Dollar Firm as Iran Tensions Rise

  • Markets are heightened alert after reports that President Trump ordered a military strike on Iran before calling it off abruptly
  • The dollar is getting some traction ahead of the weekend
  • We are left wondering if the dollar will behave like it did after the January 30 FOMC
  • Eurozone June flash PMIs were reported; Japan reported May national CPI, department store sales, and June flash manufacturing PMI
  • Korea reported weak trade data for the first 20 days of June; Colombia is expected to keep rates steady at 4.25%

The dollar is mostly firmer against the majors as an eventful week ends. Stockie and euro are outperforming, while Kiwi and sterling are underperforming. EM currencies are mostly weaker. IDR and THB are outperforming, while TRY and CNY are underperforming. MSCI Asia Pacific was down 0.4%, with the Nikkei falling 1.0%. MSCI EM is down 0.1% so far today, with the Shanghai Composite rising 0.5%. Euro Stoxx 600 is down 0.3% near midday, while US futures are pointing to a lower open. 10-year UST yields are flat at 2.03%, while the 3-month to 10-year spread is steady and stands at -9 bp. Commodity prices are mostly higher, with Brent oil up 1.3%, copper down 0.3%, and gold up 0.5%.

Markets are heightened alert after reports that President Trump ordered a military strike on Iran before calling it off abruptly. Tensions were already high after Iran shot down a US drone earlier this week, boosting oil price sharply. Reports suggest Trump warned Iran that an attack was imminent and called for talks, giving Iran a short period of time to respond. If anything, the US actions only serve to add greater uncertainty to an already volatile situation.

Give the markets an inch and they’ll take a mile. Despite the Fed’s ongoing dovish tilt, US rates continue to slide. The 10-year traded below 2% for the first time yesterday since November 2016. Implied yields across the Fed Funds futures strip have fallen. The January 2020 contract is now at 1.65%, which is fully pricing in three cuts this year. The January 2021 contract is now at 1.35%, which is fully pricing in one cut next year and part of a second. This seems way too aggressive to us. These are not insurance cuts being priced in, these are recession cuts.

And yet the US equity market continues to power ahead. S&P 500 closed at a new record high yesterday. Bond market signals recession, while equity market signals no recession. Which one is right? We think the equity market is right and that the bond market is simply too pessimistic. We also do not think that this divergence of views can be sustained for much longer.

The dollar is getting some traction ahead of the weekend. DXY is nearing the June 7 low near 94.459 but it is having trouble making a clean break below the 200-day moving average near 96.633. Likewise, the euro is having trouble sustaining a move above $1.13 and sterling above $1.27. USD/JPY traded at a new low for this move near 107 before bouncing a bit.

We need to see several more days (if not weeks) of price action, but we are left wondering if the dollar will behave like it did after the January 30 FOMC. Recall that Powell and company fist went full-on dovish at that meeting after the disastrous December 19 meeting. The dollar sold off that day and the day after but then recovered to make new highs against most currencies.

It’s too early to say we are seeing a repeat of that situation. However, it’s worth repeating that we remain bullish on the dollar for now due to our underlying optimism regarding the US economy. The bond market remains way too pessimistic on the US economy and is likely to recalibrate its rate cut expectations in the coming weeks. However, we must acknowledge that the dollar remains vulnerable until the US outlook becomes clearer.

During the North American session, the US reports June Markit PMIs and May existing home sales. Manufacturing PMI is expected to remain steady at 50.5, while services PMI is expected to rise a tick to 51.0. Home sales are expected to rise 2.1% m/m vs. -0.4% in April. With the FOMC media embargo ending, Brainard and Mester appear at a “Fed Listens” event today in Cincinnati, while Daly hosts a podcast on community economics.

Elsewhere, Canada reports April retail sales. Headline is expected to rise 0.2% m/m, while ex-autos are expected to rise 0.4% m/m. Inflation came in higher than expected in May, but markets still see the Bank of Canada remaining on hold this year. Indeed, perceived odds of the next move being a cut pick up as we move into Q4.

Eurozone June flash PMIs were reported. The headline composite reading was expected to rise to 52.0 from 51.8 in May but came in a tick higher at 52.1. This was driven by improvements in both the manufacturing and services components to 47.8 and 53.4, respectively. France saw a larger than expected improvement in its composite PMI to 52.9, while Germany’s was steady at 52.6. Final readings will be reported July 1.

While the eurozone economy appears to be stabilizing, the ECB is clearly preparing to add more stimulus in the coming months, perhaps before Mr. Draghi’s term ends October 31. Next ECB meeting is July 25. That may be too early for the next round of stimulus, but we believe that the September 12 and October 24 meetings will become live as we approach them. Much will depend on the data.

The Tory leadership race is now down to two. Boris Johnson and Jeremy Hunt were the last ones standing after the final MP vote. Johnson continued to dominate, winning 160 votes to Hunt’s 77. Voting now goes to a full vote of Conservative party members this weekend, with the next Prime Minister to be announced July 22.   Johnson is widely expected to win.

Japan reported May national CPI, department store sales, and June flash manufacturing PMI. Headline inflation eased as expected to 0.7% y/y from the 0.9% peak in April, while ex-fresh food eased to 0.8% y/y from the 0.9% peak in April. Sales continued to contract y/y, while the PMI came in at 49.5. This was the second straight reading below 50 and four of the last five months. The economy is limping into the October consumption tax hike and so the BOJ is widely expected to add more stimulus this year.

EM FX is giving back some its recent gains today. As we pointed out above, the dollar sold off after the January 30 meeting but then came roaring back. Back then, the liquidity story was not enough to sustain the EM rally, as global growth prospects started to deteriorate under the weight of the trade tensions. We suspect that may be what’s unfolding now but only time will tell. We remain cautious on EM.

Korea reported weak trade data for the first 20 days of June. This was the first glimpse of global economic activity in June and it wasn’t pretty. Exports contracted -10% y/y while imports contracted -8.1% y/y. US-China trade tensions continue to weigh on trade, with no near-term relief in sight.

Colombia central bank is expected to keep rates steady at 4.25%. CPI rose 3.3% y/y in May, well within the 2-4% target range. Meanwhile, the economy remains soft and lower oil prices are adding to the headwinds. We see steady rates through 2019.