The diverging economic performance between the US and Europe, Japan, and China on the other hand is stark. Yet, a greater divergence may be between widespread discussion of de-dollarization and its incredible strength in the foreign exchange market.
The eight-week rally in the Dollar Index (DXY) is the longest in nine years. According to SWIFT, which is not comprehensive but remains by far the largest platform, the dollar’s role in international payments (46% in July) is a record and compares with slightly more than a third 10-year ago. The increased share accounted for the Chinese yuan (3.06%, a five-month high) was not at the expense of the dollar, but the euro, whose share edged low and is now less than 25%, a record low. It peaked in 2012 around 46%.
Two events stand out in the week ahead.
The first is the US CPI, which has become the most important data point in the monthly cycle of high frequency economic data. A hefty month-over-month increase, and the second consecutive year-over-year rise will likely overshadow improvement in the core rate. And in any event, the core rate will remain above the headline rate, though over time the latter converges with former. The US two-year year has been finding the air above 5% too thin to sustain but may try again if the expectations of a November Fed hike increase. In that environment, there seems to be little incentive to resist the dollar run.
The second big event is the ECB meeting. With the economy stagnating or worse, inflation elevated but easing and the downside is set to accelerate, the euro near four-month lows, oil at the year’s high, the swaps market discounts about a 37% chance of a hike. There seems to be some risk that the euro is trapped in “damned if they do and damned if they don’t” pickle. If the ECB does not hike rates, and even if President Lagarde is hawkish, the euro may be sold. If the ECB does hike, the market will conclude it is the last, and the euro may be sold.
There are three big data points for the US next week and they will likely show more inflation, weaker demand, and slower gains in industrial output.
The median forecast in Blomberg’s survey calls for a 0.6% increase in consumer prices in August. If true, it would match the biggest monthly gain since June 2022. That would lift the year-over-year rate to 3.5% from 3.2%, the second consecutive monthly increase. On the other hand, the core rate is seen rising by 0.2%, which would allow the 12-month rate to fall to 4.3% from 4.7%. That would be the lowest since September 2021.
In the first seven months of the year, US headline and core CPI have risen at an annualized rate of about 3.6%. Jobs growth, real wage increases, and drawing on savings have helped unpin US consumption. It might be a little exaggeration to say that as consumption goes, so goes the economy. We already know that auto sales fell by almost 4.5% month-over-month at a seasonally adjusted annual rate in August, the first decline in three months. That will be a drag on retail sales.
The median in Bloomberg’s survey is for headline retail sales to have risen by 0.2% after a 0.7% gain in July. Excluding autos, a 0.4% gain is anticipated (1.0% in July). However, the core, which excludes autos, gasoline, building materials, and food services, which some models of GDP incorporate, is forecast to have fallen by 0.1% in August, the first decline since March, and follows a 1.0% increase in July.
After falling in May and June, industrial output jumped 1.0% in July. It was aided by a 0.5% increase in manufacturing, driven by the auto sector (5.2%). Auto output in July was the fastest rate in four-and-a-half years. Excluding motor vehicles, manufacturing output eked out a 0.1% gain after falling for the previous two months. The market is looking for a small gain in August industrial production and manufacturing output, though the risk seems to be on the downside.
The Dollar Index’s rally extended for the eighth consecutive week, and it pushed above 105.00 for the first time in six months. It toys with the upper Bollinger Band (~105.15). The 105.40 area corresponds to the (38.2%) retracement of the decline from the multiyear high (~114.80) at the end of last September. The year’s high was set in early March, a little shy of 105.90. The momentum indicators are stretched, as one would expect, but show little sign of turning lower imminently and the five- and 20-day moving averages continue to trend higher.
China reported its August CPI and PPI early on September 9. The takeaway is that deflationary conditions subsided a bit. Consumer prices, which had fallen by 0.3% year-over-year in July rose to +0.1% in August. Food prices fell 1.7% in the year through August. Non-food prices rose by 0.5%, led by airline ticks and hospitality industry.
Core inflation rose 0.8%, the same pace as July. The August PPI stands at -3.0% (-4.4% in July), which is the least negative reading since March. The week’s focus is what is expected to be a significant jump in new yuan loans and aggregate financing after the weak July figures, and some real sector data, like industrial production and retail sales.
The retail sales and industrial production look likely to have improved sequentially on a year-over-year basis. Many of China’s critics complain that consumption as a percentage of GDP is low, and while that is true, it reflects high investment rather than weak consumption per se. From 2010 through 2021, China’s per capita consumption rose at a compounded annual growth rate of 6.8%, which is among the fastest in the world. It is also true that China’s per capita consumption growth has been weak over the last couple of years, which seems to be a result of a combination of policy choices and the zero-Covid policy.
Unlike other large countries, China has not provided extensive support for households or business. The PBOC could cut the benchmark one-year Medium-Term Lending Facility rate, but it would seem unprecedented for it to do so at back-to-back meetings. It has cut by a combined 25 bp between June and August. It is more likely to provide a larger quantity of funds that reduce rates again soon.
The yuan fell by a little more than 1% last week, despite aggressive fixings by the PBOC. The greenback stopped as close to CNY7.35 as possible without going above it before the weekend. There is talk that CNY7.35 is the official pain threshold, but reports said the same thing previously at CNY7.30. To think/act as if the PBOC is defending some fixed level risks underestimating the understanding, savviness, and pragmatism of PBOC officials.
Should they really be expected to stand fast if the dollar continues to trend high broadly? By various measures, the euro and yen are more undervalued than the yuan. It would seem more anomalous for the yuan to strengthen, given the growth and monetary policy divergence, than for it to weaken. In a country that apparently now is going to make it a crime to wear clothes or say things that “hurt the feelings of China” (whatever that means), Beijing has the resources and power to arrest the yuan’s decline, but it is not clear why it should do more to manage the decline and keep it orderly.
Ideas that the European Central Bank could hike rates at its September 14 meeting have gradually eased. It is now seen to be around a 35% chance, which is a little more than half the probability seen around the middle of August. This is not to say that the ECB is done, and President Lagarde is likely to underscore that.
The swaps market sees about a 70% chance of a hike in Q4. As we have noted, the base effect suggests a sharp drop in eurozone CPI in September and October as last year’s 1.2% and 1.5% monthly gains, respectively, drop out of the 12-month comparisons. However, the comparisons for November (-0.1%) and December (-0.4%) are more challenging. The ECB’s staff will update its forecasts.
The weakness of the euro and the rise in oil prices could offset some of the improvement in inflation. Yet, the ECB’s June forecast of 5.4% CPI this year seems a bit high, given that the preliminary August reading was 5.3%. Growth this year was projected at 0.9%. That also seems a little high, though it matches the IMF’s and OECD’s forecast, it is well above the 0.4% projected by the World Bank.
Weakness in Germany’s industrial sector continues to cast a pall over the aggregate performance. The eurozone’s July industrial production figures are due on September 13, the day before the ECB meeting. A 0.7% fall would more than offset the June gain and the flat showing in May.
There have been 36 sessions since the euro peaked on July 16. It has risen in 15 sessions or about 40% of the time. Yet, it has fallen for eight consecutive weeks. It was pushed below $1.07 last week for the first time in three months. Initial resistance is seen around $1.0750, which was approached before the weekend, but it quickly returned to straddle $1.07. On the downside, the next important chart area is $1.0600-35. The momentum indicators are overextended but still falling.
Despite what was heralded as strong spring wage negotiations and government subsidies for various forms of energy, household consumption continues to fall on a year-over-year basis. The heady growth of 4.8% (revised down from 6%) was due to net exports, including hospitality services, and the economy will likely slow sharply this quarter.
In fact, the median forecast in Bloomberg’s survey sees a 1.3% contraction (annualized rate) in Q3. The initial estimate of July industrial output was for a 2.0% decline and is subject to revision on September 14. It rose by an average of 0.3% a month in Q2, following a flat Q1 and a 0.7% average monthly decline in Q4 22. New information will be in the tertiary industry index (July) reported the next day.
June’s decline of 0.4% was twice what the median forecast in Bloomberg’s survey projected. It has not fallen for two consecutive months since July-August 2021. Contrary to conventional wisdom, following last year’s divestment of foreign bonds following the doubling of the 10-year JGB band in December and again in July, Japanese investors have been net buyers this year through August, to the tune of more than $100 bln. This is more than what was sold in the first eight months of 2022.
Talk of a cabinet reshuffle as early as the middle of next week is unlikely to have much market impact. It is more likely about internal politics than policy.
Japanese officials have escalated their rhetoric about the yen’s weakness and have used words that in past have been high on the intervention ladder before material action. This seemed, at least for the moment, to make the market cautious.
The dollar stalled around JPY147.85, and was probing it ahead of the weekend. It largely has remained in the range set on August 5 (~JPY146.40-JPY147.85). There is market talk about the JPY150-level as a trigger as if the context is not significant and even decisive.
Sensitive to the link between US yields and the exchange rate, it seems unlikely that the BOJ will intervene ahead of the US CPI (September 13), which, as noted above, is expected to have risen for the second consecutive month, and if confirmed could push US rates higher. The BOJ intervened twice last year. Roughly speaking, the dollar fell by about 3.75% after the first bout in September 2022, and by about 4.25% in the second operation the following month.
There are two high-frequency data points of note in the week ahead.
The first is the employment report (September 12). The number of employees on payrolls jumped by 97.2k in July, more than May and June combined (87.9k). Jobless claims also rose. The 29k increase is more than the previous three months combined (17.1k).
However, the cause of investor consternation, which had caused a brief flirtation with the possibility of a 50 bp hike later this month, was the growth in average weekly earnings. They are reported on a three-month, year-over-year basis, and they rose 8.2% year-over-year in the three-months through June. It was the fourth consecutive increase and is the most in two years. It finished 2022 at 6%. When bonuses are excluded, the pace is a little slower at 7.8% in June but was at 6.7% at the end of last year. The pace is expected to be steady at these high levels in July.
The second important data point is the July GDP details. The UK economy grew by 0.5% in June, the strongest performance since October 2021. It was slightly more than the sum of the monthly GDP of the first five months of the year. Industrial output was particularly strong in June, rising 1.8% m/m, led by a 2.4% surge in manufacturing output. Construction was also strong (1.6%). Neither will likely come close to matching that performance in July, and we already know that retail sales in July plunged twice the amount expected (-1.2%, and -1.4% excluding gasoline and diesel) and practically offset the gains of the previous three months.
Sterling fell by about 1.5 cents last week to a little through $1.2450 before stabilizing ahead of the weekend. It settled near its lows. The broadly stronger dollar and what seemed like dovish comments from Bank of England Governor Bailey were the main drivers. Since the break of $1.26, we have been anticipating a test in the $1.2400-25 area. The momentum indicators are falling, as are the five- and 20-day moving averages. Sterling will likely be particularly sensitive to the wage data – the stronger, the better sterling may perform. Still, the $1.2560-$1.2600 area may be formidable.
The upcoming data, including the monthly portfolio flow report and existing home sales, is sandwiched between the Bank of Canada meeting last week and the CPI due on September 19. The unexpected contraction in Q2 GDP was -0.2% annualized, while the median forecast in Bloomberg’s survey was for a 1.2% gain. Yet, the August employment data, released before the weekend, was a bit stronger than expected.
Full-time job growth bounced back to 32.2k from 1.7k in July. The unemployment rate was steady at 5.5%, though the participation rate slipped (65.5% vs. 65.6%). The average hourly wage for permanent employees accelerated to 5.2% year-over-year, a four-month high. The greenback initially fell to test support near CAD1.3600. It held and recovered to around CAD1.3645. A break of CAD1.3565 may be needed to encourage a deeper correction after the greenback has risen nine of the past 11 weeks. The Canadian dollar’s 0.35% loss last week made it the second-best performance in the G10 behind the Norwegian krona (-0.20%).
The August employment data is the highlight of the week down under. There has been a pattern in the last seven quarters for there to be a loss of full-time jobs in the first month of the quarter, if there is to be a decline in any of the months. True to form, Australia lost 24.3k jobs in July (29.2k lost in April and 21.1k decline in January). Economists look for a recovery in August. The median forecast in Bloomberg’s survey is for a 25.5k increase in employment.
The Aussie fell by about 0.75% last week, the seventh weekly drop in the past eight. A near-term base has been forged a little below $0.6360. It reached a three-day high (~$0.6415) ahead of the weekend, shy of the $0.6420 area that is the (38.2%) retracement of the last leg down that began from a little above $0.6520 on September 1. Still, the Aussie continues to struggle to sustain upside momentum and settled around $0.6375.
The decision to wind down the currency forward hedging facility has sparked a sharp adjustment in peso positions, washing out stale longs, while providing opportunity for new peso longs to be established.
The US dollar has bounced almost 6% since the announcement. It has neared the (38.2%) retracement of this year’s decline (~MXN17.76) and overshot the same retracement of the greenback’s fall from the March high (~MXN19.2320). The important technical area is around MXN18.00.
A three-day base has been built around MXN17.40-44. We do not see constructive macro backdrop having changed (attractive rates, strong external sector, near-shoring/friend-shoring, USMCA) but we recognize that it was a crowded trade. The price action itself is yet to provide much evidence that the position adjustment is complete. We are looking for a reversal pattern, such as some kind of reversal, to suggest the risk can be better quantified.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.