package that the Democrats plan to pass by the budget reconciliation process requiring no Republican support. And yet even this is highly precarious, as centrist Democrats are threatening to withhold support unless the $3.5 trln price tag is reduced. Stay tuned.

Fed regional manufacturing surveys will continue to roll out. Richmond is expected at 10 vs. 9 in August. Yesterday, Dallas came in at 4.6 vs. 11.0 expected and 9.0 in August. Before that, Empire and Philly Fed surveys surprised to the upside at 34.3 and 30.7, respectively, while Kansas City came in slightly lower than expected at 22 vs. 29 in August. Yesterday, August durable goods orders came in stronger than expected, pointing to renewed business investment ahead. Headline orders rose 1.8% m/m vs. 0.7% expected, while core orders (non-defense ex-aircraft) rose 0.5% m/m vs. 0.4% expected. July readings were revised up to 0.5% m/m and 0.3%, respectively. The readings are likely reflecting increased investment across industries in boosting production capacity to deal with ongoing supply issues. This is a good sign for GDP going forward, to state the obvious. Advance goods trade data (-$87.3 bln expected), wholesale and retail inventories, S&P CoreLogic house prices, and Conference Board consumer confidence (115.0 expected) will all be reported today.

Brazil central bank minutes will be released. COPOM delivered a 100 bp hike to 6.25% at last week’s meeting and promised a similar move at the next meeting October 27. The minutes may provide some more clarity on the length of the tightening cycle. Our call is that the bank makes several more hikes and that the policy rate tops out around 8.5-9.0%. The central bank releases its quarterly inflation report Thursday and will add more to the market’s information set.

EUROPE/MIDDLE EAST/AFRICA

The Bank of England continues to beat the hawkish drum. Governor Bailey affirmed last week’s message that hiking rates would be the primary tool to fight inflation and that this could happen even before the bank’s current QE program ends at year-end. This makes no sense to us at all. QE is an easing measure while hiking rates is a tightening measure; to have both at the same time seems ill-advised. Bailey added that every MPC member is prepared to hike rates this year if needed to prevent higher inflation. Perhaps this is all just jaw-boning and tough talk, but the fact of the matter is that the U.K. economic outlook remains very fragile and we do not think this hawkishness is helpful. It certainly isn’t helping the pound, which is trading at the lowest level this week near $1.3625 and on track to break below the July low near $1.3570. After that is the 2021 from January near $1.3450.

Comments by Turkey’s central bank governor Kavcioglu reinforced the dovish bias even as the U.S. is threatening sanctions. Governor Kavcioglu basically deflected criticism about falling behind the curve, saying that monetary policy won’t be able to reduce inflation on its own. This sounds very much along the lines of President Erdogan’s rather unorthodox thinking, and suggests further easing is on the way at the next policy meeting October 21. On the geopolitical side, we are already starting to hear from the U.S. Congress about possible sanctions against Turkey should it go ahead with more purchase of Russian missile systems. Again, no surprise here. The lira is down 0.5%, roughly in line with losses in other higher-beta EM currencies.

ASIA

Reports suggest Japan will lift the state of emergency at the end of this month as planned. Economy Minister Nishimura reportedly made the recommendation today at a meeting of the government’s panel of experts. Restrictions on opening hours would be gradually relaxed. Prime Minister Suga is expected to make a formal decision later in the day. Lifting the state of emergency has been made possible by increased vaccination and lower infection rates, as daily new cases fell to 2,129 on Sunday vs. levels over 25,000 in mid-August. The economy has held up better than expected in Q3 and the Q4 outlook obviously just got better, especially with another fiscal package in the works.

Australia reported final August retail sales. Sales fell -1.7% m/m, better than the expected -2.5% and -2.7% in July but still down for the third straight month. Statistics official noted that “Retail turnover continues to be negatively impacted by lockdown restrictions, with each of the eastern mainland states experiencing falls in line with their respective level of restrictions. In direct contrast, states with no lockdowns performed well with Western Australia and South Australia enjoying strong rises.” We expect the uncertain outlook to keep the RBA in dovish mode. Next policy meeting is October 4 and no change is expected then.

China’s industrial profits data slowed down significantly in August to 10.1% y/y from 16.4%in July. The concerning part here is that industry is supposed to be holding up the economic engine as confidence in the services side recovers from the last pandemic wave. In the end, this doesn’t change the view that the expectations for Chinese economy will have be to downgraded this year and the government will step in to support it.

Indeed, PBOC Governor Yi noted that it has the ability to implement normal monetary policy even as growth is expected to remain around 5-6%. Yi said the PBOC will extend the time for implementing normal monetary policy as long as possible and that there is no need for asset purchases, which he said could damage market functions and create moral hazard. We find it a bit strange that Yi would mention QE because we don’t think anyone is expecting that from the PBOC. That said, it’s clear that the bank is teeing up more conventional easing in the coming weeks.

COMMODITIES

Global energy issues continue unabated. Brent hit $80 a barrel for first time in 3 years and natural gas is up another 6%. Natural gas is up a whopping 140% on the year, while Brent is up 55%. The energy crisis drivers are well understood, including distribution bottlenecks, supply constraints, weather patterns, and improved demand. Forecasters have continuously increased their year-end predictions for demand and prices, which only adds to anxiety about coming winter in the Northern Hemisphere.

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