Dollar Outlook Worsens as Pandemic Rages in US

  • The dollar continues soften; virus numbers in the US show no signs of slowing; given Europe’s past success in controlling the virus, we have more confidence that policymakers there can do it again; tensions are growing over the lack of a fiscal package
  • October PPI data will be the highlight for the US; preliminary November University of Michigan consumer sentiment is expected at 82.0 vs. 81.8 in October; Mexico surprised markets by holding rates at 4.25% yesterday
  • UK Prime Minister Johnson’s powerful (and controversial) aide Dominic Cummings will reportedly resign by year-end; the latest round of Brexit negotiations comes to an end with little to show for it; Poland is threatening to block the EU budget over the rule of law clause, just as Hungary has done
  • RBNZ continues to push back against negative rates; the US fired another salvo at Chinese corporates; Improved risk appetite over the last couple of weeks is already showing up in foreign equity flows into Asian markets

The dollar continues soften.  After peaking near 93.208 midweek, DXY is down for the second straight day and has been edging further below the 93 area.  The euro has gotten a toehold above $1.18 while sterling is looking to test $1.32 again.  USD/JPY continued to trade heavy after the rally is ran out of steam near 105.70 and is back testing the 105 area.  We believe that dollar weakness will continue (see below) and so DXY should test this month’s low near 92.13 before eventually testing the September low near 91.746.

 

AMERICAS

The virus numbers in the US show no signs of slowing. Daily cases hit a new record high near 150k, while hospitalizations and deaths are rising sharply. There still has been no coherent federal response and so we are even more pessimistic on the US outlook. Fed Chair Powell continued to warn of downside risks from the virus, noting that “With the virus now spreading, the next few months could be challenging.” He was joined by ECB President Lagarde and BOE Governor Bailey yesterday in sounding the alarm, as Europe grapples with its second wave.

Given Europe’s past success in controlling the virus, we have more confidence that policymakers there can do it again. Indeed, lockdown efforts are already being seen. These will have a negative short-term impact as economic activity slows again, but sets the table for reopening sooner rather than later. The US has never fully controlled it and the continued lack of effort coupled with Trump’s reluctance to help with the transition to the Biden administration suggests things will get much worse before they get better. Yes, the US economy has been resilient in recent months but at what cost? This renewed divergence in virus control efforts underscores our weak dollar call. Until we can control it here, the short-term economic gains will eventually give way to greater medium-term pain.

Tensions are growing over the lack of a fiscal package. Reports suggest the White House is stepping back from negotiations and leaving it to Senate Majority Leader McConnell to revive talks with House Speaker Pelosi. On the other hand, President-elect Biden, Pelosi and Senate Minority Leader Schumer accused Republican lawmakers of giving up on stimulus at a time when it’s needed the most, with Biden calling for a package before year-end. While McConnell has said that getting stimulus passed during the lame duck session was a top priority, he is not budging much from his $500 bln skinny deal and so we think the sides remain too far apart to reach a workable deal. If the pandemic continues to rage out of control as we expect, the incoming Congress will face greater pressure to get a deal done. However, the next couple of months are looking more dire.

October PPI data will be the highlight for the US. Headline PPI inflation is expected to remain steady at 0.4% y/y and core is expected to remain steady at 1.2% y/y. Yesterday, October CPI was reported. Both headline and core came in a tick lower than expected at 1.2% y/y and 1.6% y/y, respectively, and both are also the lowest since July. With tens of millions unemployed still as virus numbers continue to worsen, we see no wage pressures on the horizon. Typically, wages are the primary drivers for underlying inflation, with gyrations in food and energy prices only affecting headline inflation. With price pressures likely to remain soft near-term, we think that the 1.0% level for the US 10-year yield is going to be tough to crack. After trading at a new cycle high near 0.97% earlier this week, that yield is now back below 0.90%.

Preliminary November University of Michigan consumer sentiment is expected at 82.0 vs. 81.8 in October. While markets typically focus on the headline reading, many will be more interested in the inflation expectations components. In October, the 1- and 5-year expectations stood at 2.6% and 2.4%, respectively. These are well below the 1.2% reading we just got for October. These expectations are also are well above the equivalent TIPS breakeven rates of 1.06% and 1.64%, respectively. Even the 10- and 30-year breakeven rates of 1.72% and 1.86% are lower than Michigan expectations. The Fed’s Williams and Bullard speak today and we expect them to echo Powell’s concerns about the economic impact of the ongoing pandemic.

The monthly budget statement for October is worth discussing. The deficit came in at -$284 bln vs. -$274 bln expected. As such, the 12-month total rose to a record -$3.28 trln. Receipts continue to fall y/y while expenditures continue to surge, and this trend is likely to remain in place for the foreseeable future even without another stimulus package. The longer the pandemic stretches on, the more the fiscal outlook deteriorates.

Banco de Mexico surprised markets by holding rates at 4.25% yesterday. Expectations were for a 25 bp cut to 4.0%. There was one dissenting MPC vote in favor of a cut. October CPI rose 4.09% y/y, boosted by agriculture and merchandise prices due to supply disruptions. Core inflation is just under 4.0%. This is the third month that headline CPI stayed above Banxico’s 3% ± 1 ppt target range. The statement explained the decision by saying that the “pause provides necessary space” for inflation to converge back to the bank’s goal. That’s an impressively strong hawkish posture, in our view, given the relatively small countercyclical fiscal effort by the government and recent peso appreciation. The currency is nearly 20% stronger against the dollar from its weakest level of the year in March, and 7% since the September meeting. As such, we expect the easing cycle to resume next year. But for now the yield curve flatted substantially on the move, looking very different compared to the steeper shape of some other high-beta EMs, such as Brazil and South Africa. There was no significant reaction in the peso.

 

EUROPE/MIDDLE EAST/AFRICA

UK Prime Minister Johnson’s powerful (and controversial) aide Dominic Cummings will reportedly resign by year-end, further weakening his hand in Brexit negotiations. Amongst other things, Cummings played a crucial role in the “Leave” campaign during the EU Referendum as well as in Johnson’s electoral victory last year. The still unconfirmed news follows the resignation of Johnson’s communication chief Lee Cain.

The latest round of Brexit negotiations comes to an end with little to show for it, but we still think a deal is at hand. Talks will continue, of course, but we think the recent developments (the cabinet resignations and Biden’s victory) place Johnson in a weaker position. Taken in conjunction with the notion that a Biden victory decreases the odds of an easy US-UK trade deal as a fall back option, Johnson is literally standing alone now and so the odds of an EU-UK deal have increased, in our view. Recent developments suggest we may see greater concessions from the UK side to get a deal (even if narrow) done, hence potentially good news for sterling.

Poland is threatening to block the EU budget over the rule of law clause, just as Hungary has done. This was expected given the ongoing issue of the EU linking funds to the democratic and judicial standards in recipient countries, in line with a preliminary agreement last week. The bloc’s budget of €1.8 trln includes some €23 bln of funds earmarked for Hungary and Poland. We don’t have a clear view of how this brinkmanship game will play out, but we suspect that Hungary and Poland (despite badly needing the funds) have the upper hand here since the vote for the package must be unanimous. Polish Climate Minister Kurtyka later said he’s confident a deal can be worked to unlock the funds, confirming our suspicions that a compromise will be struck when the price is right. It’s hard to imagine the EU would let the entire rescue plan crumble given the worsening of the virus and second lockdowns and so we view this as yet another speedbump before the final deal is sealed.

 

ASIA

RBNZ continues to push back against negative rates. After Governor Orr cast doubt after the policy meeting, it was now Assistant Governor Hawkesby’s turn. He noted that the RBNZ is much less likely to go negative if banks use the new Funding for Lending Program, noting “If the banks don’t like having a negative OCR, then passing on as much of the Funding for Lending Program as possible through into lower lending rates is going to reduce the likelihood that a negative OCR is needed.”  Still, he said negative rates remain an option, adding “If the FLP doesn’t result in lower funding costs that are passed on through into lower lending rates, then we aren’t delivering more stimulus, and on current settings more would need to be done through another tool.” Of note, markets are no longer pricing in negative rates next year.

The US fired another salvo at Chinese corporates. This executive order targets 20 Chinese firms with relationships with the military. The measure prohibits US investors from buying or selling shares of these companies. On the other hand, the Trump administration has backed down on its threat to ban the social media video app TikTok (owned by ByteDance). US judges had already blocked the ban on TikTok, laying the groundwork for the government’s decision to back down, though it said it will appeal the decision.

Improved risk appetite over the last couple of weeks is already showing up in foreign equity flows into Asian markets. India’s equity markets, trading at record highs, has seen $3.7 bln of foreign inflows so far this month and should only accelerate in the aftermath of the vaccine news since the country is one of the hardest hits in Asia. Even before that, India and China were the only two major Asian countries where foreign investors have been net buyers over the last 12 months. Korea’s Kospi, one of the top performing markets this year (+13.5%), has seen $4 bln in inflows this month, though it remains well in negative territory for the year, according to data compiled by Bloomberg. Given the region’s relative success in controlling the virus, we would expect economic outperformance to continue attracting foreign investment.