The start of the week was marked by a weaker dollar and a decline in Treasury yields. Even the battered pound has managed to shrug off political risks and break above 1.22. The euro also managed to claw its way back above the critical 1.10 level overnight, although both pairs have given back some gains as we have progressed through the Asian session. So, can we expect more weakness from the dollar, and if so, how much?
The key driver of the dollar rally in recent weeks has been the rise in Treasury yields. On Monday the bond market sell off paused, and 10-year bond yields fell by 5 basis points yesterday afternoon. This may not sound like much, but for the typically slow-moving bond market it is a decline worth watching. The 10-year yield backed away from the key 1.80% level, so is a natural pause, or is 1.80% a step too far for bond investors with so much event risk on the horizon?
Watch Treasury yields to get a grip on the USD
We believe the driver of the sharp decline in Treasury yields on Monday was partly driven by fairly dovish comments from the Fed chair and vice-chair in recent days. Governor Yellen said on Friday that she would tolerate a period of higher inflation to try and counter-balance the effects from the financial crisis. Vice chair Fischer said on Monday that four factors are causing rates to remain low, including slower growth, demographics, low investment and slow foreign growth. The point on demographics is interesting to us, as Fischer mentioned that it has impacted productivity, the labour market, and pushed the savings rate higher, which is linked to an older population. Since US demographic trends continue to point to an aging population, the Fed may need to keep rates lower for longer. Thus, even if the Fed does hike interest rates in December, do not expect them to continue to tighten the screws in 2017.
Central bankers in no rush to hike interest rates
Interest rates matter for currencies, and if the Fed isn’t going to embark on a prolonged rate hiking cycle then it is hard to see how the Treasury market sell off, which is fuelling the dollar rally, can continue. However, this doesn’t mean that the buck is set to move out of the FX spotlight. Last week Bank of England governor Mark Carney also said that the BOE could look through a period of higher inflation without raising rates. Due to the better economic outlook for the US compared to the UK, we still expect the USD to outperform the G10, however, the pace of dollar gains may start to slow.
Interestingly, US stocks did not get a boost from falling Treasury yields or better than expected Bank of America earnings. We believe that election risk is starting to bite, with exactly three weeks to go before the vote. The markets appear to be taking a more cautious stance, and we may see further declines back to the 2,069 level in the S&P 500 – the 200-day sma – as investors may prefer to see the election over and done with before embarking on another leg higher in US equities.
Fundamentals come back into focus
At last, fundamentals are expected to overtake politics this week and act as a key driver of markets. UK and US CPI are due today. UK prices are expected to rise to 0.9% on an annual basis in September, up from 0.6% in August. We believe that the risks are to the upside, as the large decline in the pound starts to hit consumers in the pocket. A strong inflation number may weigh on the pound and the UK stock market, as the BOE has basically said its hands are tied to try and limit inflation pressures. This is the worst time for inflation to rear its head: just as Brexit concerns dim the economic outlook. Inflation can also be bad news for stocks, as it can dent the profitability of some sectors in the FTSE 100, who may choose to absorb price increases rather than pass them onto their customers, for example, the consumer sector. We will also be watching how the market prices in the probability of a BOE rate cut in the aftermath of the inflation data. We believe that a faster than expected increase in CPI could push back market expectations of a BOE rate cut until well into 2017, which may limit sterling’s decline for another day.
Inflation in the US is also expected to rise, with the annual headline rate expected to rise to 1.5% from 1.1%. We believe that any increase in inflation in the US could be temporary, and is unlikely to lead to multiple rate increases in the US in the coming months. In fact, a weaker than expected CPI figure for September is the bigger downside risk for the buck on Tuesday.
China risking the wrath of the international community
China’s central bank fixed its currency at the lowest level vs. the USD for 6 years at the start of this week, with USDCNY rising to 6.74. While this is largely a factor of dollar strength, if we start to hear accusations from the international community that China is manipulating its currency, then it could spark a period of volatility for USDCNY. Until then, we believe that a weak renminbi is likely to limit FX gains in the Asian world, and could benefit local stock markets, as we have seen on Tuesday.