Dollar Mixed as Markets Shift Back to Risk-Off Mode

  • Risk assets got a boost from signs of a thaw in US-China relations
  • After the initial knee-jerk reaction, markets have since moved back to risk-off mode; based on the fundamentals, we remain dollar bulls
  • July US headline CPI rose 1.8% y/y and core CPI rose 2.2% y/y, both higher than expected
  • China reported weak July IP and retail sales; the HK situation seems to have moved back to a slow simmer
  • Eurozone reported Q2 GDP; UK reported July CPI

The dollar is mixed against the majors as markets are looking beyond the US-China thaw. Yen and Swissie are outperforming, while Nokkie and Aussie are underperforming. EM currencies are mixed too. KRW and IDR are outperforming, while ZAR and RUB are underperforming. MSCI Asia Pacific was up 0.8%, with the Nikkei rising 1.0%. MSCI EM is up 0.4% so far today, with the Shanghai Composite rising 0.4%. Euro Stoxx 600 is down 1.0% near midday, while US futures are pointing to a lower open. 10-year UST yields are down 8 bp at 1.62%, while the 3-month to 10-year spread has inverted 8 bp to stand at -36 bp. Commodity prices are mostly lower, with Brent oil down 1.4%, copper down 1.1%, and gold up 0.4%.

Risk assets got a boost from signs of a thaw in US-China relations. Reports emerged yesterday that some planned US tariffs would be postponed until December 15. Nearly half the $300 bln of goods subject to the new September 1 round of tariffs will get that reprieve, consisting mainly of big ticket items that include smart phones and laptops. Despite claims that China is paying the tariffs, President Trump acknowledged that the decision to delay was made to minimize disruptions to holiday shopping season.

The news came shortly after reports that the US and China trade officials spoke by phone this week. Reports suggest China “seriously” protested the 10% tariffs planned for September 1. As such, the subsequent announcement of the delay suggests the US gave in. What did the US gain in return? Only time will tell.

Another round of trade talks by phone will be held in two weeks. China then confirmed that officials still plan to visit Washington DC in September for face-to-face talks. Yet reports suggest this is contingent on developments ahead of that and there, China officials are not that optimistic about any imminent progress. Some say that China is unlikely to make any significant concessions ahead of the October 1 celebration of the 70th anniversary of the People’s Republic of China.

After the initial knee-jerk reaction, markets have since moved back to risk-off mode. Today, European stocks are lower and US stocks are likely to open lower, while havens JPY and CHF are outperforming. Let’s take the long view. We still think a trade deal this year is highly unlikely. That means 2020, and so global trade and growth are likely to remain weak this year. We just can’t get excited over these latest developments. And we could easily see a tweet tomorrow that reverses this.

Based purely at the fundamentals, we remain dollar bulls. The US economy is well-positioned as global growth risks mount. Europe and EM quite simply are not. We continue to believe markets are overestimating the Fed’s capacity to ease (see below), even as the rest of the world is prepared to ease more aggressively in the coming months.

It’s worth noting that July US headline CPI rose 1.8% y/y and core CPI rose 2.2% y/y, both higher than expected. The core reading is particularly interesting, as it is the highest rate since January. As tariffs are extended and widened, price pressures should pick up. While the Fed is more concerned about the downside risks to consumption of tariffs rather than the inflationary risks, a sustained pickup in US inflation would catch bond markets very wrong-footed.

While WIRP still suggests 100% odds of a cut September 18, the odds of a 50 bp cut have eased. They now stand at 19% vs. 31% at the start of this week. Before that FOMC meeting, the Fed will see August jobs data, PPI, CPI, and retail sales. If the real data continue to come in firm and inflation readings tick up further, can the Fed really justify another cut then? Stay tuned.

China reported weak July IP and retail sales. They were expected to rise 6.0% and 8.6% y/y, respectively.  Instead, they rose 4.8% and 7.6% y/y, respectively. Earlier this week, China reported weaker than expected money and loan data. While we expect further stimulus measures, we think a PBOC rate cut is unlikely at this juncture.  Such a move would likely add to yuan weakness and we do not think policymakers want to put more pressure on the currency.

China refused port visits to Hong Kong for two US warships in the coming weeks. With the Hong Kong protests ongoing and US-China relations still chilly, this shouldn’t come as much of a surprise. China officials said that port visits for US warships have always been approved on a case-by-case basis but did not elaborate further. We note that some hardliners in China suspect the US of fomenting unrest in Hong Kong.

After yesterday’s mayhem at the Hong Kong airport, the situation seems to have moved back to a slow simmer. Sensing a possible loss of support due to the airport fracas, the protestors quickly apologized for their behavior. Our base case is that some sort of negotiated political settlement will be seen. Please see our recent MarketView piece “Some Thoughts on Hong Kong” for an in-depth look at the issues.

Eurozone reported Q2 GDP. Growth came in as expected and remained steady at 1.1% y/y.  Ahead of that, Germany reported its preliminary Q2 GDP, with the economy staying flat y/y vs. an expected -0.3% y/y contraction.  However, Germany contracted -0.1% q/q, as expected. Eurozone June IP was also reported. It was expected to contract -1.5% m/m but instead fell -1.6% m/m.  The y/y rate sank to -2.6% from a revised -0.8% (was -0.5%) in June. WIRP suggests 100% odds of a cut September 12, with 42% odds of a 20 bp cut now seen.

UK July CPI was reported. Headline and CPIH were both expected to fall a tick to 1.9% and 1.8% y/y, respectively.  Instead, they both rose a tick to 2.1% and 2.0% y/y, respectively. With the risks of hard Brexit rising, we feel that BOE will be more concerned about growth than inflation. Last week saw Q2 GDP contracting q/q, leading easing bets to increase.

Weak UK data and a more dovish perception of the BOE have conspired to weigh on sterling.  Cable remains near multi-year lows from earlier this week. The next targets are the January 2017 low near $1.1985 and then the October 2016 low near $1.1840.  EUR/GBP has also made new highs this week and is on track to test the October 2016 high near .9415.