Will the Dollar Recover After CPI?

by
Marc Chandler
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Overview: The US dollar remains offered ahead of today’s CPI report. Most European currencies are outperforming the dollar bloc, and the greenback is holding inside yesterday’s range against the yen. Most emerging market currencies are firmer, as well. China’s markets re-opened from the long-holiday weekend and the yuan is a touch softer. After the strong close to US equities yesterday, and some mild follow-through buying today in the futures, equities in the Asia Pacific and Europe are also extending their recent gains. Hong Kong was a notable exception in Asia and reports that regulators asked state-owned entities to report their exposure to Fosun, one of the largest non-state conglomerates, weighed on the Hang Seng. Europe’s Stoxx 600 is rising for the fourth consecutive session and is at its best level in about three weeks. The 10-year US Treasury yield is a few basis points lower near 3.32%, while European benchmark yields are narrowly mixed. Gold is a little firmer at the upper end of yesterday’s range. December WTI is also in the upper end of yesterday’s range, a little below $88, ahead the OPEC+ report. US natgas is firmer for the fourth consecutive session, while the European benchmark is off 2.3%, its third decline in a row. It is now at its lowest level since late July. Iron ore recovered from yesterday’s 0.9% pullback and rose 1.4% today. It is at its best level this month. December copper is firm and is also at its best level here in September. If today’s gains are sustained, it would be the fifth advance in the past six sessions. December wheat has come back bid after yesterday’s 1.25% pullback. The USDA boosted its estimate of the wheat harvest, while reporting tighter supplies of soybeans. November beans rallied nearly 5.4% yesterday and are up a bit more today. They are at the highest level since late June.

Asia Pacific

The threats by Japanese officials have spurred more talk of intervention. There has been an evolution in official thinking about intervention. The Plaza Agreement (1985) and the Louvre Accord (1987) marked the high point of G7 foreign exchange coordination and intervention. However, consider that the Great Financial Crisis and the Covid pandemic without intervention in the major currencies. Officials recognized that the key problem was not foreign exchange rates per se but access to the dollar. Hence, the swaps lines offered by the Federal Reserve during the GFC, some of which were converted into permanent standby arrangement, and again during the pandemic. 

Under this framework, there is no compelling need for unilateral intervention. Japan is the only G7 central bank that is still pursuing quantitative easing and is the only G7 country that is projected to record a larger fiscal deficit than in 2021. Europe is unlikely to be any more sympathetic to Japan's plight than the US. The weakness for the yen has not affected the conduct of Japanese monetary policy. Japan's inflation is among the lowest for high-income countries, and the Japanese economy will likely outperform Europe's for the next several quarters. The yen reached is at its weakest level since 1998, while sterling fell to its lowest level since 1985. The euro traded at its lowest level since 2000. According to the OECD's purchasing power parity model, the euro is undervalued by about 41.5% and the yen is undervalued by a little less than 42%, an insignificant difference.

Japan's verbal intervention coincided with the dollar's pullback more generally. Today is the fourth consecutive session that the greenback is recording lower highs. The pre-weekend low was JPY141.50 but yesterday and today, support has been found slightly above JPY142, where options for $670 mln expire today. In addition to the lower dollar, today's range, about 0.8 yen, is the smallest since last Monday when the US and Canada were on holiday. The greenback is also in a narrow range against the Australian dollar. It is consolidating in a narrow range below $0.6910. A move above $0.6920, could spur another half-cent gain. Initial support is seen around $0.6860. The Chinese yuan is a little softer today, as the mainland market re-opens from the long holiday weekend. The US dollar initially eased to about CNY6.9165, slightly below the pre-weekend low but rebounded above CNY6.9300. As it has done for nearly three weeks, the PBOC set the dollar's reference rate above when the median in Bloomberg's survey projected (CNY6.8928 vs. CNY6.9125).

Europe

Before the weekend, the (swaps) market was nearly 100% convinced the ECB would hike 75 bp at next month's meeting. The confidence has waned a bit and now is around 60%. This is despite the hawkish comments over the weekend by Bundesbank President Nagel. Other ECB officials have confirmed intentions to lift rates at the coming meetings, but not necessarily in such large steps. The neutral is seen around 1.5%-2.0%. The swaps market sees the deposit rate within that range before year end. After last week's high, the deposit rate is at 0.75%. Separately, the ZEW survey was weaker than expected. The current situation measure fell to -60.5 from -47.6. It is the worst reading since March 2021. The expectations component was even worse, dropping to -61.9 from -55.3. This level of pessimism was not seen even during the initial stages of the pandemic, when expectations bottomed at -49.5. Even during the sovereign debt crisis (2011), it did not fall this low. One has to go back to October 2008 to see such a low reading. That said, the euro barely wobbled on the news.

The International Labor Organization says that UK unemployment unexpectedly fell to 3.6% in the three months through July from 3.8%. However, the government's data shows this was driven by a 194k decline in the workforce--seemingly reflecting sickness and return to school. The claimant count rose by 6.3k, bringing the number of unemployed to 1.22 mln (compared to 1.28 mln job openings, which fell by 34k over the three-month period). Employment rose by 40k in the three-months through July, which is about a third of the median forecast in Bloomberg's survey. Average weekly earnings rose 5.5% in three-month through July compared to a year ago. It was the first increase since March when it peaked at 7%. The swaps market still favors a 75 bp hike next week with almost 69% confidence, which is where it was at the end of last week. Lastly, note that the dockworkers at Felixstowe rejected the pay deal and are preparing to strike. Separately, the dockworkers in Liverpool are also preparing to strike. In the US, the White House is said to be involved in trying to settle the railroad dispute that could lead to a strike at the end of the week.

The EC is expected to propose a mandatory program to cut power use. This is going to prove as controversial as it was when first aired earlier this year. The push back then resulted in voluntary cuts and between May and August, gas demand in northwest Europe fell by 18% year-over-year. Some countries have introduced light rationing already, in the form of temperature and light use in public buildings. The EC's proposal, leaked to the press, has two goals in terms of conservation. First a cut in overall consumption. Second a mandatory goal of lowering demand during peak hours or when electricity generation from renewables is expected to be low. The EC also will propose a minimum "exceptional and temporary" tax on "extra" (in excess of pre-tax profits reported for the past three years) made by oil, gas, coal, and refinery industries. The EC wants to cap the extra revenue other energy companies though limiting the price of electricity generated from renewables and nuclear.

The challenge is to find a solution that is agreeable throughout the EU, which like other issues, has proved quite difficult. The issues are thorny and earlier this year, tensions between Germany and the periphery were evident. in any event, it seems unreasonable to expect a quick solution. Instead, following von der Leyen's annual State of the Union address to the European parliament on Wednesday, look for the heads of state summit (informal meeting on October 6-7 and a summit October 20-21 to try to hammer out an agreement. Still, the idea that Europe is on the verge of an energy union seems to be more a case of wishful thinking. Sure, like the EU's joint bond issuance, it could prove to be the scaffolding, but more likely is one-off emergency measures.

The euro is trading with a firmer bias but holding below yesterday's high (almost $1.02). It seems to be sandwiched between two sets of expiring options today. One set is struck at $1.01 for about 725 mln euros. The other is for nearly 1.05 bln euros at $1.0175. After yesterday's advance, some, if not all the upper strike has likely been neutralized. The session highs were recorded in the European morning a little above $1.0165, and again North American dealers will start their session with the intraday momentum indicators stretched. The session low, slightly below $1.0120 was set in early Asia. Yesterday, sterling stalled near its 20-day moving average (~$1.1715), but today has edged through $1.1730. This is just shy of the (38.2%) retracement of the losses since the August 10 high near $1.2275. The next retracement (50%) is closer to $1.1840. Support is seen in the $1.1660-80 area. Our broad view anticipated the dollar to weaken through the US inflation report and then find better bids ahead of next week's FOMC meeting.

America

Today's US CPI report and the University of Michigan's preliminary September consumer confidence and inflation expectations are seen as the last two important data points before the FOMC meeting next week. Barring a surprise, another tame monthly CPI print is expected. The month-over-month reading in July was zero and the median forecast in Bloomberg's survey is for a 0.1% decline in August. The August core rate is expected to match July's 0.3% increase. The year-over-year headline rate may ease to 8%, while the core may tick up back above 6% for the first time since April. Given the Fed's assessment that that labor market remains strong, and prices elevated, few really think that today's CPI report will spur a change in the official stance. Moreover, in a bit of "what came first the chicken or the egg", the market is giving the Fed a free option to hike 75 bp.

Given the Fed's belated start and misunderstanding of the persistence of inflation, it may not want to under-deliver market expectations. That said, look at the evolution of inflation expectations. First, we note that NY Fed's August survey was out yesterday. It showed the one-year inflation expectation easing to 5.7% from 6.2%, and the three-year expectation at 2.8% from 3.2%. Second are the market-based measures. The two-year breakeven (the difference between the two-year inflation protected security and the conventional note) has fallen from almost 5% in late March (peak was almost two weeks after the Fed's first hike) to less than 2.2% last week. The 10-year breakeven peaked in late April, a little over 3% and fell to 2.30% in July and has bounced around a bit this summer, reaching nearly 2.65% in late August and now is around 2.42%, roughly the lowest it has trading since late July. Rightly or wrongly, the breakeven measure of inflation expectations seems heavily influenced by the price of oil. The generic WTI futures contract peaked in early March slightly above $130. It had a secondary peak in mid-June around $123.70. Last week, it fell to nearly $81, the lowest level since mid-January, before the Russian invasion of Ukraine, when many, including Ukrainians, did not believe the invasion was going to materialize.

There is an old rule of thumb about three gaps exhausting a move. Some interpretations of Japanese candlesticks also have rule like that. It is relevant because the S&P 500 and NASDAQ gapped higher on both Friday and yesterday, and the gaps are unfilled. The Canadian dollar, among the most sensitive among the major currencies to US equity fluctuations, has rallied sharply over the past of four sessions, which have been the best for US stocks here in Q3. The US dollar has fallen from a little above CAD1.3200 to below CAD1.3000. So far today, the greenback is trading in a tight range (~CAD1.2970-CAD1.2995). It is hovering a little above yesterday's low near CAD1.2965, which is roughly the (50%) retracement of the US dollar gains since the August 11 low (~CAD1.2730). A convincing break targets the next retracement (61.8%) a little above CAD1.2900. The US dollar fell to its lowest level since mid-June against the Mexican peso yesterday (~MXN19.7535) but closed back above the MXN19.80 floor. The greenback is under pressure today and there is little chart support ahead of MXN19.60. The JP Morgan Emerging Market Currency Index is extending yesterday's gains. If sustained, it would be the fourth gain in five sessions, and it is trading near its best level since mid-August.