Week Ahead: Is the Dollar’s Run since Mid-July Over?

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Marc Chandler
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The US and China report July CPI figures in the coming days and they are likely moving in opposite directions. Headline US CPI is likely to rise for the first time since peaking in June 2022. China's CPI has been slowing and is likely to go negative on a year-over-year basis. It finished last year at 1.8% and in June was unchanged year-over-year. The divergence of policy is what is driving force of the exchange rate, and the    question is not really so much why the yuan is weak, but why it is not even weaker, and the answer seems to be because of Beijing's use of soft power. It has moderated the pace through the setting of the daily reference rate, and it has gotten banks to reduce the interest rate on dollar deposits for example. Press reports also note that State Administration of Foreign Exchange has asked banks in recent weeks to reduce of delay their dollar purchases. Other accounts suggest that Chinese corporates have been reluctant to convert dollar revenue back into yuan. 

The idea that currencies should move to equalize trade accounts seems antiquated at best. "Theory," as is repeated several times in the Oppenheimer movie, "will take you only so far."  Capital flows dominate trade flows, so even the theory needs to be re-thought, but it is also not a very helpful explanatory model of foreign exchange movement. As a quick illustration, consider that sterling is the strongest G10 currency since the end of last September. It has appreciated by about 15% against the dollar through the end of July. Its trade shortfall in the first five months of this year was about 50% larger than the deficit in the January-May 2022 period.

Investors are digesting not only the doubling of the cap on Japan's 10-year bond but also to the Bank of Japan's purchases at market prices in its first two operations in nearly six months. These developments are unrelated to Japan's current account that will be reported on August 8. The current account has averaged JPY1.30 trillion (~$9.7 bln) a month this year through May. Last year, it averaged JPY1.36 trillion in the first five months. Many observers expected the yen to strengthen after the BOJ adjusted its Yield-Curve Control. The dollar initially rose by 2.75% against the yen and fell by about 1% over the past three sessions. Moreover, the common narrative was the stronger yen was going to reflect the sales of foreign bonds as Japanese investors repatriated funds. Benchmark 10-year G10 yields 15-22 bp last week, but it is difficult to untangle fear of Japanese repatriation from the US Treasury ramping up supply, constructive economic data, and Fitch's downgrade.

United States:  We have long argued that the improvement in headline US inflation in H1 23 was low hanging fruit and now in H2 the path will be more arduous. It begins with this week's July CPI report. A 0.2% increase will lift the year-over-year to 3.2%-3.3% from 3.0%. This will be the first increase since June 2022, when inflation peaked (yes, within three-months of the Fed first hike). Here is what is looks like from another angle:  US CPI rose at an annualized rate of 3.4% in H1 23 and 2.8% in H2 22. For headline CPI to continue to decline, it needs to average less than 0.2% a month. The core rate is a different story. A 0.2% rise would see the year-over-year rate hold steady at 4.8% or possibly slip to 4.7%. The core rate rose at an annualized rate of 4.6% in H1 23 after a 5.0% pace in H2 22. Deflation is already evident in producer prices. Headline PPI was slightly negative on an annualized pace in H1 23. It was up less than 1% at a 12-month pace in H2 22. But the base effect warns of a jump in the year-over-year rate with the July reading. A 0.2% increase is expected to replace last July's 0.5% decline. It would lift the year-over-year rate for the first time since last June. However, the core PPI may also ease slightly. The other risk is the quarterly refunding following the sharp increase in the Treasury's projected borrowing in the July-September period to $1 trillion from $733 bln projected in May. We suspect the Fitch downgrade to AA+ is more embarrassing than substantive. Even the US Treasury acknowledges that the fiscal path is unsustainable. Despite above trend so far, this fiscal year, the deficit is seen at 5.7% of GDP and is bound to deteriorate if the long-anticipated recession hits.

The Dollar Index frayed the downtrend line drawn off the May and July highs but did not close above it. The trendline begins the new week near 102.65. Ahead of the weekend, the Dollar Index approached 101.75, with support seen around 101.60. The momentum indicators are getting stretched. While we suspect a top is near, it may have to wait until the US CPI is reported and a sense of the market appetite for the stepped-up supply at the quarterly refunding is clear. If a high is in place, we look for a return to initially the 100.50-80 area.  

China: While other major economies are wrestling with inflation, China is experiencing deflation. The CPI is expected to have turned negative on a year-over-year basis and PPI has been negative since the end of Q3 22. The good news is that the base effect will begin working toward lifting price pressures as the second half progresses, and China's inflation is near its nadir. That said, expectations for more monetary support seem reasonable and this would be consistent with continued strong lending figures, which might be released next week. China will also report its July trade surplus. Even though exports and imports are falling on a year-over-year basis, China's trade surplus has risen. In the first half of 2022, the surplus averaged $62.1 bln a month, and in the first half of this year it was $68.1 bln. Beijing may report its monthly currency reserve figures early in the week ahead. The swing in valuations will likely account for the change in reserves. The dollar was weaker against the other reserve currencies and bonds prices were mostly lower. This may suggest a small increase in the dollar value of PBOC's reserves. 

The dollar is holding a trendline connecting the late June and several highs from July and last week. It begins the new week near CNY7.19 and finishes next week around CNY7.1780. The US 10-year premium over China surpassed 150 bp last week for the first time 2007. The dollar's pullback after the softer employment data may take some pressure off the yuan, but the upcoming contrasting CPI reports may discourage CNY buying. The PBOC continues to set the dollar's reference rate well below expectations as it continues to moderate the greenback's rise. A push below CNY7.10 may be necessary to persuade that a top has been recorded. 

Japan:  The most important data for the Bank of Japan probably is not about inflation but about demand, and on August 8, household spending for June will be reported. The base effect still works against it and another sharp fall after May's 4.0% year-over-year decline and April's 4.4% drop. It will validate the BOJ's argument that accommodative monetary policy is still needed and that the increase in prices is not demand driven. Indeed, Japan's PPI fell for three of the first six months of the year for an annualized decline of -1.6%. At the same time wage growth (labor cash earnings) may moderate. Japan also reports June's current account. The seasonal pattern is strong. In each of the past ten years, the June's balance deteriorated. In May, the current account surplus was JPY1.86 trillion and that included the JPY1.19 trillion trade deficit. On a balance of payments basis, Japan has not reported a monthly trade surplus since October 2021. The weekly MOF portfolio flows may draw more attention than usual as it will be the first to cover the initial reaction to the adjustment of the Yield-Curve Control.

The pullback in US rates after the employment report may take pressure off the JGBs, which the BOJ has tried to temper the increase. The dollar traded at a four-day low ahead of the weekend, briefly below JPY141.65, to meet the (38.2%) retracement of the rally nearly JPY138.05 seen before the BOJ meeting in late July that adjusted the Yield-Curve Control. A break sees JPY140.60-JPY141.00.  

Eurozone:  The economic diary is light next week, with only the Sentix surveys on the aggregate level to draw attention. Germany and France report June current account figures, and Italy's trade report is also on tap. Perhaps, the most important data point in the coming days is Germany's industrial production. After wide swings in Q1, industrial output, which includes construction, settled down April and May. The weakness in the June manufacturing and construction PMI and no recovery in July warns of the risk of another decline in industrial output. Pessimistic economic assessments have driven the market to downgrade the likelihood of a September rate hike from slightly more than a 70% chance the day after the July ECB meeting to roughly a 37% chance now. The euro finished the pre-weekend session above the five-day moving average for the first-time last week, but the nearby hurdle around $1.1050 needs to be take out to signal more than consolidation. That said, we suspect that the pullback from the year's high set on July 18 near $1.1275 is over or nearly so. We had thought the euro's downside potential could extend toward $1.08, but it stopped ahead of $1.09. 

United Kingdom: The Bank of England lifted the base rate by 25 bp to 5.25% on August 3. Despite the meeting-to-meeting reference, the swaps market is pricing more than an 85% probability of another quarter point hike next month. The data highlight in the coming days is the August 11 Q2 GDP and details, including the June GDP. After growing eking out a 0.1% expansion in Q1, the economy appears to have stagnated in Q2. The new BOE forecasts are for 0.5% growth this year, but the GDP figures are unlikely to shed much light on the trajectory of BOE policy. The employment and CPI reports on August 15-16 are more important. We have commented on China's use of informal power channels to "guide the market," for example to reduce mortgage rates. We have noted that US financial regulators have asked banks to grant forbearance in the commercial real estate space. The UK is conducting a similar exercise. The Financial Conduct Authority has "named and shamed" financial institutions for passing on less than a third of the interest rate increases to savers. More than a half dozen large banks and some smaller banks have responded over the last couple of weeks by reducing mortgage rates.

Sterling held the lows set in late June slightly below $1.2600 and recovered to near $1.2785 after the US jobs data. The momentum indicators are stretched and could turn higher in the coming days. Sterling's decline from the mid-July high (~$1.3140) appears to have come to an end. A move above $1.2820 would lend credence to the idea that the low is in place and target the $1.2900-50 area.

Australia: There are a couple of banks with a consumer and business survey in the coming days that are on Bloomberg's calendars, but they do not appear to have much market impact. The Melbourne Institute 's monthly survey of consumer inflation expectations may attract some interest. It has been at 5.2% for the past three months and was also there at the end of last year. Still, it will have to be more than the survey result to prod the market to reconsider the possibility (slim to none) that the RBA will hike rates at Governor Lowe's last meeting. From an institutional point of view, it would be better to let his successor, who is perceived to be somewhat dovish, establish good will, as it were. The Australian dollar was sold to three-month lows last week (~$0.6515) before recovering ahead of the weekend to test previous support near $0.6600. The momentum indicators are still falling, but gains back above the $0.6630, and ideally, $0.6660 would boost the chances that a low is in place. On the top side, it could spur a move back toward $0.6750.

Canada: Canada's June merchandise trade balance is the highlight in an otherwise quiet data week (that also will see June building permits). The C$3.44 bln deficit in May was a shocker. The median forecast in Bloomberg's survey was for a C$1.2 bln surplus. Before Covid, Canada recorded trade deficit. By early 2021, monthly trade surpluses were more common, and Canada recorded its first 12-month rolling trade surplus in November 2021 since 2015. However, the best news may be history, and even before May's blowout, the merchandise trade balance had been deteriorating. In the first four months of the year, the average monthly trade surplus was about C$475 mln compared with C$2.6 bln average in the first four months of 2022. The Canadian dollar was competed with the Australian dollar for the dubious honor of being the weakest currency in the G10 last week. Both were off 0.75%-0.80%. The US dollar reached almost CAD1.3395 before the weekend, its best level in nearly two months. It has closed above the upper Bollinger Band in the previous two sessions but returned into it ahead of the weekend. Still, it is not clear that the greenback has put in a significant high. A move above CAD1.3400 would target the CAD1.3440-50 area. It may take a pullback below CAD1.3300 to boost confidence a high in place.

Mexico: The peso was punished last week. It was tagged for about 3.5%, in what would have been the biggest weekly drop since late November 2021. But it recovered strongly ahead of the weekend and cut its loss to a little less than 2%, which is still the most since March. Although market positioning was arguably stretched, it was mostly guilty by association. Carry strategies fell out of favor broadly. It had more to do with the funding leg that the carry itself. The volatility in both stocks and bonds contributed to the risk-aversion. The dollar rallied against nearly all the emerging market currencies over the past week (except for the Bulgarian lev and Malaysian ringgit which were virtually steady). Latam currencies performed particularly poorly. They accounted for six of the heaviest nine emerging market currencies last week. Although both Chile (-100 bp) and Brazil (-50 bp) cut rates more than expected, the Colombian peso's 3.8% decline was larger than the losses of the Chilean peso and the Brazilian real (~-2.1% and -2.6%, respectively). After reaching new lows since 2015 on July 28, the dollar jumped through the July high (~MXN17.3960) to reach MXN17.4280. The momentum indicators are trending higher and are not yet stretched, but the sharp sell-off after the US jobs data (~MXN17.00) lends credence to our suspicions that the peso's run is not over and that pullbacks in the peso are still bought with gusto.

It is an important week for Mexico. In the middle of the week, August 9, Mexico reports July CPI. The headline pace is likely to fall toward 4.5%, which would be the lowest since March 2021. Indeed, it could fall toward 3.5% by the end of the quarter. The core rate is firmer at nearly 6.9% in June. Its decline is more gradual and by the end of the Q3 it could be near 6%. The central bank meets the following day. The central bank has signaled that is not prepared cut rates as early as Chile and Brazil. We suspect that with tight labor market (2.65% unemployment rate in June) and robust economy (1.0% GDP quarter-over-year in Q1 and 0.9% in Q2) and what appears to be a strong start of Q3 (July manufacturing PMI and IMEF surveys), the central bank needs not to do anything but affirm that it is on hold for an extended period. That said, many look for a cut late this year.