Dollar Firms Amidst Much Noise, Weak Signal

dollar currency graph marc

  • The dollar was firm before its Brainard-induced gyrations, and it has regained its footing
  • China reported firm August IP and retail sales
  • The UK and Sweden both reported lower than expected August CPI
  • South Africa’s current account gap narrowed; Brazil reports July retail sales

The dollar is broadly firmer against the majors as risk off trading picks up again. The Norwegian krone is the exception and is outperforming while the dollar bloc and sterling are underperforming. EM currencies are mostly weaker. THB and TWD are outperforming while MYR, MXN, and ZAR are underperforming. MSCI Asia Pacific was down 0.1%, with the Nikkei rising 0.3%. MSCI EM is up 0.2%, with Chinese markets falling 0.1%. Euro Stoxx 600 is up 0.1% near midday, while S&P futures are pointing to a lower open. The 10-year UST yield is down 2 bp at 1.65%. Commodity prices are mixed, with oil down 2-2.5%, copper up 0.7%, and gold up 0.1%.

The dollar was firm before its Brainard-induced gyrations, and it has regained its footing.  It was technically notable that the euro remained confined to the previous session’s range. It requires a move above the $1.1270-1.1300 band to lift the tone.  On the downside, initial support is pegged at $1.1200.  The dollar was pushed a bit lower in Asia against the yen, falling to nearly JPY101.40.  It stopped shy of the objective we saw near JPY101.20.  The JPY102.15 area marks the first hurdle.

Sterling remains in narrow ranges around $1.3300.  The dollar-bloc is under some pressure.  The Australian dollar rally yesterday has been pared and it is back probing support in the $0.7500 area.  A break of $0.7480 may shake out some of the late longs.  We continue to look for the greenback to test CAD1.3150 on its way to CAD1.32.

Our approach to Fed-watching is clear.  Among the cacophony of voices, the Troika of Fed leadership Yellen, Fischer, and Dudley provide the clearest signal.  They are most often on message, and their comments have been the best indications of policy.

Remember at the end of last summer; Dudley said a rate hike was less compelling.  This foretold the lack of hike last September.  Earlier this year, as several regional presidents were talking up a rate hike, Yellen pushed against it.

Governor Brainard is the newest member of the Board of Governors.  Well, technically, Fischer was confirmed at the same time, but his experience is vastly superior.  Brainard has completed a little more than 2 years of her 12-year term.  This is not to impeach her comments.  They are thoughtful and well considered.  They were thoughtful and well considered six months ago too.  She has not changed her assessment, though circumstances have changed.

First, the global risks appear to have eased.  The UK referendum has come and gone.  The global capital markets have become decoupled to a large extent from what happens to the Chinese yuan and stocks.  It is the politics of several emerging market countries (like Brazil, Mexico, Turkey, and South Africa), not the economics that has been the source of consternation by investors.

Second, the nine-month soft-patch in which the US economy grew less than 2% appears to be ending now.  We are familiar with three regional Federal Reserve’s GDP trackers.  The St. Louis Fed’s and the Atlanta Fed’s models point to an annualized pace of more than 3% here in Q3.  The NY Fed says the economy is tracking 2.8%.

Third, the fact that the Fed does not have conventional monetary tools at its disposal is an argument that has been developed to encourage policymakers to gradually raise interest rates.  However, Brainard turns this argument on its head.  She suggests that the limited arsenal should make the Fed even more cautious about taking risks, such as raising rates.

Brainard argued that guarding against downside risks is preferable to preemptively raising rates to guard against upside risks.  This seems to misunderstand the purpose of raising rates.  It is not to ward off too tight of a labor market or too strong of growth or too high of inflation.  A series of several rate hikes over the next couple of years would give it the interest rate tool again.

We can agree with Brainard that there is no hurry and the Fed should be cautious as macroeconomic relations may have changed, such as employment and inflation.  However, given the forward momentum of the economy, the improvement in the labor market, the modest upward pressure on prices, the Fed has arguably been cautious and patient.  Would a second rate hike in two years change that assessment?

We wonder too if the significance of 25 bp increase in the Fed funds target range is not being exaggerated.  The real funds rate remains below zero, which is a measure of the monetary stance, even on a 25 bp increase.  It is hard to see the impact of the December 2015 rate increase.  Three-month LIBOR has risen nearly as much due to the reforms in the US money market as it did in response to the Fed’s hike.   At the end of the day, we agree with Brainard.  Monetary policy should be cautious and prudent.  A 25 bp hike does not make the Fed incautious or imprudent.

Nevertheless, Brainard is the second Fed Governor (Tarullo being the other) that seemed to demur from the Troika (Yellen, Fischer, and Dudley).  The market downgraded the chances of a Fed hike in September.  Bloomberg’s calculation (WIRP) fell from 30% before the weekend to 22%.  The CME (where the contract is traded) saw the probability falling to 15% from 24%.  For the record, the probability shift was a function of the implied yield falling three-quarters of a basis point to 41 bp.

The US two-year note yield fell a little more than a single basis point on Monday.  The decline in response to Brainard was less than 4 bp from the 80 bp level that was seen as the pre-weekend move was continued.  The Financial Times called this a “plunge” but this is clearly hyperbolic.  Recall that as recently as the middle of last week, the yield was near 71 bp.

While the dollar and US interest rates were little changed at the end of the session, the S&P 500 sustained a strong bounce.  The S&P 500 open below the pre-weekend lows.  This created a gap that was soon filled.  The gap created by last Friday’s sharply lower opening is key.  It is found between 2169.06 and 2177.49.  To repair the technical damage, the S&P 500 would ideally close above the top of that range.  Most bullish would be a gap higher on Tuesday, which simply does not look to be in the cards.

Asian stocks performed poorly in light of the US equity rally and Chinese economic data.  The MSCI Asia-Pacific was down 0.1%, while MSCI EM is up 0.25% in the European morning.  China reported a series of data that lend credence ideas that the world’s second-largest economy is stabilizing.  In turn, that keeps speculation of easier monetary policy in check.

China’s industrial output rose 6.3%, a little better than expected and a bit faster than the 6.0% pace in July.  Retail sales rose 10.6% after a 10.2% gain in July.  Fixed investment rose 8.1% in the first eight months.  This is steady from the rate reported in July, but it is a little above expectations.

Some economists use power output to generate insight into growth, with the GDP figures seen as suspect.  Power output rose 7.8% in August from a year ago.  Just like capital investment in China has reached a point of diminishing returns, so too has energy output. There may be a gap between energy output and consumption.  It may also be that low energy costs have deterred efficiencies.  Also, the increase power output may reflect more industrial activity.

One detail that caught our attention was China’s steel output.  Recall that excess capacity in that industry is sufficiently salient to make it into the G20 statement.  Chinese officials have indicated intentions on shuttering some capacity.  They have around half of the world’s steel capacity.  However, today’s data showed steel output was 3% higher in the year through August.

The UK reported August CPI.  Headline inflation was 0.6% y/y vs. 0.7% expected, while core inflation was 1.3% y/y vs. 1.4% expected.  UK consumer prices were flat in 2015 (December CPI was zero year-over-year).  It stood at 0.5% in June and rose to 0.6% in July.  The core rate has been essentially flat.  It was 1.4% at the end of last year, and in August it edged up from 1.3% in July.

The UK reports labor market data tomorrow and retail sales Thursday, but so far, the impact from the Brexit vote remains limited.  As such, the BOE is widely expected to remain on hold Thursday.

Germany ZEW survey for September came in at 0.5 vs. 2.5 expected.  The current situation components fell to 55.1 from 57.6, while 56.0 was expected.  ZEW President noted that “The current ambiguity of economic impulses from Germany and abroad means that forecasts for the next few months are difficult.”  Yet it’s clear from recent data that the eurozone’s largest economy is slowing, despite Draghi’s more upbeat economic assessment last week.

Sweden reported August CPI.  Headline inflation was 1.1% y/y vs. 1.2% expected, while CPIF remained steady at 1.4% y/y vs. 1.5% expected.  The next Riksbank meeting is October 27.  A lot can happen between now and then, but for now, markets see steady policy then.  However, further disinflation in the coming months would suggest that the Riksbank may eventually have to do more.

South Africa reported Q2 current account gap at -3.1% of GDP.  The Q1 deficit was revised to -5.3% of GDP from -5.0% previously.  While the narrower current account gap would normally be considered ZAR-supportive, the improvement is being driven by weak consumption.  Indeed, with the economy remaining weak, the SARB is likely to keep policy on hold at 7% at its next policy meeting September 22.  The rand is the wild card going forward, as weakness could feed into higher inflation.  The rand is also one of the most vulnerable currencies in this risk off environment.

Brazil reports July retail sales, which are expected at -5.1% y/y vs. -5.3% in June.  The economy remains weak, but inflation may be too high to start the easing cycle at the next COPOM meeting October 19.  With fiscal and monetary policies remaining tight, the economic outlook is not so good near-term.