The Week Ahead: Dollar Bulls Still in Charge

The poor preliminary PMI readings, the ongoing European energy crisis, and the recognized commitment of most major central banks to rein in prices through tighter financial conditions are risking a broad recession. These considerations are weighing on sentiment and shaping the investment climate. Most high-frequency data due in the days ahead will not change this, even if they pose some headline risk.  

What we have seen among some central bankers applies to market participants too. It is not so much that these central bankers are congenitally doves or hawks, but they are simply activists. Whether conditions warrant tighter or easier monetary policy, the activists lead the charge and are more aggressive than most of their colleagues in both directions. Similarly, some market participants are just extreme in their views. On the one hand, given that market returns are often characterized by fat tails, it makes sense that market views are not normally distributed. Hugging the median (there is rarely truly a consensus, despite the market jargon) draws little attention and is unlikely to promote sales of research products and newsletters.  

On the other hand, depending on the corporate culture, there may be little incentive to take the risk of standing out from the crowd. It is as if some take Keynes to heart: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." Sometimes, corporate culture is broad enough to accept either approach, allowing the idiosyncrasies of the economist/analyst wider latitude. However, some are conditioned to fear being wrong that they do not let themselves be right. For them, being part of the crowd is safe. Being part of the consensus nearly always gets less pushback than being an outlier.  

II

Three high-frequency economic prints next week will likely move the markets whether they meet expectations or not: China's PMI, the eurozone's CPI, and the US employment report. These are the three biggest economies, and each is struggling to put it mildly. The data are unlikely to change this view but could impact the policy outlook. In addition, extreme weather aggravates existing challenges, including the energy crisis, supply chain disruptions, and inflation pressures.  

The US, Japan, the eurozone, and Australia's preliminary composite PMIs fell below the 50 boom/bust level. Ironically, the UK's held slightly above, though the Bank of England of a recession that will extend into 2024. Where is China?   Its July composite stood at 52.5. It had been below 50 due to the lockdowns associated with its zero-Covid policy from March through May. It reached a 15-month high in June of 54.1.  

 In the US, we argued that back-to-back quarterly declines in output were a bit of a statistical quirk stemming from the challenge of managing inventories in the current economic environment and trade, to a lesser extent. While recognizing that a sustained economic contraction was likely, we did not think it actually had begun and expected policymakers to act accordingly.  

In China's case, the economic data is consistent with growth. The median forecast in Bloomberg's survey sees the world's second-largest economy expanding by 3.4% quarter-over-quarter after a 2.6% contraction in Q2. However, Chinese officials are acting as if it were in a recession or will be shortly. It unexpectedly shaved its benchmark one-year medium-term lending facility rate and allowed lending prime rates to be cut. The larger (15 bp) cut in the five-year rate clearly reflected the ongoing concerns about the housing market. Beijing is using command functions and coordinating capabilities to push lending from banks to the property sector and new local government borrowing for infrastructure projects. It has accepted a weaker yuan against the US dollar. It fell to a new two-year low last week. The softer the PMI, the more the market will look for further easing, including reducing required reserves.  

On August 31, the eurozone publishes its preliminary estimate of the month's CPI. Headline inflation accelerated to 8.9% in July, surpassing the US 8.5% pace. The median forecast in Bloomberg's survey is for the pace to tick up slightly to 9.0%. In addition, the core rate is seen edging up to 4.1% from 4.0%. 

Many EMU members are helping struggling households by cutting the VAT on energy or other subsidies, but the price of energy is rising even quicker. While there is some debate over whether US inflation has peaked, there is less debate in Europe. Prices are still rising. Seasonal patterns may be distorted, but July's monthly change has been less than June since 2003. August's monthly CPI has increased more than July's since 2000, with the one exception of 2020 when it matched July's 0.4% decline. This month's inflation is expected to rise by 0.4% after the 0.1% increase in July. The weakness of the euro also risks boosting prices. The single currency is off about 2.5% this month after falling roughly 4.8% in the previous two months. 

The European Central Bank meets on September 8. The swaps market is confident that even though the flash PMI warns that output is contracting, the ECB will continue to hike rates. Following the half-point increase in July, the market expects another 50 bp hike next month. More than that, the swaps market has about a 50% chance of a 75 bp move. Press reports confirmed that several ECB officials want to discuss a three-quarter point hike. That said, they do not appear in the majority. Not to get too far ahead of the game, but the market is pricing in around 85 bp of tightening in Q4 (two meetings, October 27 and December 15). The latest Bloomberg survey found a median forecast for the euro to finish the year at $1.02. This seems increasingly optimistic. A one-standard-deviation band around the year-end forward suggests a mathematical range of about $0.9430 to $1.0675. While the median is in the upper third of the range, our subjective idea would put it in the bottom third. 

That brings us to the US August employment report on September 3, just before the long holiday weekend (Labor Day, US markets closed). Recall that nonfarm payrolls rose about twice as much as expected in July, 528k. That the average growth in the first seven months was slightly above 470k. In the Jan-July period last year, the US grew about 555k jobs a month on average. However, that appears to have underestimated US job growth. In the benchmark revisions announced last week. The US added 571k more private sector jobs in the year through March, which translates into around 47.6k more a month.  

The median forecast in Bloomberg's survey has crept up in recent days to 300k. The unemployment rate, which slipped to a new low of 3.5%, is expected to remain unchanged, while a 0.4% rise in average hourly earnings could see the year-over-year pace ticked back to 5.3% year-over-year. It was at 5.2% in June and July. By nearly any reckoning, that would still be a solid report and one that will likely encourage the Fed to deliver another 75 bp hike when it meets in late September.   

Market sentiment has swung back and forth a bit over the likelihood of a third consecutive 75 bp hike. Despite the poor housing sector data and the dismal PMI, the Fed funds futures market finished last week discounting a little more than a 2/3 chance of a 75 bp instead of 50 bp. Such a move would lift the target to 3.00%-3.25%. The pricing suggests that Fed will likely slow the hikes going forward. The market is pricing in a year-end rate between 3.50% and 3.75%. The market is pricing in a strong probability of a hike in Q1 23 (~80% chance). This was unchanged from before Powell's speech at Jackson Hole. In the middle of last month, the Fed funds futures market had priced in 60 bp of cuts next year. That was the gap between the implied yield of the December 2022 Fed funds futures and the December 2023 contract. It finished last week near seven basis points., about two basis points less than before Powell's speech.

III

The dollar's two-week rally that began August 10-11 may not be over despite the volatility spurred by position adjusting around Powell's Jackson Hole speech. Powell specifically warned that some pain will be associated with efforts to rein in inflation, which the Fed is committed to doing. That seems to suggest some economic weakness will not interfere with its course until inflation convincingly moves back towards its target. Other major central banks, but the Bank of Japan, have implied pretty much the same thing.  

Dollar Index:  DXY rallied from a six-week low near 104.65 on August 10 to slightly above 109.25 on August 23. However, it stopped short of the mid-July high of almost 109.30. The sell-off before the weekend took it briefly through 107.60 to set a new low for the week before recovering to almost 108.90. The MACD is rising albeit more gently, but the Slow Stochastic is overextended and suggests that this leg up is getting long in the tooth. Still, the prospect of another healthy job report at the end of next week may deter a significant retreat. The pre-weekend low approached the minimum (38.2%) retracement of the leg up (~107.50). 

Euro:  The euro recorded a new 20-year low near $0.9900 on August 23, seeming to complete the leg down that began on August 10 at around $1.0370. However, the Jackson Hole-related position adjustment saw it recover to $1.0090, which marginally surpassed the (38.2%) retracement objective (~$1.0080). The next retracement (50%) and the 20-day moving average are found in the $1.0135-40 area. Yet, the euro continues to struggle and settled nearly cent off its session highs before the weekend. The MACD descent has slowed, and the Slow Stochastic is moving sideways in oversold territory. Selling into upticks continues to be the preferred strategy. A significant low does not appear to be in place. Potential next week to toward $0.9800, maybe.  

Japanese Yen:  The greenback reached JPY137.70 on August 23 and settled into a narrow range in dull dealing for the remainder of the week. Although the dollar traded on both sides of Thursday's range ahead of the weekend, it remained mired in the range established on August 23 (~JPY135.80-JPY137.70). The MACD looks constructive, but the Slow Stochastic is poised to turn lower. The US 2- and 10-year yields reached their highest level in two months, which underpins the dollar. Above the JPY137.70 area, the next resistance may be encountered near JPY138.20-40, but there is little standing in the way of another run at the JPY140 area.  

British Pound:  Sterling posted a bearish outside down the day before the weekend by trading on both sides of Thursday's range and settling below Thursday's low. The Jackson Hole-related position adjustment stalled at $1.19, shy of the $1.1930 (38.2%) retracement target. It reversed low and fell to $1.1735, just above the two-year low on August 23 (~$1.1720). The MACD is trending lower, but the Slow Stochastic is moving sideways in oversold territory. The 2020 low slightly above $1.14 beckons, and there is little on the charts to prevent it. Sterling cannot sustain upticks even though its discount to the US on two-year yields has fallen from around 135 bp on August 9 to 45 bp in the middle of last week before finishing around 60 bp.  

Canadian Dollar:  The US dollar had given back about half of the gains scored since August 11 (~CAD1.2730 to almost CAD1.3065) before Powell spoke at Jackson Hole. That retracement and the 20-day moving average converged around CAD1.2895. The sharp sell-off of US equities ahead of the weekend saw the greenback jump to almost CAD1.3045. The MACD is rising gently, while the Slow Stochastic has begun moving sideways near its highest level in two months near overbought. The poor price action in the S&P 500, with the upside gap on the weekly charts left unfilled before the breakdown to the lowest level since August 2, warns that the US dollar could challenge the CAD1.31 area in the coming days. The nearly two-year high was set on July 14 at around CAD1.3225. That may be the next important chart area.  

Australian Dollar:  Like the Canadian dollar, the Australian dollar has recovered half of the losses seen in the latest leg down that began from the August 11 high near $0.7135 and bottomed on August 23 around $0.6855. The Aussie staged a key reversal from that low and closed above the previous day's high. That retracement objective was near $0.7000 and the next (61.8%), and it was briefly surpassed before the weekend and Aussie's reversal back to $0.6900 to take out the previous session's low.   The MACD is not generating a strong signal, while the Slow Stochastic is curling higher after dipping into oversold territory. A return to the $0.6855 area looks likely, and below that could see $0.6800, though a return to the two-year low set in mid-July near $0.6680 cannot be ruled out.  

Mexican Peso:  The dollar forged a bottom against the peso in mid-August around MXN19.81-82. That is also roughly where the dollar bottomed in late June. The greenback bounced to MXN20.2665 and retreated last week to around MXN19.85. The momentum indicators are not generating strong signals, but the floor looks strong. In the face of the sharp US equity losses, and the broader risk-off mood, the peso was surprisingly resilient.  It rose by about 0.65% last week. Initial resistance may be near MXN20.06 and then MXN20.11-13. Latam currencies generally outperformed within the emerging market space last week. Four of the top five emerging market currencies were from Latam, led by the Chilean peso's 5.9% rally. The current intervention program runs out on September 30 but could be extended. The intervention to support the Chilean peso after it fell to record lows last month has given the currency a reprieve but could exacerbate the current account deficit, which reached 8.5% of GDP in Q2.  

Chinese Yuan: The Chinese yuan slumped to two-year lows last week as policy divergence grew more acute with the latest Chinese rate cuts. More easing of monetary policy is expected, and there is some speculation that another cut in required reserves could materialize in early Q4. China's discount to the US on 10-year bonds rose for the fourth consecutive week, and at 37 bp, was the largest weekly close since June. The PBOC has fixed the dollar weaker than expected over the last few sessions, and the magnitude seems sufficient to suggest a warning from Chinese officials not to get too carried away. That seems similar in spirit to the reports that the State Administration of Foreign Exchange called a few banks last week and warned them about large speculative yuan sales. We suspect the message is that while a weaker yuan is acceptable, the current pace is not. The next objective is around CNY6.90, but the risk of a move to CNY7.0, which did not seem so likely a couple weeks ago, seems more so now. 

Disclaimer