US Dollar On Top – All Eyes On Jackson Hole

Although risk assets rallied at the end of last week, weaker than expected US July retail sales data and China’s July data slate including industrial production and retail sales, helped to intensify growth concerns.  As it is, many indicators are showing that we are past peak growth. US economic surprises are becoming increasingly negative as reflected in the Citi US economic surprise index, which has fallen to its lowest level since May 2020.  Combined with intensifying Delta virus concerns, worsening supply chain pressures and sharply rising freight rates as reflected in the spike in the Baltic Dry Index to its highest since June 2008, it has led to a marked worsening in investor risk appetite.  This has been compounded by China’s regulatory crackdown and rising geopolitical risks in Afghanistan

The US dollar has been a key beneficiary while safe haven demand for Treasuries has increased and commodity prices have come under growing pressure.  Equity markets wobbled last week after a prolonged run up though the pull back in the S&P 500 looked like a healthy correction rather than anything more sinister at this stage.  The moves in the USD have been sharp, with the USD index (DXY) rising to its highest since November 2020 and EURUSD on its way to testing the 1.16 low.  Some Asian currency pairs broke key levels on Friday, with USDCNH breaking through 6.50.  Safe haven currencies such as CHF and JPY are holding up much better, highlighting that USD demand against other currencies is largely due to a rise in risk aversion while currencies such as CAD appear to be pressured by weakening commodity prices.  

This week attention will turn to the Jackson Hole Symposium (Fri) where markets will look for clues to the contours of Fed tapering.  Fed chair Powell is likely to repeat the message from the July minutes, with QE tapering likely by year-end if the labour data continue to strengthen.  Markets will be on the lookout for any further clues on the timing and shape of tapering. Separately the US July Core Personal Consumption Expenditures (PCE) report is likely to show a high 3.6% y/y increase though this is unlikely to change the Fed’s perspective on transitory inflation pressures.  Monetary policy decisions in Hungary (Tue) and Korea (Thu) will be in focus, with the former likely to hike by 30bps and the latter on hold, albeit in a close decision.  Ongoing US budget talks and European Central Bank minutes (Thu) will also be in focus. Finally, closer to home New Zealand (Tue) and Australia (Fri) retail sales reports are in focus. 

Market Cross-Currents

There are many cross currents afflicting markets at present.  Equity valuations look high but US earnings have been strong so far, with close to 90% of S&P 500 earnings coming in above expectations. This has helped to buoy equity markets despite concerns over the spreading of the Delta COVID variant and its negative impact on recovery.  Yet the market doesn’t appear entirely convinced on the recovery trade, with small caps continuing to lag mega caps. 

The USD index (DXY) remained supported at the end of last week even as US yields remain capped, but the USD does appear to be losing momentum. Positioning has now turned long according to the CFTC IMM data indicating that the short covering rally is largely exhausted; aggregate net USD positioning vs. major currencies (EUR, JPY, GBP, AUD, NZD, CAD & CHF as a percent of open interest) turned positive for the first time in over a year. 

Inflation fears have not dissipated especially after recent above consensus consumer price index (CPI) readings, for example in the US and UK.  Reflecting such uncertainty, interest rate market volatility remains high as seen in the ICE BofA MOVE index while inflation gauges such as 5y5y swaps have pushed higher in July.  There was some better news on the inflationary front at the end of last week, with the Markit US July purchasing managers indices (PMIs) revealing an easing in both input and selling prices for a second straight month, albeit remaining at an elevated level. 

This week we will get more information on inflation trends, with the June Personal Consumption Expenditures (PCE) report in the US (Fri), Eurozone July CPI (Fri), Australia Q2 CPI (Wed) and Canada June CPI (Wed), on tap this week.  We will also get to see whether the Fed is more concerned about inflation risks at the Federal Open Markets Committee (FOMC) meeting (Wed).  The Fed is likely to continue to downplay the surge in inflation, arguing that it is transitory, while the standard of “substantial further progress” remains a “ways off”.   Nonetheless, it may not be long before the Fed is more explicit in announcing that is formally moving towards tapering. 

An emerging markets central bank policy decision in focus this week is the National Bank of Hungary (NBH) where a 15bp hike in the base rate is expected.  Central banks in emerging markets are taking differing stances, with for example Russia hiking interest rates by 100 basis points at the end of the week while China left its Loan Prime Rate unchanged.  The July German IFO business climate survey later today will be in focus too (consensus 102.5).  Overall, amid thinner summer trading conditions market activity is likely to be light this week.

Game Changer

Pfizer and BioNTech’s game changing announcement that its vaccine had been found to be more than 90% effective in a late stage trial added more fuel on a stock market rally that was already underway following President-elect Biden’s election win and likely split Congress.  It was the time for beaten up value/travel/oil stocks to shine while conversely stay at home stocks have come under pressure.  However, that story appeared to reverse overnight, with tech stocks making a comeback, suggesting that it’s not going to be a one way bet for value stocks. 

One obstacle is the rampant increase in virus cases in the US and Europe and risks of more lockdowns. Though the vaccine news is clearly positive its worth highlighting that it could take some time for any vaccine to be rolled out in sufficient numbers to allow for an opening up of economies anytime soon.  In the meantime, we still have to contend with a big wave of virus infections in Europe and US, which implies more economic pain to come.  All of this could put a renewed dampener on risk sentiment and limit the rally in stocks in the near term.  

Technical indicators (Relative Strength Index) suggest resistance in the short term; for example, the US Russell 2000 index (a broad small cap index) is verging on hitting Fibonacci retracement levels around 1746, while its also above its upper Bollinger band.  Not helping tech stocks is the regulatory stance, with Amazon hit by an antitrust charge from regulators in the EU.  The USD’s weakness also looks overdone in the short term. In particular, technical indicators show that Asian currencies and dollar bloc currencies (CAD, AUD, NZD) look stretched. The USD is likely to make further gains in the short term even as its medium term outlook remains more negative.

Meanwhile Republicans are increasingly standing with President Trump in not accepting the outcome of the election, fuelling concerns about the transition process, even as President-elect Biden’s lead in various states has grown. Many are doing so with an eye on 2024 elections. Georgia is auditing the presidential results in its state by hand, but even so, it seems extremely unlikely that Trump can reverse Biden’s 14k lead in the state and even if that does occur it wouldn’t change the outcome. 

Rising risk aversion

The US ADP November jobs report and October new home sales both beat expectations yesterday piling on the pressure on US Treasuries and adding further weight to support those looking for the Fed to taper at the December 17-18 FOMC meeting. Consequently non farm payrolls expectation will likely be revised higher from the current consensus of around 180k. In contrast the ISM non manufacturing index came in below consensus, with the jobs component slipping. US equities ended marginally lower while the USD held its ground. However, risk measures such as the VIX “fear gauge” moved higher. Rising risk aversion may reflect expectations of imminent tapering and some angst ahead of US budget talks.

US November payrolls data to be released tomorrow will be crucial to provide more decisive clues to the timing of Fed tapering. Attention ahead of the jobs report will turn to the European Central Bank policy decision where no action is expected although some downward revisions to staff forecasts are likely. We continue to expect a more aggressive ECB stance into 2014. The Bank of England and Norges Bank will also decide on policy rates but no change is expected in both cases. In the US an upward revision to Q3 US GDP is expected to around 3.1% QoQ annualised while jobless claims will also be in focus. Market nervousness is likely to continue today although activity is likely to be limited ahead of the US payrolls data tomorrow.

The USD should be supported due to higher US Treasury yields although USD/JPY has lost some ground in the wake of higher risk aversion. The large short JPY market position may also be limiting the JPY’s downside for now. EUR/USD is trading shy of its recent highs above 1.36 and could be vulnerable to a dovish ECB statement today as well as to growth forecast downgrades by the ECB. AUD continues to remain under pressure having traded just below 0.90 overnight in the wake of disappointing GDP data yesterday and is likely to remain vulnerable to further slippage. CAD was further undermined by a relatively dovish Bank of Canada statement following the decision overnight to leave policy rates unchanged.

Given that US Treasury yields have risen by around 33bps since the end of October it is worth looking at which currencies are most sensitive to rising yields. In Asia the most correlated currencies with 10 year US Treasury yields over the last 3 months and therefore most vulnerable currencies are the SGD, THB, and MYR. The least sensitive have been CNY, IDR and KRW. Playing long KRW / short SGD appears to be a good way of playing an environment of rising US yields, especially given that yields are set to continue to rise over the coming months.

It’s all about communication

Calm has settled over markets as anticipation builds ahead of tomorrow’s Fed FOMC outcome. Equity markets registered broad based gains globally while US yields rose and the USD stabilized. It’s worth reiterating that effective Fed communication is the key to ensure that this calm continues otherwise market volatility will quite easily return.

Yesterday’s mixed data releases did not offer much to the debate on Fed policy as the Empire manufacturing survey rose more than expected but disappointed on the detail, while home builders’ confidence jumped. May CPI inflation data will perhaps offer more clues today, with a benign reading likely to ensure that markets do not get carried away in expecting any major shift in Fed policy. In Europe, a likely decline in the German ZEW investor confidence survey in June will do little to boost confidence in recovery.

GBP/USD has rallied impressively over recent weeks although much of its gain has been spurred largely by USD weakness rather than inherent GBP strength. Nonetheless, UK data has looked somewhat more encouraging, a fact that has played some role in reinforcing GBP gains. Whether this continues will depend on a slate of data releases this week including retail sales on Thursday. CPI inflation data (today) and Bank of England MPC minutes (tomorrow).

On balance, I look for UK data to continue to paint an encouraging picture of recovery, which ought to provide further support for GBP. However, the risk / reward does not favor shorting the USD at present and I suggest playing further GBP upside versus EUR.

CHF has strengthened as risk aversion has flared up. While I remain bearish CHF over the medium term the near term outlook will be driven by risk gyrations (given the strong correlation between CHF and our risk barometer). Both EUR/CHF and USD/CHF have already fallen sharply having priced in higher risk aversion.

Obviously much in terms of risk appetite will depend on the Fed FOMC outcome tomorrow and I would suggest caution about shorting the CHF just yet. Additionally Swiss data in the form of May trade data and more importantly the SNB policy decision this week will be watched closely, especially given the threat by SNB Jordan of implementing negative interest rates. I don’t expect any shift in policy on Thursday, however, leaving USD/CHF firmly supported around 0.9130.

Since Fed Chairman Bernanke highlighted the prospects of Fed “tapering” during his testimony on May 22 commodity currencies have performed poorly. The notable exception has been the CAD which has eked out gains over recent weeks. Like GBP, the CAD has been helped by relatively positive data releases, which in turn have prompted growing expectations of policy rates hikes from the Bank of Canada. Market positioning in CAD remains relatively short, suggesting more scope for gains over coming weeks. Meanwhile, data this week including May CPI and April retail sales will be scrutinized for clues as to the next move from the BoC and in turn whether gains in CAD are justified.

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