Dollar Remains on the Defensive

new united states

  • The US dollar is narrowly mixed after selling off following the FOMC statement 
  • The bottom line is that the scenario we suggested after the June FOMC meeting remains most likely 
  • The US economic calendar includes weekly jobless claims, preliminary durable goods orders, merchandise balance, and wholesale and retail inventories 
  • After markets closed last night, COPOM cut rates 100 bp to 9.25%, as expected 
  • Central Bank of Turkey is expected to keep rates steady; Colombian central bank is expected to cut rates 25 bp to 5.5%  

The dollar is mixed against the majors. Sterling and the dollar bloc are outperforming, while the Scandies and Swiss franc are underperforming. EM currencies are mixed. KRW and TWD are outperforming, while the CEE currencies and ZAR are underperforming. MSCI Asia Pacific was up 0.9%, with the Nikkei rising 0.2%. MSCI EM is up 0.8%, with the Shanghai Composite rising 0.1%. Euro Stoxx 600 is down 0.1% near midday, while S&P futures are pointing to a lower open. The 10-year US yield is up 1 bp at 2.30%. Commodity prices are mostly higher, with oil up 0.3%, copper up 0.8%, and gold up 0.1%.

The US dollar is narrowly mixed after selling off following the FOMC statement. Sometimes the narrative explains the price action, and sometimes the price action explains the narrative. This seems to be the case of the latter. The dollar and interest rates fell, and so the Fed was dovish.

First, let’s turn to the fall interest rates. At the end of last week, the two-year note yielded 1.34%. It rose slightly at the start of the week and fell slightly yesterday. It sits at 1.35% now. The December Fed funds futures contract finished last week with an implied yield of 1.225%. It had risen to 1.24% on Tuesday, but finished yesterday at 1.225%. This shows that expectations for the trajectory of Fed policy have not changed. The 10-year yield, which has less directly to do with Fed policy, is five basis points higher this week.

Second, consider that the dovish read of the consensus narrative was based on the changed characterization of the current situation, not in the forward-looking section. The FOMC statement said that inflation was “below target” (not “persistently” as some press accounts characterized it) as opposed to the previous statement in June that said, “somewhat below target.” The FOMC did not change its assessment that inflation would move toward its target in the medium term.

Third, consider the inflation data that have been released since the mid-June meeting. The May PCE deflator was released at the end of June. As was seen with the May CPI, which was released a few hours before the June FOMC meeting concluded, the core PCE deflator eased for the fourth consecutive month. There was the June CPI in mid-July. The headline rate eased to 1.6% from 1.9%, but the core rate was unchanged at 1.7%. This is to say that there has been limited high frequency price data over the past six weeks, which also limits the significance we attach to the word “somewhat” in the economic description.

The bottom line is that the scenario we suggested after the June FOMC meeting remains most likely. That is for the FOMC to announce in September (“relatively soon”) that it will not completely rollover maturing securities but will instead allow some to roll-off. This will allow it to retire an equivalent amount of excess reserves, and through this allow its balance sheet to shrink. By doing so in September, it also succeeds in distancing its balance sheet operations from monetary policy. It also allows the Fed to “closely watch” the evolution of prices (inflation). The CME calculation puts the odds of a December hike near 47% while the Bloomberg model is a little lower.

The news stream is light. Of note, Moody’s raised its outlook for China’s banking system to stable from negative. It expressed confidence in its regulators to manage the risks emanating from the shadow banking sector and forecast that the growth of new bad loans will moderate. Recall Moody’s cut the sovereign rating in May on its rising debt levels. Today’s announcement culminates an eight-month process whereby Moody’s upgraded rating on medium-sized banks last October, and five large banks a few months ago. Lenders with stable outlooks by Moody’s account for nearly 90% the total assets of the Chinese banks that it rates.

Asian shares rallied. The MSCI Asia Pacific Index rose nearly 1% to new multi-year highs. Favorable earnings reports by Samsung and Nintendo were among the highlights. The Nikkei advanced slightly even though the yen had strengthened. European markets are mixed, and the Dow Jones Stoxx 600 is little changed. Health care and industrials are the main drags, while telecom and consumer staples sectors are up more than 1%. It is an important earnings day for European companies, and some of the divergences in performance are due to the story stocks.

The US economic calendar includes the weekly jobless claims (expected to bounce back after last week unexpected fall), preliminary durable goods orders for June (expect a strong recovery in the headline after soft May), the June merchandise balance (expect little change) and wholesale and retail inventories. Economists will fine tune their forecasts for Q2 GDP which will be reported tomorrow. We have penciled in 2.25%. The Senate Banking Committee holds confirmation hearings on Fed nominee Quarles today.

Also, the Senate continues to debate and vote on various proposals to pass a health care reform bill that would get the process to move to the reconciliation phase. There, a joint committee of Republicans would bring the House and Senate versions together. Meanwhile, the House is slated to start a five-week holiday on Friday, and tax reform and the FY18 budget (spending authorization) also appears to be stalling as the split between the moderate and conservative parts of the Republican coalition are at odds.

After markets closed last night, COPOM cut rates 100 bp to 9.25%, as expected. The statement seemed to downplay political and fiscal uncertainty, suggesting another 100 bp cut at the next meeting. Markets are pricing in a 75 bp cut to 8.50% at the September 6 meeting followed by a 50 bp cut to 8.0% at the October 25 meeting, where it is expected to stay through the end of 2018. With inflation running so low, we see downside risks to the SELIC forecasts and potential for a dovish surprise at the December 6 meeting.

Central Bank of Turkey is expected to keep rates steady. Inflation has been falling but at 10.9% y/y in June, it remains too far above the 3-7% target range to start an easing cycle. We do not think last week’s cabinet shuffle will have any policy implications, since President Erdogan calls all the shots anyway.

Colombian central bank is expected to cut rates 25 bp to 5.5%. A small handful looks for a 50 bp cut to 5.25%. IP and retail sales contracted in May, while CPI inflation has fallen to 4%, right at the top of the 2-4% target range. We believe easing will continue into Q4.