Dollar likely to remain a buy on dips, strategists think

What had looked to be a promising start to the week for US equities, which at one point during Monday’s session saw major bourses holding onto gains of more than 0.5%, quickly unravelled and, in the end, the major US bourses posted losses on the day of around 0.7% each. That saw the S&P 500 reverse from early session highs just above 4400 to close the session around 4360. There wasn’t much by way of fresh news of catalysts to drive trade. Rather, market participants would have spent much of yesterday’s session fretting about known risks to the economic outlook, including the recent sharp rise in energy prices, about increasingly hawkish expectations for rate hikes from major central banks, and about slowing global growth momentum. A surge higher in oil prices during yesterday’s session, where WTI was at one point above $82.00 per barrel (its highest since 2014) served to worsen these inflation fears, which was reflected by a further rise in global bond yields (excluding the US, where bond markets were closed for Columbus Day) and break-even inflation expectations; the German 10Y yesterday hit its highest level since May, though it is worth noting that some of the recent rise can be attributed to rising real rates, perhaps a reflection of money markets pricing an increasing chance that the ECB starts raising interest rates significantly earlier than it is currently guiding.

Looking at how markets are performing thus far this Tuesday; it was a broadly downbeat session in Asia Pacific markets, with the Shanghai Comp, Hang Seng and Kospi 50 all losing more than 1.0% and the Nikkei 225 dropping just short of 1.0%, with market commentators in the region citing familiar concerns about energy price rises and a more intense build-up of inflationary pressures that may prompt a more hawkish central bank response as reasons for the downside. Developments in China were also a cause for concern, with the WSJ reporting that the Chinese Communist Party is to tighten scrutiny and oversight of state-run banks amid concerns that their relationship with the private sector have become too “cozy” and thus have enabled a worsening of credit quality, which (as the WSJ put it), comes amid a widening push to curb the power of capitalist forces in the Chinese economy. There was also more negative news flow about missed coupon and principal payments from Evergrande and another major developer (Sinic Holdings Group), which has served to keep the negative theme of deteriorating Chinese financial stability in the spotlight. European markets have mostly taken their cue from the downbeat Asia Pacific tone, though in fairness, stocks there are off earlier lows and the Stoxx 600 is currently down just 0.1% this morning having found decent support at 450 and bounced back above 455. Similar price action can be seen in pre-US open equity market trade, with E-mini S&P 500 futures having bounced at last week’s low in the 4320s to current levels where it trades roughly flat on the day around 4360.

But taking a broader look at the S&P 500’s recent performance, the recent negative trend appears to remain strongly intact; since posting record highs above 4500 in early September, the index appears to have been gradually moving to post lower lows followed by lower highs. Should this trend continue, that would suggest the index is at some point in the next few days/weeks headed below the current October low at 4280. At current levels, the index is only trading just over 4.0% below recent highs and these losses, some strategists might argue, may not fully reflect the build-up in equity market risks seen over the past few months; Deutsche Bank pointed out in a note this morning that median US inflation expectations (i.e. from polls of investor/economist forecasts) for 2021 have risen from close to 2.0% at the start of the year to well above 4.0%. Over the same period, money markets have brought forward pricing for the first post-pandemic rate hike from the FOMC to as soon as Q3 2022 from market pricing back in January for a first-rate hike in 2024. Expectations for higher US (and global) inflation are, of course, the direct cause of the market’s increasingly hawkish expectations for Fed policy. All points to a more challenging outlook for equities; higher interest rates hurting valuation and higher inflation potentially hurting the economy, thus hurting the prospect for real earnings growth.

In terms of global bond markets this morning; German yields continue to hang out close to recent highs just under -1.0% and US bonds markets have opened up again and the treasury curve is seeing some quite pronounced flattening. 2-year US yields have surged to fresh post-pandemic highs at 0.35% as the short-end races to catch up the recent hawkish repricing in US money markets; note that money markets are now pricing a near-50% chance that there will have been at least two 25bps rate hikes by the Fed by the February 2023 FOMC meeting. Meanwhile, after opening the week sharply up and at multi-month highs above 1.63%, but having found resistance at the early June highs, 10-year yields are seeing a bit of downside and are currently testing the 1.60% level. 10-year real yields continue to trade sideways around -0.9% and close to where they have been for most of the last two weeks. That suggests that bond markets might be taking the view that, despite fears that the US (and global) economy is headed towards a higher inflation regime, the Fed will not be able to tighten enough to bring real yields back into positive territory given concerns about the outlook for long-term growth. Perhaps that is reading too much into it, as others might argue that US real yields are destined to move higher as significant monetary tightening from the Fed draws closer.

Turning now to take a look at how G10 FX markets are performing this morning; the US dollar is flat with the DXY still within recent intra-day ranges around the 94.30 mark, despite many analysts/commentators taking the view that recent market developments ought to be positive for the buck. Danske Bank suggest that as long as the general tone of markets remains one of risk-off and yield spreads continue to move in favour of the dollar amid expectations for a more hawkish/proactive Fed when it comes to tackling inflation versus the likes of the ECB and BoJ, the dollar should remain supported. ING agree, saying the buck is likely to remain a buy on dips ahead of tomorrow’s US CPI report and FOMC minutes release, both of which will provide further colour on the inflationary backdrop and monetary policy discussions taking place in the US.

EURUSD, meanwhile, is flat on the day and continues to linger within recent ranges around the mid-1.1500s, but not far above recent lows. A divide between the ECB hawks and doves is becoming more evident, with the usual ECB hawks such as Klass Knot taking their cue from the comparatively more hawkish BoE and flagging concerns about a more persistent rise in inflation, but the ECB doves like ECB Chief Economist Lane continuing to insist that the recent spike in inflation is a “one-off”. The dovish majority at the ECB ought to ensure that the ECB’s rate-hiking cycle remains well behind that of the likes of the BoE and Fed, and that the bank’s PEPP will be replaced by a smaller but still beefy QE programme when it expires in March. Given expectations for the ECB to be much less likely to respond to rising inflationary pressures than other central banks, this ought to keep EUR broadly on the back foot, argue FX strategists, with some also citing recent downwards revisions to near-term Eurozone growth estimates given 1) the negative impact on industrial output from global supply chains disruptions, which are being felt most acutely in manufacturing hubs like Germany, as well as 2) the sharp rise in energy costs is set to weigh on consumer purchasing power. This morning’s weaker than forecast German ZEW survey for October will hardly help these concerns, though EUR has not shown much of a reaction as of yet.

Looking at the rest of the G10, AUD and NZD are outperforming and are up about 0.5% on the day versus USD each, helped in recent trade by the recovery of global stocks from earlier lows this morning. A sharp rise in metal prices in recent days (the Bloomberg Industrial Metal Subindex or BCOMIN has surged from close to 160 to above 170 over the past five sessions) is helping the Aussie gradually push to its highest levels in more than four weeks close to 0.7400, though if the dollar does start to broadly press higher again, these recent gains remain at risk of being quickly eroded. CAD and GBP are up about 0.2%, meanwhile, with USDCAD eyeing a test of its lowest levels since late July with the energy export-dependent Canadian economy standing to be a great beneficiary of the recent sharp rise in global fossil fuel prices (other energy exports such as NOK, RUB and COP have all benefitted while big energy importers TRY and JPY have suffered). GBPUSD, meanwhile, continues to hold above 1.3600. The pair didn’t show much of a reaction to decent UK jobs data this morning that saw the economy (according to HMRC payroll data) add over 200K employees in September and the unemployment rate drop to 4.5% in the three months to August. The consensus take from analysts of the data was that it shouldn’t push back on the market’s increasingly hawkish pricing for BoE rate hikes – markets are pricing a 15bps hike to 0.25% with near certainty before the end of the year and recent hawkish remarks from the like of Governor Bailey, Chief Economist Pill and MPC member Saunders seemed to endorse this view. One key X factor for the BoE to consider is how the end of the government furlough scheme in September impacts the labour market in the near term, with this impact not likely to be fully understood until December – if labour market conditions hold up, this ought to solidify expectations for an imminent rate hike from the bank.

Increasingly hawkish expectations for an imminent BoE rate hike have sent short-end UK bond yields flying higher; UK 2-year continue to surge and crossed above 0.6% yesterday, up from under 0.3% before the 23rd of September BoE policy meeting. This surge in UK yields has not been able to offer GBP as much support as might typically be expected, some analysts have pointed out. Perhaps this reflects concerns amongst market participants that the BoE’s (likely) hawkish stance is not appropriate given expectations for economic weakness in the UK over the coming months. Remember that the UK economy faces risks including continued severe supply chain chaos, a sharp rise in energy costs that are set to damage household purchasing power, a meaningful tax hike in April (1.25% more on both employers and employees to fund national insurance) and wind down in fiscal stimulus (the end of furlough and a £20 reduction in the weekly universal credit allowance) – adding rate hikes to the mix gives economists further reasons to revise lower UK growth expectations for 2022. That might, in the end, mean that the BoE are not able to lift interest rates as high as they might currently want to, which may be (net-net) negative for sterling. A rise in Brexit tensions with Brexit Minister Frost today expected to shoot down a proposal on the Northern Ireland protocol from the EU are also being cited as sterling negative and could lead to further supply-side disruptions for the UK. For the time being, MUFG maintain a short bias on sterling, despite the comparatively hawkish BoE, as a result of the above risks.

Finally in FX, much has been made of the recent surge higher in USDJPY. The pair is this morning consolidating in the mid-113.00s having yesterday surged to its highest levels since December 2018. The main driver of the move higher has been a further widening of US/Japan rate differentials (that attract flows of money out of Japan and into the US, given the higher yields on offer) – this divergence is being driven by a rise in global inflation expectations (aside from in Japan, where it seems inflation cannot get a foothold), to which the Fed is expected to react (with rate hikes as soon as Q3 2022) but the BoJ is not. FX strategists also note that the surge in global energy prices is also having an impact on the pair via shifting expectations for terms of trade; the US is a net energy exporter, so its trade balance is expected to be a net beneficiary of the spike in prices, while the situation is the exact opposite for Japan, one of the world’s major energy importers (as noted above).

Looking ahead to the rest of the day, market focus will be on central bank speakers, US labour market data and US debt auctions. Starting with the former; ECB Chief Economist Lane is speaking (again) at 1330BST, followed by fellow Governing Council member Elderson at 1400BST. In the afternoon/evening, it’s the turn of FOMC members Clarida, Bostic and Barkin. US JOLTs Job Opening data out at 1500BST ought to reinforce the fact that the major obstacle to further employment gains in the US is a lack of labour supply, not demand, as it will likely show the number of job openings in the economy to be close to 11M (significantly more than the number of unemployed persons). We then have 3 and 10-year US government bond auctions at 1630BST and 1800BST respectively, with the former an offering of $58B and the latter an offering of $38B in debt.