Dollar Mixed as Trade Tensions Feed Risk Off Sentiment

  • The dollar is undergoing a correction as the slide in US interest rates accelerates
  • We remain dollar bulls but just like the Fed, we are struggling with how to compensate for a trade war
  • EM remains under severe pressure; onshore yuan traded above 7 for the first time since early 2008
  • Eurozone and UK reported final services and composite PMIs
  • Turkey July CPI Monday rose 16.65% y/y vs. 16.90% expected and 15.72% in June

The dollar is mixed against the majors as risk off sentiment builds.  Swissie and yen are outperforming, while the dollar bloc is underperforming.  EM currencies are mostly weaker.  RON and RUB are outperforming, while CNY and KRW are underperforming.  MSCI Asia Pacific was down 2.1%, with the Nikkei falling 1.7%.  MSCI EM is down 2.1% so far today, with the Shanghai Composite falling 1.6%.  Euro Stoxx 600 is down 1.8% near midday, while US futures are pointing to a lower open.  10-year UST yields are down 8 bp at 1.76%, while the 3-month to 10-year spread has inverted 6 bp to stand at -26 bp.  Commodity prices are mostly lower, with Brent oil down 0.9%, copper down 0.5%, and gold up 1.3%.

The dollar is undergoing a correction as the slide in US interest rates accelerates in response to the renewed tariff threats.  The implied yield on the January 2020 Fed Funds futures contract has fallen to 1.52% from 1.80% last week.  Two more cuts are now back to being fully priced in, with a third now largely priced in.  WIRP suggests 100% odds of a cut at the next meeting September 18, with 30% odds of a 50 bp cut then.

We remain dollar bulls but just like the Fed, we are struggling with how to compensate for a trade war.  Powell admitted last week that the Fed is still trying to figure out how to react to global trade tensions.  Markets clearly believe the Fed will bail Trump out again.  We are not so sure.  The Fed simply should not reward bad trade and fiscal policies with rate cuts.  With growing risk-off sentiment, the dollar should eventually benefit from renewed safe haven flows.

EM remains under severe pressure.  The less dovish than expected Fed, renewed trade tensions, and broad-based risk off sentiment have conspired to absolutely crush EM FX and equities.  These drivers are carrying over into this week and so we remain bearish on EM.  MSCI EM is testing the May low and is on track to test the January low near 945.50.  Likewise, MSCI EM FX is about to test the May low near 1609 and is on track to test the December low near 1597. 

The onshore yuan traded above 7 for the first time since early 2008.  For offshore CNH, it was the first time it has ever traded with a 7-handle.  Of course, this will bring on complaints from President Trump, but we believe the weak yuan is largely reflecting broad-based EM FX weakness.  The correlation between CNY and MSCI EM FX is currently around .82, which means the yuan is very much subject to greater market forces.

The PBOC noted today that the yuan is stable and strong against a basket of currencies and that the move in the bilateral rate above 7 was due to renewed tariff threats.  The central bank added that it will act to curb speculation and will try to keep the yuan stable.  China has pledged not to weaponize the yuan in the past, and we believe that pledge still holds.  However, policymakers have told state-owned companies to suspend imports of US agricultural products.

During the North American session, ISM July non-manufacturing PMI will be reported and is expected at 55.5 vs. 55.1 in June.  Final Markit services and composite PMIs will also be reported today.  The US economy remains in solid shape.  The Atlanta Fed’s GDPNow model is tracking 1.9% SAAR growth in Q3, down from 2.2% previously.  This is still close to trend (~2%) and little changed from the preliminary 2.1% SAAR in Q2.  Elsewhere, the NY Fed’s Nowcast model is tracking 1.6% SAAR growth in Q3, down from 2.2% the previous week.

Even though the FOMC media embargo has ended, Fed speaking engagements this week are light.  The only ones on the schedule today is Brainard.  Meanwhile, George said Friday that she dissented because the data and outlook warranted no change in rates, adding she is open to incoming data to prove her wrong.

Final July eurozone services and composite PMI readings were reported.  Headline composite PMI remained at the 51.5 flash reading, even though the services PMI fell a tick from the flash reading to 53.2.  Looking at the country breakdown, Germany composite PMI fell to 50.9, as the services PMI sank to 54.5 from the 55.4 flash reading.  France composite PMI improved a few ticks to 52.6, dragging the composite PMI up to 51.9 from the 51.7 flash reading.  Italy composite PMI rose to 51.0 from 50.1 in June, while Spain composite PMI fell to 51.7 from 52.1 in June.

The entire German curve out to 30 years is yielding negative rates.  Yet the 2-year US-German spread has fallen to 242 bp, the low for this cycle.  This is helping to boost the euro near-term, though we suspect the upside will be limited.  It has retraced about half of the fall from July 19, and a break of the $1.1185 area is needed to set up a test of that July 19 high near $1.1280.  That and the 200-day moving average near $1.13 will be hard to break.

UK July PMI readings wrapped up with firm services and composite PMI.  The two improved to 51.4 and 50.7 vs. expectations of 50.3 and 49.8, respectively.  They follow manufacturing (48.0) and construction (45.3) reported last week.  The BOE delivered what we consider to be a dovish hold last week, but WIRP suggests odds of a cut at the September 19 meeting are only 5%.

Turkey July CPI Monday rose 16.65% y/y vs. 16.90% expected and 15.72% in June.  Inflation accelerated for the first time since March, yet this is unlikely to prevent the central bank from cutting rates again at the next policy meeting September 12.  The lira has remained remarkably steady during this EM selloff.  This cannot last given Turkey’s poor fundamentals and outlook for lower interest rates and so the lira should start to underperform in the coming days.