Dollar Consolidates Ahead of CPI, FOMC Minutes

• U.S. short rates continue to rise; September inflation readings will be closely watched; Treasury concludes a heavy auction schedule; FOMC minutes will be released; Fed officials seem unfazed by the jobsreport; Chile is expected to hike rates 100 bp to 2.50%; higher carry across Latin America has not been enough to shift the downdraft on local currencies
• Eurozone IP was reported; reports suggest the EU will offer some concessions to the U.K. regarding Northern Ireland; U.K. had its monthly data dump and it wasn't pretty; BOE officials remain hawkish
• Japan reported August core machine orders; China September trade data came in on the strong side
  

The dollar is consolidating its recent gains. DXY is down modestly today after posting a new cycle high yesterday near 94.56 as U.S. short rates continue to rise. USD/JPY traded yesterday at the highest level since December 2018 near 113.80. The November 2018 high near 114.20 is the next target, followed by the October 2018 high near 114.55. Elsewhere, the euro remains heavy near $1.1565 after trading yesterday at the lowest level since July 2020 near $1.1525. Sterling is holding up relatively better and remains above $1.36 but the negatives (weak data, Brexit tensions, energy crisis) continue to pile up and so we see a period of underperformance ahead. If U.S. data point to rising price pressures and continued strength in the economy, rates and the dollar should continue to move higher.

AMERICAS

U.S. short rates continue to rise. The 2-year yield rose to 0.36% yesterday but has since fallen to 0.35%, still the highest since March 2020. This largely reflects shifts in Fed tightening expectations, as the Fed Funds strip now see around 55% odds of Q3 22 lift-off and 100% for Q4 22. Of course, this will all have positive implications for the dollar, which has been on a tear despite the disappointing jobs report. The 2-year differentials with Germany (102 bp) and Japan (46 bp) are both at cycle highs and support further dollar gains vs. the euro and yen. Elsewhere, the 10-year yield traded as high as 1.63% yesterday but has since fallen back below 1.60%.

September inflation readings will be closely watched. CPI will be reported today, with headline expected to remain steady at 5.3% y/y and core expected to remain steady at 4.0% y/y. PPI will be reported tomorrow, with headline expected to pick up nearly half a point to 8.7% y/y and core expected to pick up nearly half a point to 7.1% y/y. The rise in PPI will be particularly troublesome, as reports suggest firms are finding it easy to pass through higher costs to consumers, which implies upside risks for CPI in the coming months.

The U.S. Treasury concludes a heavy auction schedule. A $24 bln sale of 20-year bonds will be held today. At the previous auction, indirect bidders took 69.7% and the bid-cover ratio was 2.49. Yesterday, $58 bln of 3-year notes and $38 bln of 10-year notes were sold and demand was much stronger at the long end. Indirect bidders took 44.2% and 71.1% vs. 56.7% and 71.1% at the previous auction, respectively. The bid-cover ratios were 2.36 and 2.58 vs. 2.45 and 2.59 at the previous auction, respectively.

FOMC minutes will be released. At the September meeting, the Fed delivered what we viewed as a hawkish hold and so the minutes should reflect this hawkishness. It said that tapering "may soon be warranted" as the economy and employment have continued to strengthen. Powell later said that if the economy progresses as expected, the Fed may move at the next meeting. He added that the Fed needs to see a "reasonably good" jobs report but that in his thinking, the test is "all but met." Lastly, Powell said that gradual tapering is likely to conclude around mid-2022. The last time the Fed tapered, it was spread out over a year. Powell said it will only take 6 months.

Fed officials seem unfazed by the jobs report. Yesterday saw several Fed speakers signal comfort with tapering still, Bullard said he'd support starting to taper in November and would like to wrap it up by the end of Q1. He added that while he wants to keep tapering separate from lift-off timing, he wants the flexibility to be able to move in 2022 if needed. Bostic said tapering won't adversely affect the pace of recovery and added that rate lift-off is more than a year off in his forecast. Lastly, Clarida said inflation risks are to the upside and that moderation in the pace of Fed bond buying may soon be warranted. We believe a tapering announcement next month remains on track. Brainard and Bowman speak today.

Chile central bank is expected to hike rates 100 bp to 2.50%. Some see a 75 bp hike and one analyst even sees a 150 bp hike. After starting the tightening cycle with a 25 bp hike to 0.75% back in July, the bank delivered a larger than expected 75 bp hike to 1.50% in August. Headline inflation came in much higher than expected at 5.3% y/y in September, the highest since November 2014 and further above the 2-4% target range. As such, we think the bank will maintain the faster pace of tightening for now. Bloomberg consensus sees the policy rate at 3.75% in Q1, rising to 4.5% in H2.

Higher carry across Latin America has not been enough to shift the downdraft on local currencies. It's probably fair to say that without tightening, performance would have been far worse, but rates have clearly not been the most important variable here. The broad LatAm currency index is down -7.5% this year, underperforming the broad EM index (-5%) and especially the EM Asia index (-2%). There are a few factors in play, including these markets' usual higher-beta status and greater sensitivity to the dollar trends. But we think it ultimately boils down to politics, especially for Brazil, Peru and Chile. Indeed, Mexico has outperformed the lot considerably, as political headwinds there are comparatively tame.

EUROPE/MIDDLE EAST/AFRICA

Eurozone IP was reported. It fell - 1.6% m/m vs. -1.7% expected and a revised 1.4% (was 1.5%) gain in July. Overall, recent eurozone data have come in soft and should give the ECB doves cover to push back against the hawks, who want to end accommodation. ECB's Visco speaks. Next policy meeting October 28 is likely to be contentious and so no decision on QE is expected until the December meeting.

Reports suggest the EU will offer some concessions to the U.K. regarding Northern Ireland. The EU will reportedly offer to cut customs checks by 50% and by up to 80% of sanitary checks on food imports for Northern Ireland with a streamlined process. However, the EU staked out the role of the European Court of Justice as a red line. This comes a day after U.K. Brexit Minister Frost threatened to unilaterally scrap the Northern Ireland protocol. Of course, much of this is posturing as an EU delegation goes to London tomorrow to hold talks. Indeed, Frost later noted that "There are several stages in this process where everybody can look carefully at it and decide to pull back from the brink."

U.K. had its monthly data dump and it wasn't pretty. August IP, construction output, services, trade, and GDP came in mostly softer than expected. IP was the outlier, rising 0.8% m/m vs. 0.2% expected and a revised 0.3% (was 1.2%) in July and driven in large part by a 0.5% gain in manufacturing vs. flat expected and a revised -0.6% (was flat) in July. Otherwise, construction fell -0.2% m/m vs. an expected 0.4% gain and a revised -1.0% (was -1.6%) in July, services rose 0.3% m/m vs. 0.6% expected and a revised -0.1% (was flat) in July, and GDP rose 0.4% vs. 0.5% expected and a revised -0.1% (was 0.1%) in July. The data and revisions certainly add to the notion that the U.K. economy is losing momentum even as policymakers contemplate removing stimulus. The trade deficit came in at -GBP3.7 bln vs. -GBP2.8 bln expected and a revised -GBP2.95 bln (was -GBP3.1 bln) in July.

BOE officials remain hawkish. Over the weekend, both Saunders and Bailey seemed to validate market expectations for an imminent hike. The short sterling strip has fully priced in lift-off in Q4, with another three hikes priced in over the course of 2022. This strikes us as overly hawkish and comes at a time when fiscal policy is also about to be tightened. This is a double whammy that will hit the economy even as it's already slowing. We believe that this potential policy mistake makes sterling vulnerable in the coming days. Cunliffe speaks today.

ASIA

Japan reported August core machine orders. They were expected to rise 1.4% m/m but instead fell -2.4% vs. a 0.9% gain in July. Still, the y/y rate picked up to 17.0% vs. 13.9% expected and 11.1% in July. Final August IP will be reported Thursday. Q3 may not have been as weak as anticipated, while Q4 is looking a bit better with the end of the state of emergency and another fiscal package expected soon. The weak yen should also help boost export competitiveness as well as inflation, which would both be positive for the economy.

China September trade data came in on the strong side, but we are more concerned about the domestic economy. Exports rose by 28.1% y/y (21.5% expected), though imports disappointed at 17.6% y/y (20.9% expected). This led the trade balance to shoot higher to $66.8 bln, from $58.3 bln the previous month. While good news, we don't think this is sustainable given the state of the global economy and the domestic issues that China is facing. Energy shortages, commodity prices, and chip shortages will continue to weigh on the economy ahead despite the still favorable external accounts. There was no sustained market reaction to the data.

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