U.S. Returns from Holiday to Higher Yields and Stronger Dollar

January 18, 2022
  • As the U.S. returns from holiday, markets are grappling with sharply higher yields and a stronger dollar; Fed tightening expectations continue to rise; regional Fed manufacturing surveys for January will start rolling out
  • U.K. reported firm labor market data; BOE tightening expectations remain elevated
  • Two-day BOJ meeting ended with a dovish hold; this was a very strong effort at damage control by Kuroda; PBOC cut its 1-year Medium-term Lending Facility rate Monday by 10 bp to 2.85%; the widening monetary policy divergence between the Fed and the PBOC is unmistakable

The dollar is gaining more traction as U.S. yields surge. DXY is up for the third straight day and trading at the highest level in a week near 95.356. The euro is trading back below $1.14 after last week’s rally ran out of steam just below $1.15, while sterling is down for the third straight day after failing last week to break above the 200-day moving average near $1.3735. USD/JPY traded back above 115 today for the first time since January 12 after the BOJ delivered a dovish hold (see below). With U.S. rates powering higher, we believe the dollar rally is back on track after last week’s correction.


As the U.S. returns from holiday, markets are grappling with sharply higher yields and a strong dollar. The U.S. 2-year yield traded near 1.06% today, while the 10-year traded near 1.85%. Both are the highest since early 2020. With the 10-year breakeven inflation rates stuck below 2.50%, the real U.S. 10-year yield rose to -0.66%, the highest since April 2021. The 2-year differentials with Germany and Japan rose to 160 bp and 110 bp, respectively, both new cycle highs. This move in rates argues for further dollar gains. This week’s price action reaffirms our view that last week’s drop in yields and the dollar were a countercyclical correction, not a trend change as many dollar bears believed.

Fed tightening expectations continue to rise. There are no Fed speakers until Chair Powell’s post-FOMC decision press conference on January 26. Given this way U.S. yields are moving, it’s clear that the Fed’s full court press last week made a significant impression on the bond market. We fully expect a hawkish hold next week that sets up liftoff at the March 15-16 meeting. WIRP suggests a hike then is now fully priced in, followed by hikes in June, September, and December. The expected terminal Fed Funds rates is also starting to move towards 2.0%, which is a key part of the market repricing. That said, we feel that this repricing still has some ways to go. Equity markets are finally getting the message, with NASDAQ futures pointing to a -2% move today when markets reopen.

Regional Fed manufacturing surveys for January will start rolling out. Empire survey is expected at 25.0 vs. 31.9 in December. Philly Fed reports Thursday and is expected at 19.8 vs. 15.4 in December. These readings, while down from December, would still be relatively high and suggests ongoing strength in the manufacturing sector. November TIC data will also be reported While this is old news, we expect the data to show continued foreign inflows into the U.S., drawn by comparatively higher yields. We suspect this trend will continue in 2020.


U.K. reported firm labor market data. Unemployment for the three months ending in November fell a tick to 4.1% vs. expectations that it would remain steady. The rate is the lowest since June 2020 and came as employment rose 60k over the same period vs. 125k expected and 149k previously. Average weekly earnings rose 3.5% y/y in November, moving real wage growth into negative territory for the first time since July 2020. Of note, the number of payrolled employees jumped 184k in December vs. 130k expected and a revised 162k (was 257k) in November. It appears that the omicron variant is so far having little impact on the U.K. economy, and may give policymakers more confidence to tighten.

Bank of England tightening expectations remain elevated. WIRP suggests over 90% odds of another hike February 3, followed by hikes at very other meeting that would take the policy rate to 1.25% by year-end. We think this pricing overstates the BOE’s need to tighten, as headwinds abound from Brexit, higher energy costs, and fiscal tightening. Along the way, Quantitative Tightening will also kick in as the policy rate moves higher. The hawkish BOE outlook that had helped sterling outperform is getting crowded out a bit lately by the more hawkish Fed outlook. After peaking near $1.3750 last week, sterling is down three straight days and trading near $1.36. Upcoming retracement objectives from the January rally come in near $1.3590 (50%) and $1.3550 (62%). A break below $1.3550 would set up a test of the January 3 low near $1.3430.


Two-day Bank of Japan meeting ended with a dovish hold. As leaks had suggested, the bank upgraded its inflation risk assessment for the first time since 2014. Other leaks had suggested some bank officials wanted to start preparing markets for eventual removal of accommodation. Governor Kuroda quashed such notions by stressing “We’re expecting long- and short-term policy rates to remain at the current low levels, or fall even lower. Raising rates is unthinkable.” He emphasized that any moves to normalize policy would not happen until the 2% core inflation target is reached. There were some modest tweaks to the macro forecasts in its Outlook Report, but it remains clear that inflation is not seen high enough to warrant any talk of tightening. Of note, FY24 will be added to the forecast horizon in the April Outlook Report and is likely to show inflation falling well short of 2%, which would imply no tightening until FY25 at the earliest.

This was a very strong effort at damage control by Kuroda. However, it’s clear that there are some on the MPC that are uncomfortable with the bank’s stance during this period of rising inflation. Kuroda will likely continue working to get these unnamed BOJ officials back on the same song sheet. USD/JPY traded above 115 today for the first time since January 12 and has nearly retraced half of this year’s tumble. A break above 115.25 is needed to set up a test of the cycle high near 116.35 from January 4.

The PBOC cut its 1-year Medium-term Lending Facility rate Monday by 10 bp to 2.85%. This was the first cut in nearly two years. This move will likely be followed by commercial banks setting the 1- and 5-year Loan Prime Rates lower Thursday. Of note, this weekend’s batch of data were mixed. Q4 GDP growth came in stronger than expected at 1.6% q/q and 4.0% y/y. However, retail sales came in weaker than expected at 1.7% y/y and IP came in stronger than expected at 4.3% y/y. PBOC Deputy Governor Liu said China will work to keep the yuan stable, noting that market and policy forces will help correct any deviations from its equilibrium level. Liu added that the PBOC will also open its “monetary policy toolbox wider” and roll out more policies to stabilize growth.

The widening monetary policy divergence between the Fed and the PBOC is unmistakable. The 2- and 10-year yield differentials between the U.S. and China have fallen steadily and are at multi-month lows. This should discourage fixed income inflows into China and eventually weaken the yuan. We’re not quite there yet, however, as USD/CNY just traded at a new cycle low today near 6.3380. Liu’s comments suggest increasing concern about the strong yuan and we expect other policy tweaks besides rate cuts that are meant to weaken the currency.

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