Dollar and U.S. Rates Rise in Tandem

• U.S. 10-year yield traded today at the highest level since June 29 near 1.50%; the current move in U.S. rates and the dollar should perhaps be viewed through the lens of past tapering; with the FOMC meeting out of the way, Fed speakers become plentiful; Fed regional manufacturing surveys will continue to roll out
  
• U.K. is taking emergency measures to deal with the energy crisis; eurozone reported firm August M3; ECB asset purchases for the week ending September 24 will be reported; a coalition in Germany is taking shape but the process will likely be slow; there is now a new layer of risk in Turkey from a worsening of diplomatic tensions with the U.S.
  
• The latest polls suggest the LDP leadership vote will likely have to go to a run-off; there were lots of cross-currents in China headlines over the weekend
  

The dollar begins the week on a firm note as U.S. rates continue to climb. DXY is up for the second straight day and is nearing the post-FOMC high around 93.524. After that is the August 20 high near 93.729. The euro remains heavy and is once again testing support just below $1.17. We see an eventual test of the August 20 low near $1.1665. Sterling has held up relatively well due to the hawkish hold from the BOE last week but the growing U.K. energy crisis (see below) argues for significant underperformance and a test of the July 20 low near $1.3570 soon. USD/JPY is trading at the highest level since July 5 near 111 and should test the July 2 cycle high near 111.65. We believe the hawkish Fed and ongoing China risks will help keep the dollar rally going.

AMERICAS

The U.S. 10-year yield traded today at the highest level since June 29 near 1.50%. It appears to be on track to test the June 25 high near 1.54%. Of note, 1.45% is the 50% retracement objective of the March-August drop and a clean break above 1.53% is needed to set up a test of the March 30 high near 1.77%. The real 10-year yield is also higher and at -0.85% is the highest since June 25. Similarly, a break above -0.82% is needed to set up a test of the March 19 high near -0.59%. If this rise in U.S. yields can be sustained, it is yet another dollar-positive factor to consider. Of note, the Fed Funds strip now has lift-off in Q4 2022 almost fully priced in.

The current move in U.S. rates and the dollar should perhaps be viewed through the lens of tapering. In the only previous episode of tapering, U.S. rates rose over the course of 2013, leading up to actual tapering in late 2013 and that sort of curve steepening may be what we are seeing now. Eventually, tapering began and the yield curve flattened again as markets prepared for rate lift-off. That did not come until December 2015. Previous tightening experiences typically see a curve flattening as short rates rise and that seems to be the consensus outcome looking ahead. Of note, the dollar strengthened sharply as tapering progressed, with DXY rising from around 79 in May 2014 to over 100 by March 2015.

With the FOMC meeting out of the way, Fed speakers become plentiful. Evans, Williams, and Brainard speak today. All Fed officials are expected to continue advancing the tapering timeline, with the aim of preparing markets for an official announcement at the November 2-3 FOMC meeting.

Fed regional manufacturing surveys will continue to roll out. Dallas Fed is expected at 11.0 vs. 9.0 in August. Richmond reports tomorrow and is expected at 10 vs. 9 in August. So far, Empire and Philly Fed surveys surprised to the upside at 34.3 and 30.7, respectively, while Kansas City came in slightly lower than expected at 22 vs. 29 in August. From what we can tell, supply chain issues remain a headwind for U.S. manufacturing but are not enough to fully offset ongoing strength in the sector. August durable goods orders (0.6% m/m expected) will also be reported.

EUROPE/MIDDLE EAST/AFRICA

The U.K. is taking emergency measures to deal with the energy crisis. The government issued 5k short-term visas to truck drivers to help alleviate supply chain issues even as many gas stations ran dry over the weekend. The head of the FNV union representing truck drivers across Europe issued a blunt assessment, calling the visa program a "dead end" due to poor U.K. working conditions, adding "The EU workers we speak to will not go to the U.K. to help the U.K. out." Other reports suggest that the government is considering bringing in army drivers to help out.

These developments come at a precarious time for the U.K. Recent data show the economy was already softening ahead of this fuel crisis, and likely to soften further as the jobs furlough program ends this month. Does the Bank of England really think that monetary tightening is the right answer? We were disappointed that it took such a hawkish tone last week but we suspect a huge walk-back in the coming days and weeks of the economic outlook continues to darken. While continental Europe is also having to deal with energy shortages, the U.K. is faring far worse and is yet another reason to remain negative on sterling.

Eurozone reported firm August M3. Growth picked up to 7.9% y/y vs. 7.7% expected and 7.6% in July. This is the first acceleration since January, when M3 growth peaked at 12.5% y/y. Still, the pace is disappointing in light of the ECB's more aggressive asset purchases and now that the pace of QE will slow in Q4, M3 growth is unlikely to pick up much more in the coming months. In light of slowing economic data, we suspect will keep the ECB tilting dovish in the coming months as it debates the fate of PEPP.

ECB asset purchases for the week ending September 24 will be reported. This weekly number has taken on more importance after the ECB announced that it would aim for a more "moderate" pace going forward. Net purchases were a surprisingly higher EUR19.1 bln for the week ending September 17 vs. EUR14.7 bln for the week ending September 10 and EUR16.7 bln for the week ending September 3. The ECB had been aiming for net weekly purchases of around EUR20 bln since the accelerated pace began in March but it will likely take a few more weeks to figure out what the new pace will be.

A likely coalition in Germany is taking shape but the process will likely be slow. As many anticipated, the Social Democrats (SPD) led by Scholz are hoping to partner with the Greens and the Free Democrats to form the next government. This would mean three of the top four vote-getters would govern, leaving the second largest and outgoing CDU/CSU to lead the opposition. Of note, reports suggest CDU leader Laschet is also trying to woo the same two parties to form a government but the fit does not seem so natural. The horse-trading has begun but we foresee a leftward shift in German policy under the more likely coalition led by the SPD.

After last week's surprise rate cut by the Turkish central bank, there is now a new layer of risk from a worsening of diplomatic tensions with the U.S. Over the weekend, President Erdogan said Turkey is considering purchasing another Russian missile defense system, in part because he can't buy U.S.-made Patriot missiles. If it happens, it will re-invigorate anger in U.S. Congress against Turkey, and we will be discussing sanctions again. Of course, this could be distraction tactics to shift focus away from the economic situation and the lira hitting record lows last week, but we have learned never to doubt Turkey's capacity to further complicate an already complicated situation for themselves. The lira is marginally stronger on the day, but nowhere near offsetting the last three consecutive weeks of strong depreciation and rising CDS prices.

ASIA

The latest polls suggest the LDP leadership vote will likely have to go to a run-off. Recall that the "electorate" consists of the 382 lawmakers as well as rank-and-file party members whose support translates into another 382 "votes." If no candidate can win a majority of the 764 "votes" then the top two go to a run-off. A weekend poll from the Asahi newspaper found about 110 lawmakers said they would support Kishida, 110 would support Kono, 80 would support Takaichi, and 20 would support Noda. A separate poll from Kyodo News found 47% of the rank-and-file members supported Kono vs. 22% for Kishida, 16.2% for Takaichi, and 3% for Noda.

There were lots of cross-currents in China headlines over the weekend, netting out to an underperformance in the equity space but still range-bound CNY. On the negative side, government intervention continues, this time through a new anti-corruption push targeting 25 financial institutions focusing on "political awareness gaps." There was also a renewed crackdown on cryptocurrencies, once again stating that transactions are banned. One of the largest crypto exchanges, Huobi, will no longer allow mainland clients to register, closing the offshore account loophole. However, owning cryptocurrencies is still legal. Some were quick to interpret this as a sign that the PBOC intends to depreciate the yuan and is making the system airtight ahead of it, but we wouldn't go that far. We link the crypto crackdown with preparation for the coming digital yuan.

On the positive side, we got some positive headlines on the U.S.-China relations and there was another large capital injection by the PBOC. On the latter, officials provided CNY 100 bln to ease quarter-end liquidity tightening and, of course, the lingering Evergrande concerns. On the diplomatic side, the release of Huawei executive Meng Wanzhou could be an important step for near-term rapprochement between the U.S. and China. On top of this, we heard some supportive comments from U.S. Commerce Secretary Gina Raimondo and some new ties are being sowed on the climate change side.

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