Dollar Pullbacks Remain Shallow As Rate Differentials Widen

The trajectory of monetary policy in the US and Europe has been fairly clear. There is practically no doubt that the Fed will hike rates on September 26. Despite softer than expected PPI and CPI figures, the market has become more confident of another move in December. The Federal Reserve’s balance sheet unwind reaches its maximum velocity of $50 billion a month in Q4.

It is also understood that ECB will reduce its asset purchases to 15 billion euro a month in Q4 and finish at the end of the year. Interest rates will not be raised for another year. The reinvestment of maturing proceeds appears to be the next operational issue that needs to be sorted. The capital key will continue to be lodestar, but many investors are interested in the strategy, and in particular, the maturities that will be considered.

The Bank of England has been clear. Rates need to gradually increase. By gradually, the Federal Reserve has meant in practice anything between two and four hikes a year. By gradually, the Bank of England means once a year. Next week’s high-frequency data is expected to reinforce the understanding that there most likely will not be another increase in the base rate until after next March when the UK leaves the EU. All three measures of consumer prices (CPIH, CPI, and core CPI) are expected to ease slightly, while retail sales are likely to soften after the strong 0.9% rise in July, excluding petrol. The UK consumer is still shopping even though there will be some payback. Through July UK retail sales have risen by an average of 0.5% a month. The average for the same period last year was 0.1%.

The Bank of Japan has been more difficult for investors. It is buying fewer JGBs but it denies tapering. It comes to the market less frequently to buy government bonds, but it increased the amount of the operations. It is not exactly clear why it is still buying ETFs, though here too, it may be slowing its purchases. The BOJ meets this week it is not expected to announce any new innovations and reiterate its commitment to boost prices.

The August CPI will be reported later in the week and the core rate,which the BOJ targets, is expected to tick up to 0.9%. It had risen steadily even if slowly over the past couple of years before softening this a few months earlier this year. Yet, the increase in energy goes a long way in explaining the improvement. Excluding energy from the core, and the rate was 0.3% and is expected to rise to 0.4% due to restaurants and apparel.

What has gone largely unremarked is that the premium the US offers on two-year money continues to steadily increase. Many participants argue that last year’s heavy dollar tone in the face of Fed tightening shows that interest rates differentials are not helping in anticipating changes in the foreign exchange market. This is a bit of a straw man. Interest rates are not the only determinants of exchange rates and can be overwhelmed by other factors. That is what we understand to have happened last year. After the UK referendum and Trump’s election, investors were afraid of the populist-nationalist wave sweeping across Europe in a series of elections. Many were under-weight European assets. When it became clear that this was not going to be the case, these investors moved back to Europe and sent the euro higher, triggering the echo of trend followers and momentum players.