US Dollar bears bide their time as economic strength persists

Reuters: A strong U.S. economy is giving an unexpected boost to the dollar, frustrating bearish investors betting on its decline. The US dollar is up 2.5% from its recent low against a basket of currencies and stands near its highest level since March.

US Dollar

The nascent rally has defied expectations for the currency to resume a decline from last year’s multi-decade highs: Net futures bets against the dollar stood at $12.34 billion in the week to May 30 after hitting a two-year low earlier in the month, according to data from the Commodity Futures Trading Commission. Fund managers in the latest BofA Global Research survey named shorting the dollar as the market’s third “most crowded” trade. The dollar is “in a very messy transition from bull market to a bear market,” said Aaron Hurd, senior portfolio manager, currency, at State Street Global Advisors. “That transition period is going to be fairly frustrating.” Hurd expects the dollar to remain buoyant over the very short term, but decline steadily over the next few years.

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Bears argue that the dollar has plenty of room to fall, as the currency remains some 15% above its post-pandemic low and the Federal Reserve is widely expected to soon end the interest rate increases that have helped support the greenback. But the bears’ view has been stymied by a run of strong U.S. data that suggests the economy remains resilient despite the barrage of Fed hikes aimed at slowing growth and containing inflation. Most investors believe the dollar will likely remain elevated until U.S. data turns decidedly weaker, allowing the Fed to cut rates. The latest evidence of the economy’s strength came Friday, when the U.S. reported greater-than-expected employment gains for May. Other recent data points, including consumer spending and new home sales, have also weighed against the view that the Fed will cut rates anytime soon.

Traders on Friday were betting that the fed funds rate – which currently stands between 5% and 5.25% – would finish 2023 at 4.988%, compared with expectations in early May to end the year at 4.188%. Higher rates tend to boost the dollar’s appeal. “The dollar strength is entirely related to the fact that U.S. data is actually pretty good,” said Alvise Marino, a strategist at Credit Suisse. Credit Suisse strategists recently bet on the dollar’s gaining against the euro, according to a note. The greenback rose about 3% against the euro in May. A stronger dollar can be a headwind for risk assets as it helps tighten credit conditions while weighing on the profits of U.S. exporters and multinationals. Another potentially complicating factor for dollar bears is a flood of U.S. government bond issuance expected in the remainder of the year, with the U.S. Treasury expected to begin refilling its coffers now that the debt limit has been raised.

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One view holds that such a large amount of Treasuries will drain liquidity from the market, potentially creating demand for dollars, said Bipan Rai, North America head of FX strategy at CIBC. Still, many believe it’s only a matter of time until the dollar resumes a downtrend that saw it lose as much as 11.5% from its September highs. UBS Global Wealth Management ranks the dollar as its “least preferred” currency, saying the Fed is likely to cut rates late this year or early in 2024, reducing its yield advantage over the euro and other currencies.

Federal Reserve officials indicated last week that the central bank was likely to skip an interest rate hike at its upcoming meeting, on June 13-14, while leaving the door open to a future rise in borrowing costs. In Europe, European Central Bank President Christine Lagarde said further policy tightening was necessary, a trend that would undermine the dollar’s yield advantage. “Once the Fed stops hiking, the market will focus more intently on the timing of the first rate cut and that is likely to undermine the dollar,” said Brian Rose, senior economist at UBS Global Wealth Management. Rai, of CIBC, believes the dollar’s lingering strength will give way to weakness as it becomes clearer later this year that the Fed will hold off from further rate hikes while the ECB may have more work to do. “From a macro sense, I still believe the dollar needs to decline,” he said. “But that story might need to wait until the second half of this year.”

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British Pound

Reuters: Sterling headed for its biggest one-week rally against the dollar in six months on Friday, as U.S. interest rates looked increasingly likely to plateau sooner than UK rates. With the all-important monthly U.S. employment report due later in the day, activity in the currency market was subdued. “From a cable perspective, this release may extend the rally (NFP miss or in line with estimates) or cap upside should the report come in stronger than expected,” IG analyst Warren Venketas said. The pound has gained 1.5% against the dollar last week, the most since early December, and nearly 1.1% against the euro – which would be its largest weekly increase in nearly four months. The main driver has been a redirection of investor capital out of the safe-haven dollar, now that lawmakers in Washington have passed a bill that would suspend the U.S. government’s borrowing limit.

Juicing up that flow has been a series of signals from Federal Reserve officials this week that the central bank might stand pat when it meets on June 13-14 to discuss monetary policy. This has fed a sharp repricing in interest-rate expectations. Traders now place a 29% chance the Fed will raise rates this month, compared with a 70% chance a week ago. Meanwhile, as UK inflation remains stubbornly high, traders have reassessed the outlook for monetary policy in Britain too. Money markets show markets are pricing for UK rates to peak at 5.32% by year-end, up from 4.50% now. A month ago, the expectation was that UK rates would be around 4.80% by December.

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Similarly, as U.S. Treasury yields have retreated with the passing of a bill in Congress to raise the U.S. government’s borrowing limit and avoid a potentially catastrophic default, UK yields have ramped up, thereby giving sterling an advantage – at least in theory. The premium of UK 10-year gilt yields over those for 10-year Treasuries has widened this week to its largest since early 2009. In practice, however, sterling has not nearly as much of a lift as some might expect, given the 50-basis point premium that gilts wield over Treasuries.

Jordan Rochester, a strategist at Nomura, said in a recent note this is typical of an emerging market currency – a description often ascribed to sterling given its high volatility and sensitivity to domestic politics. “Sticky inflation in the UK will prolong the length of the BoE rate hike cycle = lower growth, less UK inflows,” he said. Global growth expectations are waning, asset managers hold a small long position in sterling – giving them less incentive to load up on pounds – and the currency’s correlation with bond yields is weaker than that say of the dollar with Treasury yields, Rochester said. It’s all down to stagflation. The UK has the highest inflation and the slowest growth among the G7. Britain has avoided recession, but the squeeze of the cost of living crisis on consumers and households is clear, given recent data on business activity, employment and lending.

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South African Rand

Reuters: The South African rand was up about 1% on Friday, extending a recovery from the previous session on growing expectations that the U.S. Fed will stand still on interest rates this month. At 1118 GMT, the rand traded at 19.4400 against the dollar, around 1% stronger than its previous close. The rand struck a new record low of 19.9075 on Thursday but ended the day stronger as U.S. manufacturing data and comments by Fed officials reinforced expectations that the Fed would skip a rate hike at its June policy meeting. The dollar was down around 0.05% against a basket of global currencies on Friday.

Markets are now pricing in a 20% chance of the Fed hiking by 25 basis points compared to a 50% chance a week earlier, according to the CME FedWatch tool, prompting a move back to riskier currencies. “Some ‘risk on’ trade has seen a weakening in the U.S. dollar as investors pile back into equity,” said Rand Swiss Portfolio Manager Gary Booysen. The rand had a tumultuous May, losing more than 7% against the dollar, as investor sentiment soured badly on unrelenting power cuts and U.S. allegations that South Africa supplied weapons to Russia.

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South African Electricity Minister Kgosientsho Ramokgopa will give an update on efforts to address the crippling power shortage at 1200 GMT. Shares on the Johannesburg Stock Exchange were last trading in the green, with both the blue-chip Top-40 index and the broader all-share index up nearly 2%. South Africa’s benchmark 2030 government bond was trading stronger, with the yield down 7 bps at 11.170%.

Global Markets

Reuters: Most Asian stock markets extended a global rally on Monday on optimism the Federal Reserve would pause its rate hikes this month after a mixed U.S. jobs report, while oil jumped after Saudi Arabia pledged big output cuts. Brent oil rose 1% to $76.89 a barrel, giving up some of its earlier gains to as high as $78.73, while U.S. crude climbed 1.2% to $72.61 a barrel, after hitting a session high of $75.06. Oil prices have recently come under pressure amid heightened concerns about China’s slowing economic recovery. They rose after Saudi Arabia announced it would cut its output to 9 million barrels per day in July, from around 10 million bpd in May, the biggest reduction in years, while a broader OPEC+ deal to limit supply into 2024 also underpinned futures. “With Saudi Arabia protecting oil prices from sliding too low we think oil markets are now more prone to a shortfall later this year,” said Vivek Dhar, a mining and energy commodities strategist at Commonwealth Bank of Australia. “We think Brent futures will rise to $US85/bbl by Q4 2023 even with a tepid demand recovery in China factored in.”

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On Monday, MSCI’s broadest index of Asia-Pacific shares outside Japan gained 0.2%, while Japan’s Nikkei surged 1.7% to stand above 32,000 for the first time since July 1990. Hong Kong’s Hang Seng index rose 0.6% while China’s bluechips underperformed with a drop of 0.4%. S&P 500 futures dipped 0.1% and Nasdaq futures dropped 0.3% in Asian hours, after a strong rally on Friday, driven by a mixed U.S. jobs report, a resolution to the debt-ceiling issue and the prospect of a U.S. rate pause this month. Data on Friday showed U.S. economy added 339,000 jobs last month, higher than most estimates, but moderating wage growth and rising jobless rate led markets to continue to bet on no change in Fed rates this month, with a 75% chance priced in for that, according to CME FedWatch tool.

However, there is about a 70% probability that Fed funds rates would reach 5.25-5.5% or beyond at the policy meeting in July and little chance of a rate cut by the end of this year. Treasury yields continued to climb on Monday. Yields on U.S. two-year Treasuries rose 4 basis points to 4.5449%, on top of a surge of 16.2 bp on Friday, and 10-year yields also climbed 3 bps to 3.7215%, after a rise of 8 bps on Friday. Fitch Ratings said the United States’ “AAA” credit rating would remain on negative watch, despite the debt agreement. The U.S. dollar remained elevated on Monday at 104.14 against its major peers, after gaining 0.5% on Friday on the jobs report. The greenback also rose 0.16% on the Japanese yen to 140.17 while the euro eased 0.1% to $0.10698.

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Central banks from Australia and Canada will meet this week. Markets see a sizeable chance – about 40% – that the RBA could surprise with a quarter-point hike on Tuesday, after a minimum wages decision that some economists feared could further stoke inflationary pressures. The Bank of Canada will meet on Wednesday. A majority of economists polled by Reuters expect the BOC to keep interest rates on hold at 4.5% for the rest of the year although the risk of one more rate hike remains high.

Published by the Mercury Team on 5 June 2023

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