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FX: A Fed thaw needed to deliver a sustained USD turn lower
John J. Hardy
Chef makrostrateg
Oversigt: Barring a sudden resumption of Russian natural gas flows to Europe in the coming quarter, an economic winter is coming for Europe and the euro, as well as satellite currencies sterling and the Swedish krona. Despite the ECB and other central banks - with the extremely notable exception of the Bank of Japan - playing some catchup with the Fed in delivering policy tightening in Q3, the Fed remains the central bank that "rules them all". We will need to see the Fed easing again before we can be sure that the US dollar is finally set to roll over.
USD: after the Fed tried to get cute on a policy deceleration, it found religion again.
The US dollar found a temporary peak in the wake of the June 16 FOMC press conference as the market figured that the first 0.75 percent hike since 1994 would prove a peak in Fed hawkishness for the cycle. For its part, the equity market bear market low of the cycle at the time of writing was posted on the day after that FOMC meeting. Risk sentiment found further fuel and the USD dipped slightly heading into the late July FOMC meeting as Powell offered insufficient pushback against the market, which was beginning to price that the Fed policy rate would peak by as early as December 2022 and begin rolling over in the first half of 2023. However, beginning in early August Fed members quickly moved to push back explicitly against the notion of forecasting any Fed easing with consistently hawkish rhetoric almost across the board. The USD rallied anew, even as a number of other central banks moved even more aggressively with their own rate tightening moves and guidance. The ECB even hiked 75 basis points at its September 8 meeting, the largest hike in the central bank’s history, with another 75 basis points priced for the October meeting.
After the remarkable thaw in financial conditions since the June FOMC meeting, despite that meeting delivering the first “super-size” rate hike of 75 basis points, the Fed clearly decided that it had more to gain by maintaining a hawkish tone than in trying to guide for the possibility of any imminent policy pivot due to some abstract notion like the neutral rate. The Fed probably can see now that that it is easier to back down from accidents created by excessively tight policy than to risk aggravating inflation risks with easing financial conditions in the middle of a tightening cycle by trying to play cute with guidance.
One factor that has added to the potential for a bounce-back in the US economy fairly deep into Q4 is the steep decline in petrol prices after their remarkable peak at record prices north of $5/gallon in early June. The decline to well below $4.00 already in August could have a significant real and psychological impact on the legendary US consumer and keep the economy and wage pressures humming a bit longer than expected for this cycle, requiring that the Fed maintain course and continue its attempt to achieve the full pace of quantitative tightening, promised to reach $95 billion in balance sheet reductions per month in September. Hence our Steen Jakobsen’s anticipation of “peak tightness” in the coming quarter.
Tail risk alert for USD in Q4: the mid-term elections. The mid-terms are an important tail-risk event in Q4 for the longer-term outlook for likely US policy responses in the next recession or soft patch. The pundits and oddsmakers assure us that, while the Democrats are very likely to solidify their majority in the Senate, they are nearly certain to lose control of the House. That may well be, but the last two election cycles have taught us to treat election polls with more than a grain of salt, and two developments have dramatically raised the potential for surprises in our view: the Trump-packed US Supreme Court overturning of the Roe v. Wade case from the 1970s that guaranteed access to abortion services at a federal level, and a couple of special elections in Trump country in recent months falling to Democrats—particularly the election for Alaska’s US House representative in which the pro-Trump Sarah Palin lost to a Democrat. This was a state that voted for Trump in 2020 by a margin of 10 points and for the Republican House member by nine points over an independent challenger in the same election. With a deeply divided partisan political environment, the US is only able to make policy at the margin on the fiscal side when one party does not control both houses of Congress and the Presidency. There are important exceptions, including bipartisan issues like reducing supply chain vulnerabilities with China and limiting Chinese access to military and advanced technology. In any case, if the Democrats surprise and maintain control of the House, together with a stronger control of the Senate, it could completely flip the script on fiscal policy potential ahead of the 2024 US presidential election, generally increasing the risks of far higher inflationary outcomes. Had Biden enjoyed a mere seat or two more in the Senate over the last two years, his party might have passed a package some $2 trillion larger than what actually made it through in the so-called Inflation Reduction Act.
Graphic: The jaws are widening perilously! The story since mid-2021 has been of a widening performance divergence between the soaring US dollar and weakening euro and even weaker JPY. Note that the indices are CPI-adjusted, and Japan’s retail CPI measures have likely been suppressed, meaning that the picture would look even worse than it does here. Something could give in Q4 on the Bank of Japan’s commitment to containing yields. Note that the euro weakness looks pedestrian in comparison, even after trading below parity at times in Q3.
EUR, GBP and a winter of discontent. The euro fell to below parity against the US dollar on the intense and excessive pressure on inflation in the EU from soaring energy and power prices, which also presented risks to output volumes and had a seismic impact on external balances. Europe went from being the world’s largest surplus bloc on trade to a deficit bloc in a world heading into a slowdown and likely recession in Q4 and early next year.
Much has been made of the EU’s heroic efforts to build natural gas storage ahead of the heating season beginning in the autumn, but this will not cover the additional supply needed unless Russian gas flows resume over the winter—unless EU demand drops further. If Russian leader Putin, or anyone of his ilk, remains in power in Russia, the longer-term energy supply picture for Europe will remain difficult as the EU will have to continue bidding up for shipments of LNG in a tight global market. New sources of gas could be in the wings, possibly in the long run from Algeria and already in coming months from the newly-arrived-on-the-scene LNG from Mozambique. But the EU energy outlook will likely never again prove as bad as it does for the coming winter of discontent, so some major low in the euro may emerge in the coming quarter or early next year. The EU plans to cap prices may help nominal EU inflation readings to begin rolling over in coming months, but this won’t kill demand. Physical limits to natural gas supply, possibly aggravated by risks that French nuclear power is not fully back on line until late in the winter, might force power rationing and real GDP output drops. Europe will be hoping that a mild winter lies ahead, and daily and weekly weather forecasts will receive more attention than perhaps at any time in the continent’s history. Ditto for the UK with the cherry on top that the UK lacks strategic gas storage facilities even if it is scrambling on that front. Again: winter is coming and will continue to come every year, but the EU will move with existential haste to address its vulnerabilities.
The UK bears extra close watching as a country capable of a more nimble and forceful policy response than any other major country, given the combination of tremendous pressures on the UK economy from its external deficits and cost of living crisis on the one hand, and a new Prime Minister Liz Truss and her nothing-to-lose mentality on the other. Her instinct will be to move fast and move big to keep the lights on and to keep her country warm this winter for starters, but also to ensure that policy moves the UK away from its current predicament and vulnerabilities. The UK simply must find a new path toward balancing its external deficits and decreasing energy vulnerabilities if she is to enjoy more than a brief stint as PM. Her approach of populist price controls on the one hand together with tax cuts on the other are a risky gambit for sterling on the implications for the national deficit. Sterling may see an aggravated further drop this winter as long as energy prices remain divergently high for Europe (natural gas is the critical factor in particular). Further out, policy will have to show traction in attracting investment, bringing rising UK domestic energy output (UK shale gas potential unleashed?) and improving productivity to see sterling rising from the ashes. And for perspective, sterling isn’t even fully in the ashes yet anyway, as we note that in CPI-adjusted real-effective-exchange-rate terms, it is actually only mid-range since the 2016 Brexit referendum collapse.
Continued tension among the Asian giants CNH and JPY: Q4 to deliver a big bang?
We have highlighted the still very stretched CNYJPY exchange rate in both of the last two outlooks. The CNH has loosely tracked the USD higher, while the JPY has remained the weakling of G10 currencies on the Bank of Japan’s stick-in-the-mud refusal to shift to a tightening stance and away from its yield-curve-control policy. In Q3, the CNYJPY exchange rate reached new multi-decade highs well north of 20.00. Could Q4 finally be when something “breaks” here? On the CNY side of the equation (and closely linked, the tradeable offshore CNH), China might decide that it is simply no longer in its interest to maintain a strong currency, especially if commodity prices begin to fret at the economic outlook souring. But more likely, the capitulation could come from the Bank of Japan via a stronger JPY as discussed in our Q3 outlook.
Significant further downside pressure on the yen may simply force the Bank of Japan to surrender after it held out so long in the hope of seeing wage gains rising sufficiently to suggest a sustainably positive inflation outlook. But there may also be a chicken-and-egg problem in the Bank of Japan’s measures of inflation and inflationary risks from here: the policy by Japan’s supermarket chains to keep food prices capped even as wholesale and import prices have soared, the latter aggravated by the tanking JPY. October 1st is meant to see a reset of retail prices for retail shoppers overnight, which could lead to soaring official inflation readings and a growing sense of popular outrage as the cost-of-living rises. Fiscal attempts to shield lower income households will do nothing for the JPY or alleviate the concern for medium-wage and higher income earners. Will Q4 finally be the quarter that sees the Kuroda BoJ surrender and shift its guidance, and at least shift the goal posts on yield-curve control? There is tremendous two-way volatility potential for JPY crosses, particularly if the USDJPY rips to new aggressive multi-decade highs before the BoJ finally then capitulates.
The rest of G-10 FX. In this case, the “rest of G-10” would be the Swiss franc (CHF) and the “G-10 smalls” that include the AUD, CAD, NZD, SEK and NOK. Regarding CHF, with cost-of-living pressures at a maximum over the coming winter, the Swiss National Bank will be happy to continue its tightening policy and encouraging a stronger franc, which has helped materially in dampening inflation pressures for Switzerland. For the G-10 smalls, the “peak tightness” we anticipate in Q4 will likely not be kind to these less liquid currencies. For the Antipodeans AUD and NZD, we’re curious whether AUDNZD can break above the multi-year range capped by 1.1300 that stretches back over seven years, as we consider Australia’s formidable commodities portfolio and its newfound status as a current account surplus country while New Zealand is reliant on energy imports. New Zealand was also quick to tighten rates and is therefore likely at the leading edge of countries set to roll over into a slow-down and an eventual pause of its rate-tightening regime. In Europe, Norway will have to play ball to some degree with Europe’s move to cap energy prices after the country has reaped enormous windfall profits from soaring natural gas prices in particular. The Swedish krona looks cheap, but may need to see a major market bottom before its prospects can brighten sustainably, given its history as one of the more sensitive currencies to the economic outlook and risk sentiment.