Taking a short break and going on vacation has provided me with valuable time to reflect on my personal goals and the bigger picture. However, there are some drawbacks to this break, such as losing momentum and losing touch with current market trends. Returning to my routine and understanding the fundamental landscape has proven challenging, especially given the volatile nature of the markets and some counter-intuitive movements.
In the upcoming weeks, my focus will be on gaining a comprehensive understanding of the major currencies and the factors that could drive their fluctuations in the second half of 2023.
To begin, I will analyze the situation surrounding the US dollar. I rely on various sources, including Fed Watch, Central Bank speeches, and recent data releases, to assess the overall state of the USD and its global impact. I also consider technical indicators and correlated markets.
USD
Regarding the USD, the next FOMC meeting is scheduled for next week, and it is widely expected that the Fed will announce a 25 basis points hike. Since this expectation is already priced in by the market, there may be a “buy the rumor, sell the fact” scenario, making me cautious about going long on the USD unless there are significant changes in available data. As there is a gap between meetings, it is unlikely that the Fed will take intra-meeting action, so the current course of action will likely remain in place until the end of September.
Market projections for the September meeting indicate an expectation of holding rates.
Examining recent statements from the Fed, the last decision was to hold rates to allow the impacts of previous hikes to take effect. The Fed reiterated its commitment to achieving maximum employment and 2 percent inflation in the long run. Individual board members have also made hawkish statements, indicating the need for two more 25-basis-point hikes in the target range over the remaining meetings this year.(this is a good tool for statements: https://graphics.wsj.com/fed-statement-tracker-embed/)
“I see two more 25-basis-point hikes in the target range over the four remaining meetings this year as necessary to keep inflation moving toward our target,” – Waller.
Looking at the data releases over the past 4 weeks, we can try and get a picture of any changes since the last meeting.
Analyzing the data releases from the past four weeks, I can identify any changes since the last meeting. Chairman Powell has emphasized that Core PCE is the primary measure of inflation for Fed decisions. It differs from core CPI in that it focuses on individual rather than business or sector-based indicators. The recent Core PCE release on June 30th showed a month-on-month increase of 0.3%, resulting in an annualized figure of 3.6%. Since Core PCE data is released after the next FOMC meeting, I need to seek clues from other recent data releases.
Looking at other indicators, JOLTS openings ticked down slightly, while unemployment remained steady, indicating a strong employment market compared to historical levels. Average earnings also grew by 0.4% month-on-month, demonstrating strength in the employment aspect of the Fed’s dual mandate.
Examining inflation outside of Core PCE, ISM manufacturing prices fell and missed expectations, returning to pre-COVID levels.
CPI, although not the same as PCE, is highly correlated with it. If we look at the trend and what it means for the YoY figure. We can see that it has dropped from over 6% in Feb, to 3%. This is likely more a result of the large inflation spikes dropping off the calculation, but some of it will likely be attributed to the rate hikes.
CPI YoY history
Source : Forex factory
Finally, PPI data was released last week.
This dropped into the fed’s annualised target rate zone, with the non core element further dropping into negative territory after being revised down however its not the measure of inflation that is being watched but does show that inflation may be steadily dropping off.
Overall, I disagree with the suggestion that two more rate hikes are necessary. It would not surprise me if there is no hike this week, but considering the market’s positioning and expectations this could cause large proce move.
At present, I do not foresee much upside potential for the USD, and I may seek opportunities for short USD trades, although this may change with new data. Currently, all the data is moving toward the direction desired by the Fed, suggesting a holding pattern until the cutting cycle begins. I anticipate long-term weakness in the dollar during the final two quarters of this year. However, there may be a plateau and range-bound prices during the transition from full hiking to an accepted pause, so I expect the weakness to manifest in Q4. It’s worth noting the relationship between a severe recession and dollar strength is inverse, and this could impact the dollar depending on the broader economic situation.
Moving on to other major currencies, I will briefly touch on them to identify potential high-level opportunities to pair against the dollar.
Euro
There is an expectation here that two more rate hikes are expected. The euro (ECB) situation although it only has a single mandate re:price stability compared to the Feds dual mandate (which includes employment), it has a lot of complexity brought into it by each of the member states. Notably the big economies such as Germany, France, Italy and Spain all have their own issues and data which needs to be taken into account.
Just like the situation with the FED, there is over a 90% probability of a hike already priced in, however where the market has priced in a Fed hold for the subsequent meeting, the market is already over a 60% chance of an ECB increase.
The relative relationship and the potential divergence may offer an opportunity if the technicals also line up.
One of the key drivers of inflation was food – with Ukraine supplying a significant portion of grains, cereals and cooking oils to the European market the war and disruption this has caused resulted in price spikes, these have largely calmed however in the recent days Russia has abandoned it’s grain deal which could again cause supply shocks resulting in higher prices for foodstuffs.
This again highlights something which I discussed recently – I think we are entering a period where inflation is no longer primarily driven by demand, but by supply. The supply aspect has been relatively stable over the recent decades, production and energy was cheap, the geopolitical landscape was pretty stable, China was content to be a large scale producer, but now there is a slight shift, the demand can stay the same and even drop, but if the supply of goods, materials, food etc is disrupted then prices then prices will go higher. Interest rates and tightening financial conditions are unlikely to be successful as they when when trying to control demand driven inflation.
As Russia has now stopped the grain deal, there is the potential that food prices may begin to rise across Europe and if we are stuck using the higher rates to fight inflation mode, then I guess we may be in for more hikes.
GBP
Turning to the UK, inflation remains extremely high, with the expectation that the next CPI measure will exceed 8.0% (8.2%). There are opposing forces at work here. The Bank of England (BoE) aims to reduce inflation by increasing rates to cool demand, but wages are growing, and the expectation of further wage growth is deeply ingrained in the system. The combination of rising wages and prices presents a challenge.
From an on-the-ground perspective, consumption and spending in the UK show no signs of slowing down. Cafes, bars, and restaurants are as busy as ever, and people are booking multiple holidays. While this behavior may seem reckless, it could lead to a significant drop-off moment in the UK if consumers ignore the risks or are unaware of them. The issues in the UK extend beyond financial concerns and encompass political and social challenges. The next general election is not scheduled until January 2025, suggesting that internal politics will remain unsettled for some time. It is a difficult and turbulent period for the UK, and solutions are unlikely to emerge soon. It’s worth mentioning that the UK government has implemented a 12-month delay on home repossessions, which may contribute to a sense of complacency.
Regarding housing in the UK, many fixed-rate mortgages will soon expire, and homeowners who fixed their rates around 1% will face significantly higher rates upon renewal. For example, a 1% fixed-rate mortgage on a £300,000 loan would have cost £1,130, whereas a remortgage at the current rate of 6.5% would amount to £2,025. While people can tolerate higher mortgage rates for a short period, once savings are depleted and credit facilities are maxed out, a period of real financial distress may follow. However, until that point, people seem to carry on as if nothing is wrong. The 12-month delay on home repossessions implemented by the UK government may contribute to this complacency.
The Russian grain deal collapse could also drive up food prices in the UK, triggering another wave of inflation.
Considering GBP strength, arguments can be made for both strength and weakness. If the long-term outlook for the UK is a need to hike rates to combat inflation and wage-price spiral, relatively low-risk assets will become attractive due to increased returns. However, this approach also entails increased risk, albeit minimal, such as the possibility of the UK defaulting or the economy collapsing.
AUS and NZD
Moving on to the Australian dollar (AUD) and New Zealand dollar (NZD), one of the main expectations for 2023 was that China’s reopening would drive up the AUD and NZD through increased exports and economic growth. However, this prediction has not materialized. The
Reserve Bank of New Zealand (RBNZ) has taken a proactive stance by quickly and aggressively hiking rates to control inflation. While concerns about high inflation persist, there is an expectation that it will trend downward, potentially ruling out further rate hikes. The RBNZ held rates at 5.5% during its last meeting, and there were dovish comments suggesting a high threshold for future rate hikes.
As for the AUD, employment and wages have been seen a very hot throughout this year and continue to be at historically strong levels. There is currently a 1.15% difference between the AUD and NZD rates in favour of RBNZ.
In terms of the AUD, employment and wages have remained strong throughout the year, reaching historically high levels. Currently, the AUD has an interest rate advantage of 1.15% over the NZD, favoring the RBNZ. The recent Reserve Bank of Australia (RBA) meeting resulted in a hawkish hold, indicating a fine balance between holding rates and hiking them due to persistently high inflation and upside risks.
This would suggest that the interest rate differential between the RBA and it’s peers may shrink on the back of further hikes.
JPY
As for the Japanese yen (JPY), the Bank of Japan’s (BoJ) ultra-loose experiment may be entering its final stages with the appointment of Ueda. This theme, expected to be significant in 2023, has not yet materialized. However, groundwork has been laid, and breaking the long-standing stance with hikes may not have been the best approach. Japan faces chronic low inflation, and the recent round of Shunto negotiations, which led to increased wages and bonuses, marks a step forward. Early signs of inflation picking up have emerged through increased consumption and rising prices. If this trend continues, Japan may transition into a more mainstream central bank approach, driving high growth and repatriation of money, thereby strengthening the JPY. Several factors need to align for this scenario, but it could be a significant theme in H2 2023.
CAD
The labour market within Canada is strong, with high levels of immigration in Canada supporting the economy. From an internal demand level there are factors which are keeping the dollar resilient to the impacts of higher rates. With a lot of people competing for jobs, the wage price spiral is not as much of a concern – businesses in Canada have said that they expect any labor shortage to be less intense than previous.
However, the CAD is very much driven by exports of commodities. Mainly gas and oil. The correlation of oil to canada strength is a strong positive one, meaning that when the price of oil rises, it is usually accompanied by a rise in CAD.
The factors which drive oil demand don’t seem to be present – an expanding global economy especially commercial demand from China, combined that with a one of the largest oilfields coming back online in Libya and also Russia supplying cheaper oil to its allies (one of which is China) mean than as global oil prices fall, the CAD may also follow suit.
Currently the BoC and Gov Macklem are holding rates and have recently said that further progress on disinflation will be required before he can consider a change in monetary policy. This means that there would have to be something present in the data to make them hike or cut.
Overall
Combining my views on the USD with a brief look into the other currencies, I will be looking for opportunities
Short USD – unless big signs of impending recession coupled with . . .
Long JPY – especially if there are any announcements from Ueda and inflation starts growing more.
Long GBP – This is a tricky one but in the search for interest rates, there maybe be more of the hiking cycle left for the BoE than people think.
Slightly long AUD – based on where it is at relative to it’s peers and the wage growth in Australia, I think more hikes will be required.
However there are many different factors to consider and I will not be blindly taking these. The technicals are super important for confirmation and risk management of the ideas. Also, taking high probabilty set-ups on a short term which are contrary to my high level longer term thinking is also fine when it is backed up with a solid idea.
Kind regards,
James
