The key driving force in the foreign exchange market that has lifted the dollar is a reconsideration of the trajectory of Fed policy. Consider that since the 2-year US yield reached a six-week low near the 200-day moving average slightly below 16 bp on August 4, it has risen for six of the past eight sessions to almost reach 25 bp before stabilizing. The high for the year so far was set in mid-June near 28 bp.
One of the reasons we suggested that the Fed had been reluctant to talk formally about tapering was that tapering was not just about the pace and composition of the Fed's asset purchases, but it was a necessary prelude to the first rate hike. The current Fed funds target is zero to 25 bp, and it has been averaging 10 bp since mid-June's technical adjustment.
If we assume that the first hike will lift the target to 25-50 bp, but that the effective average will be about 35 bp, we can see how the January 2023 Fed funds futures contract, implying around 33 bp, has a hike nearly fully discounted. Yet, there is no FOMC meeting in January 2023. The December 2022 meeting concludes on December 14. Assuming a hike, fair value is about 24 bp, and the contract settled at 26.5 bp ahead of the weekend.
We have argued that a rate hike has been discounted in the December 2022 Eurodollar futures, which are more actively traded than the deferred Fed funds contracts. Three-month LIBOR is near 12 bp, and the implied yield of the December Eurodollar futures is about 46 bp, up from 35 bp on August 4, which was nearly an eight-week low. Moreover, at the June FOMC meeting, only seven of the 18 Fed officials thought a hike in 2022 would be appropriate, of which two thought there would be scope for a second hike.
The shifting expectations of Fed policy while ECB views remain steady is reflected in the two-year rate differential. The US premium neared 100 bp last week, the highest since May 2020, before pulling back a little. It has risen by about 20 bp since mid-May and nearly 10 bp since the end of June. As the Bloomberg chart illustrates, the euro-dollar exchange rate has been tracking the two-year rate differential closely.
The ability to generalize from this example is difficult. Consider sterling's two-year yield discount to the US has been more than halved since the end of June, and the only reason sterling has not fallen against the greenback over the same period is that it bounced by nearly 0.5% ahead of the weekend. Also, Canada offers nearly twice what the US does to borrow for two years, and its premium is the widest since last March. Canada's premium has practically doubled since mid-June, while the Canadian dollar has depreciated by about 2.60% against the US dollar since then.
On the other hand, the dollar-yen exchange rate is particularly sensitive to US interest rate developments. The correlation is stronger with the ten-year differential than the two-year (60-day correlation of differences (~0.63 vs. 0.33). That said, the correlation is stronger just using the US two-year yield (change) rather than the spread (0.43 vs. 0.33). Pundits are fond of reminding their audiences that correlation does not mean causation. Still, sometimes the correlation, like the number of churches and mortuaries, reflects a correlation to a third series that is often missing, such as population size. Similarly, the yield and exchange rate could be correlated to something else, such as risk appetites or growth.
The high-frequency economic data due in the coming days may not matter as much as market positioning and thinner trading conditions. The spread of the Delta mutation continues to spur extended emergencies (Japan), lockdowns (China, Philippines, Australia), and many large businesses, already struggling to induce workers to commute and work as they did prior to the pandemic are postponing the return to the office. This may not slow large businesses, and corporate earnings have been strong, but the ecosystem created around the large pools of labor will take longer to recover. The possibility likelihood of a more contagious mutation, and one that could prove more lethal, remains a source of anxiety.
The US recovery is uneven, and this will be illustrated by next week's reports. If the pace of growth did not peak in Q2, it might be peaking now. The first look at August comes from the NY and Philadelphia Fed surveys. The former may dip, and the latter may rise. July retail sales likely softened, not just because of the sharp drop in auto sales (14.75 mln unit seasonally adjusted annualized rate from 15.3 mln, the least since July 2020). In addition, there may be a broader pullback of purchases after a splurge of 1.1% in core retail sales in June. Finally, while economists expect a solid report on industrial production after a 0.4% gain in June, the risk is on the downside, as supply shortages, bottlenecks, and labor issues continue to be reported.
Housing starts rose by about 8% in the first two months of Q2 but probably could not sustain the pace last month. To appreciate the strength of this sector, consider that starts averaged less than 1.3 mln a month annualized rate in 2018 and 2019. Last year, the average was closer to 1.4 mln and averaged closer to 1.6 mln in H1 21. As delays, costs, and shortages impacted decision-making, permits fell every month in Q2 and may have stabilized in July.
The Federal Reserve's public agenda is light and features an interesting, even if not market-moving, discussion with Chair Powell and teachers on August 17. The following day, the FOMC minutes from the July meeting will be released. However, a couple of things are clearer following recent official comments. First, as one would expect, as policy approaches a turning point, opinions seem to vary more, even among the Board of Governors, which often show a united front. Second, the differences do not seem particularly profound. Essentially, the difference between the hawks and doves appears to be a few months.
The UK and Canada report CPI and retail sales in the week ahead. The market's more hawkish takeaway from the recent Bank of England meeting has seen the risk of rate hike around the middle of next year has risen. The implied yield of the June 2022 short-sterling futures contract has risen from almost 25 bp at the end of the first half to 42 basis points in the middle of last week. The implied yield on the December 2022 contract has risen from about 38 bp to nearly 58 bp. The UK also reports employment data. The furlough program is to terminate at the end of September, and only after then will a clearer view of the UK labor market be possible.
The vagaries of high-frequency data notwithstanding, the Bank of Canada and the government's confidence in the economy has strengthened. The robust demand in the US has lifted Canadian exports and helped generate the largest merchandise trade surplus since 2008. Moreover, Prime Minister Trudeau seems so confident with the economic outlook and the vaccination rollout after the slow start that many expect a snap election to be announced shortly.
Japan kicks off the new week with its first estimate of Q2 GDP. If it escaped a contraction, it did so barely. The world's third-largest economy contracted by 1% in Q1 after expanding in H2 20. Large parts of the economy are in areas with formal or informal states of emergency, which largely impose a curfew and limit alcoholic drinks. Talks emerged last week as it became clear that more people contracted the virus than won medals in the Olympics that the existing emergency protocols might be extended until the end of next month.
Japan reports July trade figures, and seasonally it typically deteriorates from June (15 of the past 20 years). The trade surplus was JPY383 bln in June. Due to the base effect, exports in June were almost 49% above year-ago levels. Still, net exports shaved 0.2% of Q1 growth and are expected to have reduced Q2 growth by the same amount. Japan also reports the July CPI figure. Without much fanfare, the June series was revised sharply lower. Initially, June CPI was estimated to have risen by 0.2% year-over-year. It has been subsequently revised to -0.5%. Similarly, the core rate, which excludes fresh food, was subject to the same revision from 0.2% to -0.5%. The earlier release of the Tokyo CPI estimate warns that the most that may be reasonably hoped is a move out of deflation.
Two central banks meet, the Reserve Bank of New Zealand and Norges Bank, the Norwegian central bank. Both are at the forefront of major central banks shifting monetary policy from supporting growth to achieving their mandates. Recall that a couple years ago, the New Zealand parliament gave the RBNZ a maximum employment mandate alongside price stability. There seems little holding it back from hiking. Unemployment in Q2 fell to 4.0%, where it was in Q4 19, and price pressures are accelerating to move above 3%.
The swaps market appears to have a 25 bp rate hike discounted for next week and another 25 bp hike before the end of the year. The New Zealand dollar is in the middle of its $0.6900-$0.7100 trading range that has persisted since the middle of June, but well off the $0.7300 high seen in late May and the year's highest set toward the end of February near $0.7465. If the RBNZ does not deliver, the currency is vulnerable to a knee-jerk drop. However, the Kiwi is likely to bounce back if it is seen as a hawkish hold.
After contracting in Q1, the Norwegian economy snapped back in Q2, and the Norges Bank has indicated it intends to lift the deposit rate from zero this year. Inflation has been averaging near 3% this year, though the underlying rate, which adjusts for tax changes and excludes energy, has been trending lower over the past year when it peaked at 3.7% in August 2020. It stood at 1.1% in July, matching the slowest pace since late 2017. Ironically, over the past month, while the New Zealand dollar has been the best performing major currency and the only one to gain on the greenback (~0.8%), the Norwegian krone has been the weakest, shedding 2%. While a rate hike on August 19 is possible, on balance, the next meeting on Norges Bank meeting on September 23 is favored.