by Marc Chandler
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The dollar rose against all the G10 currencies last week, but it was not because of higher US rates. In fact, the 10-year US Treasury yield fell for the first time in five weeks. The two-year yield did not rise for the first time in three weeks. Rather than an increase in US rates, several other countries' rates fell. The result was that the US 2-year premium over Germany rose for the fourth consecutive week and is now the most since June. The US premium over Canada rose for the third week and the sixth week in the past seven. It is approaching 100 bp, the most since 1997. The US discount to the UK narrowed to less than five basis points, the least in nearly two months. Both the JP Morgan and the MSCI emerging market currency indices fell for the third consecutive week.
The US election is emerging as a factor. The tightness of contest at this late date is maximum uncertainty. In the capital markets, volatility is risk. In politics, risk is a function of credibility (how likely something is) and capability (how powerful it may be). In this framing, the political risk has focused on a Trump victory, whose aggressive tariff proposal are thought to be dollar positive in the first instance because the across-the-board tariffs, the defection of the US from the managed free-trade world that it was instrumental in building is seen as negative shock to US trading partners. The debate seems to be over how big of a shock and the extent of the retaliation. In the week ahead, however, there are four highlights: China will likely cut loan prime rates before the market open Monday; the Bank of Canada is likely to deliver a 50 bp rate cut following the sub-2% inflation reading; the Fed's Beige Book, which Federal Reserve Chair Powell has put emphasis on, especially at turning points, as was the case last month; and the preliminary October PMI.
United States: There are two types of data in the coming days: Survey data for October (various Fed surveys and the preliminary PMI) and some late Q3 real sector data (new and existing homes sales, durable and factory orders). The first estimate for Q3 GDP is due October 30 and this week's data are unlikely to have much impact on expectations. The Atlanta Fed's GDP tracker for Q3 GDP is 3.4% and NY Fed's model puts it at 3%, the same as the median in Bloomberg's latest survey. Arguably, the Fed's Beige Book is the most important report next week. Past Fed chairs have tended to play down the Summary of Economic Projections and rarely mentioned the Beige Book. Chair Powell takes a different tact. He plays up the dot plot and has cited the Beige Book at turning points. He mentioned it most recently to help justify the half-point rate cut that kick-off the easing cycle in September. Looking a bit further down field, but not wanting to get too far ahead of ourselves, we continue to think that the market exaggerated the significance of the September employment report. The early forecasts for October nonfarm payrolls (November 1) are coming in around 130k.
The Dollar Index's upside correction has been a little deeper than we expected, encouraged by the market's re-convergence with the Fed's forward guidance, which resulted in a recovery in short-term US rates. This is the fourth rally of the year. The first one lasted about the first six weeks of the year and was worth almost 4%. The second one, was from early March through mid-April. It was worth a little more than 4%. The third one lasted about three weeks in June and the Dollar Index rose by slightly more than 2%. The fourth rally began in late September, and through last week's high, appreciated by about 3.7%. It stopped shy of the (61.8%) retracement of the decline since the high for the year was recorded in mid-April found near 104.10. The momentum indicators are stretched and look poised to turn lower shortly. Initial support may be around 103.00 and then 102.45.
China: Beijing could continue to drip-feed policy adjustments to the market. Yet, the one-year Medium-Term Lending Facility has been downgraded as a policy instrument and could very well remain at 2%, after last month's 30 bp cut (followed 20 bp cut in July). However, the loan prime rates have not been cut since July and a 20 bp cut seems likely before the markets open on Monday. A 20 bp cut would bring the one-year rate to 3.15% and the five-year rate to 3.65%. However, when last week's fiscal briefing came up short on specifics, attention shifted to the Standing Committee of the National People's Congress meeting (October 20-24). China's critics want to see fiscal support for bolster domestic demand, and in particular, consumption. There is also a BRICS Summit (October 22-24). In some ways, it is repeating the experience of the EU, pursing a broadening strategy over deepening. The more countries join, the wider range of interests, the more difficult to arrive at timely decisions. There are two contradictions within BRICS. First, at the very heart is an antagonism between India and China. The second is Beijing’s effort to internationalize role of the yuan and promote its China International Payment System (CIPS). Why would it support the development of a rival platform or currency? The BRICS could endorse greater use of their own national currencies to invoice and settle trade, and it would not be the first time. There is little formally stopping them, but progress has been very slow, begging the question why.
As the US dollar rebounded broadly since late September, it recovered from about CNH6.97 to reach almost CNH7.15 last week. A move above there would target the CNH7.18 area and the 200-day moving average near CNH7.2035. Previous resistance around CNH7.10 may now act as support, and then CNH7.08. Due to idiosyncratic developments in both Japan and China, the correlation of the respective currencies weakened in recent week but has stabilized and looks to improve.
Japan: There is practically no chance that the Bank of Japan changes policy at its October 30-31 meeting. The national election is October 27, and BOJ officials have done little to prepare the market. After the drama around the July move, it can be expected to tread carefully and communicate clearly. While Japan sees the preliminary October PMI and the final estimate of September machine tool orders (preliminary estimate -6.5% year-over-year), the most important data point is Tokyo's October CPI. It provides a robust guide to the national figure, which is not released for several weeks. In fact, the national September figures were reported last week, confirming the decline Tokyo pointed to in both the headline and core measures. Tokyo's core CPI (excludes fresh food) peaked in January 2023 at 4.3%. It was halved before the end of last year (2.1% year-over-year in December 2023). It has averaged 2.1% in the first nine months of the year and was at 2.0% in September.
Still, we note that changes in the exchange rate is more correlated with changes in the US 10-year yields than with changes in the 10-year differential (~0.72 vs. 0.54) on a 60-day rolling basis. The correlation of changes in the exchange rate and the US 10-year yields is the highest since the spike in early 2020. The 60-day correlation on changes in the 10-year interest rate spread and the exchange rate peaked slightly above 0.70 in February and fell to the low of year near 0.32 in August before recovering. The US 10-year yield appears to be stalling around 4.10%, and that warns that the greenback may struggle to extend to its gains that carried it to about JPY150.30 in the second half of last week. The momentum indicators look poised to turn down. Initial support is seen near JPY148.85.
Eurozone: Last week's ECB rate cut may reduce the market's sensitivity to the preliminary October PMI. A poor number will lend credence to market expectations of another cut at the next ECB meeting (December 12). With September CPI below 2%, the ECB has more leeway to act, and the central bank's chief economist Lane has already warned of an accelerated easing cycle if the economy disappoints. Germany is fragile. The economy is on a knife's edge: It might be contracting for the second consecutive year. It would be for the first time since 2002-2003. The IFO survey will be updated October 25. Expectations have fallen for the past four months. The current assessment has not risen in April, and at 84.4 in September, it was lowest since mid-2020. Note that Moody's is to announce the results of its review of France's creditworthiness on October 25. Moody's currently sees France as an Aa2 credit, while Fitch and S&P are one notch lower (AA-). Since late July, the French 10-year premium over Germany has traded mostly 70-80 bp. In Q1 24, the premium was more like 45-55 bp. France's 10-year yield is above Spain and Portugal's.
The euro's pullback has been a little deeper than we expected. The double top near $1.12 and neckline near $1.10 projected to $1.08, but we thought this was a bit deep. Yet, the low set last Thursday was about $1.0810. It stabilized ahead of the weekend, but must recover above $1.0870, and ideally, $1.09 to be notable from a technical perspective. Weighing on the euro has been a surge in the US two-year premium over Germany. The premium fell to almost 135 bp in mid-September, the smallest since May 2023 and recovered to nearly 190 bp before the weekend, the most since late June. The spread reflects the divergence in economic performances and adjustment to central bank outlooks. If the interest rate adjustment is over or nearly so, the euro may begin finding better traction.
UK: The softer September CPI lends credence to the market's conviction that the Bank of England will deliver its second quarter-point cut when it meets again on November 7. There was over a 90% chance priced into the overnight swaps before the CPI report. The real question is about the last meeting of the year (December 19). The market was split, but after the CPI, the swaps market's confidence of a cut in December increase from a little less than a 50% probability to around 75% and was little changed after the stronger than expected September retail sales report. The CBI trends and preliminary PMI, due in the coming days are unlikely to have significant impact. With the jobs report, CPI, and retail sales behind it, the market now has little distraction from the first Labour budget, after rocky first 100-days or so. Chancellor of the Exchequer Reeves discovered a GBP22 bln funding gap and seeks to close it, but in the campaign, Labour ruled out increasing the VAT, employee contributions to the NIH (National Institute for Health), and income tax. Of course, there are other taxes that can be raised, including the capital gain tax, which is at the low range of income tax rates, business contributions to NIH, resident foreigners, and tightening the carried interest tax break. However, it will challenge Prime Minister Starmer's efforts to re-brand Labour as the party for business.
Sterling traded below $1.30 for the first time last week in nearly two months. It held slightly above $1.2960, the (61.8%) retracement target of the rally from the August 8 low near $1.2665. Sterling recovered to about $1.3070 after the stronger retail sales report before the weekend. A close above $1.31 bolster the chances a low is in place. The euro set new 2 1/2-year low against sterling ahead of the weekend, slightly below GBP0.8300. It recovered to set new session highs in North America near GBP0.8335. The euro must overcome resistance in the GBP0.8350-80 area to boost the technical tone.
Canada: The Bank of Canada meets on October 23. It has cut rates three times this year and Governor Macklem has suggested that there may be scope to accelerate the pace. Last week's CPI underscored that such scope may very well exist. Headline inflation fell to 1.6% in the year through September, the lowest since February 2021. It has fallen on a monthly basis in three of the past four months, during which time it has contracted by almost 1% at an annualized rate. The underlying core measures, which the central bank emphasizes but does not formally target it, are stickier, but trend, which is important, remains lower, though the median and trimmed mean calculation core CPI. The swaps market is pricing in around an 85% chance that the Bank of Canada delivers a 50 bp cut, up from about 55% chance a week ago. Moreover, the market is beginning to consider another 50 bp cut at the last meeting of the year in December. If one subtracts current CPI from the overnight target, a proxy for the real policy rate, Canada and US rates are roughly the same, around 2.60%-2.65%. But that does not get you far in understanding the run on the Canadian dollar. Instead, note Canada's nominal two-year yield is nearly 100 bp less than what the US Treasury offers. The discount widened around 35 bp since earlier this month and is largest discount since the 1997.
There has been a dramatic run on the Canadian dollar this month. It has risen only three sessions in the past three weeks and two of them were last week. The greenback reached a two-month high near CAD1.3840. And yet, the Canadian dollar is the best performing G10 currency this month, down only 2%. A break of the CAD1.3750-CAD1.3850 may signal the direction of the next big figure move.
Australia: The stronger than expected September employment report further dampened market speculation of a rate cut this year. Australia has filled 290k full-time positions in the first nine months of the year compared with 143k in the same period last year. The participation rate reached a new record high of 67.2% (66.5% in September 2023), while the unemployment rate was steady at 4.1% (which it has averaged since the end of Q1). The futures market recognizes less than a 7% chance of rate cut next month. The odds of a December cut are about 20%, the least since the end of July. Australia sees the preliminary October PMI on October 24, but it tends not to be a market-mover. Instead, the quarterly CPI on October 30 is the next important data point for the Reserve Bank and the markets.
The Australian dollar is also sensitive to developments in China, directly as its largest trading partner, and indirectly, through commodity prices and the terms of trade. The Aussie found support last week slightly below $0.6660, coming close to the (50%) retracement of the rally from the low for the year set early August (~$0.6350) to the year's high recorded at the end of September (~$0.6940). The momentum indicators have not turned up, but the Australian dollar posted a four-day high close ahead of the weekend. A move above $0.6720 would be constructive but the $0.6760 area offers more formidable resistance.
Mexico: Mexico is particularly vulnerable if Trump is re-elected. Mexico's modernization, to a large extent, has been driven by the integration into the continental economy with the US and Canada. Trump has suggested 60% tariffs on China and 20% on goods from the rest of the world. He has singled out the auto sector and says that automakers building plants in Mexico are a "serious threat" to the US. Mexico exports about 85% of its vehicle production (mostly to the US). Depending on the extent of the retaliation, some estimates project that "Trump tariffs" could cost Mexico 2% of GDP by 2028. Investors have yet to be convinced that the new government will be any more friendly than the previous government, while moderating price pressures will allow the central bank to cut rates again before the end of the year.
The US dollar rallied from almost MXN19.24 at the start of the last week to poke above MXN20.00 last Thursday for the first time in a little more than a month. It reversed low and posted a bearish shooting star candlestick. Follow-through dollar selling ahead of the weekend saw a three-day low near MXN19.65 before snapping back to MXN19.90 in late dealings. Political considerations warn of the continued downside risks for the peso ahead of the US election. The US dollar is likely to hold above MXN19.50 and last month's high, almost MXN20.15 will likely be challenged. The greenback is also pushing against the upper end of a two-month range against the Brazilian real near BRL5.70. The high for the year was set in early August near BRL5.8550.
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FX: The dollar
traded mostly higher last week. I suspect more near-term gains, but
I am less convinced than I was a week ago. Given the FOMC minutes
and more recent commentary from Fed officials, I suspect the market is
exaggerating the chances of two cuts this year. That had been my
leaning too, but I think the recent resilience of the labor market and
sticky inflation has shifted the views at the Fed. The futures
market is pricing in a little more than a 37% chance of a second
cut. That is down from 76% on May 17. There is room for
further adjustment. The dollar traded above JPY157 for the
first time since May 1. The market is likely to turn more cautious
as JPY158 is approached. The euro peaked on May 16, slightly
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