Dollar Firms as Risks Start to Pile Up

  • Geopolitical risk is back in play with at least three sources of tension; the dollar has gotten some traction from the building risks
  • Powell delivers the second part of his semi-annual report to the House; May retail sales report was a shocker
  • Canada reports May CPI; Brazil is expected to cut rates 75 bp to a record low 2.25%
  • Reports from Germany suggest that the €750 bln recovery plan will be agreed to next month; UK’s May CPI and PPI data confirm the BOE’s leeway to ease tomorrow
  • Japan reported weak May trade data; inter-Korea and Sino-Indian tensions remain high

Please see our new table at the end of this piece for a snapshot of the biggest movers of the day across asset classes.

Geopolitical risk is back in play with at least three sources of tension: the Korea Peninsula, China-India, and US-Germany. The first two are discussed below in the Asia section. On the US-Germany tensions, the Trump administration said it would be removing thousands of troops from Germany. The decision is highly controversial on both sides, representing yet another front of diplomatic friction between the US and the EU. Meanwhile, the virus news stream remains negative. Beijing is struggling to contain an outbreak, with schools closed and flights canceled but stopping well short of a full lockdown. In this hemisphere, many US states are seeing record rates of infection, as is Brazil.

The dollar has gotten some traction from the building risks. DXY has risen two straight days and four of the past five and is back above 97. Still, we believe it will be hard for the dollar to mount a significant comeback while the Fed is operating in dovish mode. The euro feels heavy and is trading back below $1.13 area, as does sterling after failing to break above the 200-day moving average near $1.27 yesterday. USD/JPY is back stuck in the familiar 106-108 trading range.

AMERICAS

Powell delivers the second part of his semi-annual report to the House today. In yesterday’s Senate appearance, Powell stuck closely to the script from last week’s FOMC meeting. That is, he recognized recent improvements in the economy but warned that the US still has a very deep hole to dig out of. Powell stressed again that the downturn is impacting low-income households the hardest and warned of long-term damage to the economy as a result. Elsewhere, Vice Chair Clarida said yesterday that more support from fiscal and monetary policies may be needed, and echoed Powell’s view that there remains extraordinary uncertainty regarding the duration and depth of this downturn. Mester also speaks today.

May retail sales report was a shocker. Headline sales were expected to rebound 8.4% m/m but rose more than double that at 17.7%. Same for ex-autos, which rose 12.4% m/m vs. 5.5% expected, as well as the so-called control group used for GDP calculations at 11.0% m/m vs. 5.2% expected. June should show some further improvement as more states reopen, but much will depend on how the virus numbers develop. May building permits and housing starts will be reported today.

For now, we are in a sweet spot where the economic data are improving but the Fed is still adding stimulus. That should help equities build on their recent gains. The US yield curve remains relatively flat, as the 10-yearyield has been effectively trapped in a 0.60-0.80% range in Q2. The recent spike up to 0.96% quickly subsided, but we suspect yields will come under upward pressure again if the US data continue to improve in June. Early signs are positive and on top of that, there is a lot of supply coming down the pike from expanded budget deficits.

Canada reports May CPI. Headline inflation is expected to come in flat y/y from -0.2% in April, while common core is expected to remain steady at 1.6% y/y. For now, the Bank of Canada is in wait and see mode. However, Governor Macklem warned that a full recovery is a long way off and that will require interest rates to remain at the current lows for the foreseeable future. He also said that the bank will continue to buy government bonds until the economic recovery is well under way, adding that he is not concerned about the size of its balance sheet since it is “still relatively small.” Next policy meeting is July 15 and no change is expected then.

Brazil COPOM is expected to cut rates 75 bp to a record low 2.25%. IPCA inflation fell to 1.88% y/y in May, the lowest since January 1999 and further below the 2.5-5.5% target range. CDI market is pricing in a 25 bp cut to 2.0% at the August 5 meeting. Yesterday, April retail sales came in at -16.8% y/y vs. -14.1% expected and -1.2% in March. As we suspected, the recent BRL rally could not extend much below 5 and now we are back above that level. Brazil is posting record daily Covid-19 infections, while total deaths are now only second to the US. Cases are spreading inland and to the poorer regions of the country, and so this crisis is likely to get worse before it gets better.

EUROPE/MIDDLE EAST/AFRICA

Reports from the German government suggest that the €750 bln recovery plan will be agreed to next month. Merkel, at least, seems optimistic about it. We are as well. We are sensitive to the resistance by the frugal bloc, but their objections don’t seem unsurmountable. Yes, offering grants to Southern Europe and mutualization of debt will never go down easily for countries such as Austria, the Netherlands, Sweden, and Denmark, but the stakes are high enough to convince them to move as Germany has. In fact, the pandemic (an exogenous shock) provides the perfect political cover to push ahead with what is effectively a cultural change for the union. It would have been much harder, if not impossible, for this to take place if the need for extra funding for these counties were a result of their poor policy decisions, for example.

UK’s May CPI and PPI data confirm the BOE’s leeway to ease tomorrow. CPI came in at 0.5% y/y, as expected and down from 0.8% in April, driven largely by lower fuel costs. CPIH also came in as expected at 0.7% y/y, down 0.9% in April. Lastly, PPI came in at -1.4% y/y, contracting more than expected. Market consensus is calling for a £100 bln expansion of its asset purchase program, but we see the risk of a upside surprise. Please see our full BOE preview here.

ASIA

Japan reported weak May trade data. Exports contracted -28.3% y/y vs. -26.1% expected and -21.9% in April, while imports contracted -26.2% y/y vs. -20.4% expected and -7.1% in April. This was the deepest slump in exports since 2009, and the trade surplus with the US was the smallest since 2009 too. With many of Japan’s trading partners reopening this month, there is scope for some improvement ahead, but we suspect the pace will be modest. Indeed, Toyota warned that it may take a year for global car sales to return to pre-pandemic levels.

Tensions on the Korean Peninsula have not yet subsided, but we suspect they will soon. North Korea said it would send troops into the disarmed area at the border, accusing South Korea of breaching the 2018 agreements and criticizing its ties to the US. In Seoul, meanwhile, the unification minister offered to resign. The escalation comes after the North blew up an inter-Korean liaison office on its side of the border. We think the North Korea has a very short runway to escalate this conflict given such the complex geopolitical landscape at the moment, in particular with respect to China dealing with a new virus outbreak, tensions in Hong Kong, skirmishes on the Indian border, and the conflict with the US. The won is down 0.6% on the day, bucking the trend of regional currencies.

The India-China Himalayan borer conflict remains tense. Indian authorities now reported that 20 of its soldiers were killed and 17 critically injured. China said there were fatalities on its side as well. These are the first confirmed deaths in 45 years of conflict. Note that the fighting was hand-to-hand (stones and iron rods), respecting the tradition of disarmament in the region, designed to prevent escalation. With both nations dealing with so many other issues (from virus outbreak to other conflicts), the risk here is that a relatively small border skirmish could turn into a rallying point that forces escalation. For now, however, we still downplay this risk, but will keep a close eye.