August 2024 Monthly

[PocketOption]

August 2024 Monthly

We
suspect the long-anticipated turn of the US dollar is at hand. The policy mix
of tight monetary policy and loose fiscal policy is coming to an end. The
moderation of price pressures for the past three months has boosted the
confidence of Federal Reserve officials that inflation is headed back toward
its 2% target. At the conclusion of the July FOMC meeting, Federal Reserve
Chair Powell gave his strongest signal yet that a rate cut at the next meeting
is likely. Further validation of market expectations may be delivered at the
Jackson Hole symposium at the end of August. The jump in the US unemployment
rate, following a series of poor labor market data, emboldened expectations for
a 50 bp cut to start the cycle.

The easing of monetary policy among the
high-income countries is poised to accelerate in the coming months, leaving
aside Japan. The easing cycle is expected to continue not only next year, but
into 2026. If the recent history is a guide, the key for the dollar's exchange
rate is more about US monetary policy than other central banks cutting rates.

This is what happened in Q4 23, which
later reversed in Q1 24 as the market unwound the aggressive Fed cuts it
anticipated. In December 2023, the Federal Reserve's median forecast was for
three rate cuts in 2024. The markets raced to price in more than six cuts by
mid-January 2024. The greenback fell dramatically in Q4 23 but recovered as
smartly in Q1 24 as the markets re-thought its aggressiveness. At the risk of
over-simplifying, driven by the shift in Fed policy, we expect similar forces
to weigh on the dollar.

There are two new elements in the mix.
Since the US presidential debate in late June, and then the assassination
attempt, many observers see a second term for Trump as nearly inevitable. Trump
and his running mate see the strong dollar as eroding America's
competitiveness, and that others have been purposely kept their currencies weak
to gain export advantage. It is this combination of strength and victim
messages that appear to have struck a respondent chord among many Americans.
That said, with President Biden decision to withdraw his reelection bid has
changed the dynamics. At this juncture the electoral contest looks close. and
it may come down to a handful of swing states (Pennsylvania, Michigan,
Wisconsin, Georgia, and Arizona). The second new element is deterioration in
the US labor market, the triggering of Sahm's Rule (when the three-month
average unemployment rate moves 0.5% above the past 12-month low, a recession
has always been signaled). Fed policy was set when the US economy overheating.
This is no longer the case. The Federal Reserve is likely to ease policy more
aggressively than it pointed to in the June Summary of Economic
Projections. 

Still, the dollar's role as numeraire was
not foisted on the US from foreign powers, but the American officials and banks
took it willingly and deliberately after WWII. That was what Bretton Wood
codified and implemented. And, when Bretton Woods collapsed after the US
unilaterally decoupled the dollar from gold 53 years ago this month, the
American officials and businesses strove to sustain the role for the dollar,
which it has done through the era of floating exchange rates.

The dollar's role has been understood as
an integral instrument of US power projection. Moreover, since 9/11, the
weaponization of the dollar (access not price) has allowed the US to check
terrorist financing and sanction those that seek to harm American interest. In
fact, the extent of the sanctions has given risen to concerns, recognized
recently by US Treasury Secretary Yellen, that it is encouraging workarounds,
which means different payment systems that do not go through the US dollar or
Federal Reserve system.

Coinciding with the turn of the US
monetary cycle, the kind of mercantilist policies that are associated with a
second Trump term also favors a weaker US dollar. As we have noted in previous
commentary, according to the OECD's measure of purchasing power parity,
recently the dollar was more overvalued against the yen and euro (German mark)
than it was on eve of the Plaza Agreement in 1985, which saw the G-5 countries
(Canada and Italy were excluded) coordinate intervention to drive the dollar
lower.

The cyclical decline in the dollar, however, should not be
confused with de-dollarization. Nor is the key to the dollar's role to be found
in its use invoicing and settling trade even when a US company is not involved
in the transaction. There was much talk the echo chamber of the internet that
claimed an alleged 50-year-old US-Saudi agreement to price oil in dollars was
expired. 

There was no such
agreement, but even if some part of OPEC priced accepted other currencies than
dollars, it would not challenge the dollar's role. Saudi Arabia and the U.A.E.,
for example, peg their currencies to the dollar, which in effects outsources their
monetary policy to the Federal Reserve. This means that when the Fed cuts
interest rates in September, as we suspect, so will Saudi Arabia and the UAE,
as sure as Hong Kong, whose dollar is still pegged to the greenback.

The kernel of truth,
though, in the petrodollar claim, is that the origins of the dollar-centric
financial system, and the reason it was able to remain the numeraire after the
fixed-exchange rate system of Bretton Woods collapsed may indeed lie in the Middle
East. 

In late October 1956,
a few days after Soviet Union tanks rolled into Hungary, the UK, France, and
Israel invaded Egypt. The US was surprised and pressed its financial advantage
over the UK, threatening to sell sterling, which was already struggling to maintain
its parity level in the Bretton Woods system and block a large IMF package the
UK sought. 

Moscow, seeing how
America's special ally was treated and considering its own vulnerability, moved
the dollars they had in the US to British clearing banks, and in a somewhat
simplified account, you have the origins of the Eurodollar market, the offshore
dollar market. Within a couple of years, Moscow was recycling its wheat and oil
sales by lending in the Eurodollar market.

The commercial
interest of US banks and British banks also played a role. The offshore market
was outside the US regulatory jurisdiction and was not bound by Regulation Q,
which capped deposit rates. Meanwhile, due to pressure on sterling, the
interest rate spread between the UK and the US widened. British banks could
borrow dollars and instead sterling and earn a carry.

The Eurodollar market
grown inordinately. According to the Bank for International Settlements, non-US
banks have about $50 trillion of dollar debt. When the dollar rises, the cost
of servicing this debt increases. It acts as a force multiplier. As the dollar
rises against that foreign currency, dollar debtors must sell their own
currency and buy dollars to neutralize the impact, chasing it higher. As US
interest rates decline and the dollar weakens, foreign companies and countries
will be attracted to the low-cost borrowing and the cycle repeats. 

Currencies from the
emerging markets were mixed in July and this is reflected by the MSCI Emerging
Market Currency Index posted a small increase (0.30%), while the JP Morgan
Emerging Market Currency Index declined slightly (-0.15%). The unwinding of
carry trades added to the pressure on the Mexican peso, which had not fully
regained market confidence after the early June national election and the
negativity associated with a possible second Trump term. The MSCI Emerging
Markets Equity Index snapped a five-month rally with a minor 0.15% loss,
leaving it about 6% higher than at the end of 2023. The MSCI index of developed
equity markets rose 1.7% in July to bring this year's gain to 12.7%. Emerging
market bonds, as an asset class, also underperformed. The premium of JP
Morgan's Emerging Market Bond Index over Treasuries widened slightly above 350
bp in July the most since last November. 

The Bannockburn World
Currency Index, a GDP-weighted basket of the currencies from the largest dozen
economies, made a marginal new 20-year low in early July. It recovered through
the middle of the month but returned to its trough by the end of the month. It
eked out an inconsequential gain of slightly less than 0.1% in July. The
downside momentum appears to be stalling and we anticipate a recovery in
August, which is consistent with a weaker greenback.  

The Japanese yen,
with a 5.3% weight, was the best performer, with a 7.25% rise in July, helped
by intervention, a short-squeeze, and anticipation of a more hawkish Bank of
Japan stance, which was delivered at the end of July. Sterling rose 1.7% in
July, putting it in second place in the BWCI. It has a weighting of slightly
less than 4%. The strongest developing country currency was the Chinese yuan
(0.55%), and it has almost a 23% weighting in our index, second only to the US
dollar. The two weakest performances were delivered by the Mexican peso (-1.6%)
and the Australian dollar (-1.9%). While several forces were at work, as we
note, the unwinding of short yen carry trades appeared to have played a role.

U.S. Dollar:  The Federal Reserve did not push
against market expectations that the rate cutting cycle will begin in September.
Moderating price pressures allows the central bank to take its foot off the
brake to bolster the chances that the soft-land can be sustained. The
derivatives markets have another cut fully discounted and about a 70% of third
cut this year. Although the economy expanded at a 2.8% annualized pace in Q2
(1.4% in Q1), helped by stronger consumption, government spending, and private
investment (which include increased inventories), the quality was suspect, and
economists look for a return to the pace seen in Q1 in the second half of this
year. The dollar has been supported by the favorable policy mix of tight
monetary and loose fiscal policy. With the Fed about to being the monetary
easing cycle, the policy mix will be less supportive of the greenback. After
falling in the first half of July, the Dollar Index recovered in the second of
the month. While the upside correction may have a little more room to run, we
expect its best days in the extended cycle are behind it.

 

Euro:  The European Central Bank delivered its first rate
cut in June, and the market is confident of another cut in September followed
by cut in Q4. The swaps market has almost a 25 bp cut discounted each quarter
through the middle of next year. The economy has little forward momentum,
expanding by 0.3% in Q2. European politic tensions have eased, and the European
Commission are in place. France has a caretake government, but there are
expectations that President Macron may try to appoint a new prime minister in
August. Hungary holds the rotating EU presidency and his trip to  caused
greater consternation. Three German states (Saxony, Brandenburg, and Thuringia)
next month. Eurozone inflation rose at an annualized pace of 4.0% in Q2,
matching the Q1 pace. It rose by less than 1% at an annualized pace in H2 23,
suggesting a difficult base effect comparison in the coming months. However,
the exchange rate may be more sensitive to the more aggressive easing expected
by the Federal Reserve over the next several quarters. The two-year US premium
over Germany, which often tracks the exchange rate, has been trending lower
since mid-April. It is recorded a new low for the year after the US jobs data
on August 2 near 152 bp. The euro peaked in mid-July near $1.0950, its best
level in four months. It found support on August 1 near $1.0775, which we
expect to hold in in the coming weeks. The high for the year, which will likely
be challenged, was set in early March near $1.0980.

(As of August 2, indicative closing
prices, previous in parentheses)

Spot: $1.0910 ($1.0715) Median Bloomberg One-month
forecast: $1.0845 ($1.0745) One-month forward: $1.0925 ($1.0730)   One-month implied vol: 5.5% (6.5%)  

 

Japanese Yen: The Bank of Japan acted decisively. It
hiked its overnight target rate 15 bp to 0.25%, and provided price pressures
remain firm as officials expect, additional rate hikes are signaled. The swaps
market is discounting a 10 bp increase by the end of the year. The 13% decline
in the Nikkei in the past three weeks, and the more than 11% drop in the Topix
Bank index in the past two weeks have served to rein in more aggressive
expectations. The BOJ also announced plans to reduce its bond purchases by
about JPY400 bln a quarter through the end of the next fiscal year. This
essentially will halve its purchases and put them below the amount maturing. The
BOJ's balance sheet is about 128% of GDP. In comparison, the Federal Reserve's
balance sheet is about 25% of GDP and the European Central Banks balance sheet
is around 45% of GDP. Japanese officials have taken to covert intervention, but
it quickly becomes visible. At the end of July, the BOJ's monthly statement
showed intervention of JPY5.5 trillion (or about $36.6 bln) in what appears to
be two operations. The earlier market estimate was JPY5 trillion. Since April,
Japanese officials appear to have bought about JPY15 trillion to support the
yen. A powerful short squeeze after the intervention and ahead of the BOJ
meeting helped drive the dollar from near JPY161.75 to about JPY152. The yen
gained 7.25% in July, its second monthly advance this year and its best
performance since November 2022. The BOJ's adjustment of monetary policy and
the hawkish rhetoric and weak US jobs data pushed the greenback to JPY146.55
and below the uptrend line off the January 2023 and January 2024 lows. Although
momentum indicators are stretched, the downside risk for the dollar may extend
toward JPY145 and possibly JPY140 in the coming weeks. 

Spot: JPY146.55 (JPY160.90) Median
Bloomberg One-month forecast: JPY151.40 (JPY158.20) One-month forward: JPY145.85 (JPY160.15) One-month
implied vol: 11.8% (9.5%) 

 

British Pound:  In a 5-4 vote, where Governor Bailey
cast the deciding vote, the Bank of England delivered its first rate cut in the
cycle on August 1. Besides saying that the decisions will be made on a
meeting-by-meeting basis, there was not much forward guidance. Still, the swaps
market is undeterred and has another cut fully discounted at the November BOE
meeting and is nearly convinced of a third cut this year. The best inflation
news is probably behind the UK for several months. The BOE recognizes this, and
its median forecast is for inflation to bit at 2.3% in Q3 and 2.7% in Q4. It
was at 2.0% in June. In Q3 23, UK's CPI rose at annualized rate of 1.6% and
less than 1% in Q4 23. It will be difficult to match that this year. The new
government seems committed to fiscal consolidation and Office for Budget
Responsibility projects the deficit in the new fiscal year may fall below 3%
for the first time since 2019. The pullback since July 17, when sterling set
the high for the year near $1.3045 looks corrective in nature and may have been
completed near $1.27. A move above $1.29 could signal a retest on the 2023 high
near $1.3140.

Spot: $1.2800 ($1.2645) Median
Bloomberg One-month forecast: $1.2700 ($1.2630) One-month forward:  $1.2810 ($1.2650) One-month
implied vol: 6.3% (5.9%) 

 

Canadian Dollar: The Bank of Canada cut its key rate in
July (to 4.5%) following an initiation of the easing cycle in June. The dovish
rhetoric and US developments have encouraged the market to price in a cut in
each of the last three meetings of the year. Still, Canada's two-year
interest rate discount to the US did not challenge the 18-year high set in June
slightly above 90 bp. It was a little above 70 bp after the US employment data. Headline
Canadian inflation was softer than expected in June (2.7%). The moderating
price pressures give the central bank the leeway to begin addressing the clear
slowdown in the labor market. The unemployment rate has risen from 5.7% in
January to 6.4% in June, a full percentage point higher in in June 2023. The US
dollar rose to a new high for the year against the Canadian dollar near CAD1.39
before the US jobs report pushed it lower. Still, it needs to break below
CAD1.3780-CAD1.3800 is suggest a top may be in place. 

Spot: CAD1.3875 (CAD 1.3680) Median
Bloomberg One-month forecast: CAD1.3775 (CAD1.3650) One-month
forward: CAD1.3860 (CAD1.3670) One-month implied vol: 4.9%
(4.9%)  

 

Australian Dollar: If the Bank of Canada is seen to be among
the dovish of G10 central banks, the Reserve Bank of Australia is among the
less dovish. The hawkish rhetoric of the central bank has persuaded the
investors that even if it does not raise rates, the RBA is unlikely to cut
rates until well into next year. The futures market has the first cut nearly
fully discounted for mid-Q2 25. Yet, such views were not able to prevent a
sharp sell-off in the Australian dollar in the second half of last month, as
yen carry-trades were unwound. The Australian dollar began last month breaking
to the topside of the $0.6600-$0.6700 range that dominated activity since
mid-May. It reached a six-month high near $0.6800 on July 11, and after a brief
consolidation, tumbled to $0.6515 two weeks later. We suspect that exhausted
the position adjustment and the Australian dollar can recover in the coming
weeks, but it may take some time to repair the technical damage.

Spot: $0.6520 ($0.6670) Median Bloomberg One-month
forecast: $0.6625 ($0.6680) One-month forward: $0.6525 ($0.6675)    One-month implied vol: 9.5% (8.1%) 

 

Mexican Peso: In the first half of July, the peso
extended its recovery from the post-election sell-off. President-elect
Sheinbaum's key cabinet appointments were from the moderate wing of the Morena
party. The technical expertise of the cabinet may have also helped ease
investor anxiety. When many assumed a Trump victory in the US was nearly
inevitable, the peso was sold as part on ideas that more pressure would be
brought to bear on Mexico on trade, direct investment, and immigration. Yet
even when the US election dynamics changed, the peso was hit by the dramatic
unwinding of carry-trades against the Japanese yen, and the heightened sense of
risk-off as equity markets tumbled. The peso gave back in full and more the
gains scored in the first half of July. The US dollar set new highs for the
year after the poor employment report near MXN19.2150. The market remains wary
of what AMLO will do in September, when he has a strong congressional majority
for a month before Sheinbaum is inaugurated on October 1. The economy expanded
by 0.2% in Q2, slightly slower than in Q1. Improvement in the headline
inflation has stalled but the core rate continues to edge lower. While central
bank notes the high degree of uncertainty, the swaps market has nearly 50 bp of
cuts discounted over the next three months and 180 bp over the next 12
months. 

Spot: MXN19.18 (MXN18.32) Median
Bloomberg One-Month forecast: MXN18.61 (MXN18.06) One-month forward: MXN19.27 (MXN18.41) One-month
implied vol: 15.3% (14.5%)

 

Chinese Yuan: The yuan fell every month in H1 24
before rising by about 0.55% in July, even though it surprised the market by
delivering a small rate cut. The yuan's weakness had encouraged many pushes out
rate speculation to later in Q3. However, disappointing Q2 GDP (4.7%
year-over-year, down from 5.3% in Q1) and soft June CPI (0.2% year-over-year)
spurred the PBOC to cut rates. Its monetary policy tools are shifting, and it
raised the significance of the seven-day reverse repo rate, which is cut by 10
bp to 1.7%. The banks quickly followed with a similar cut in the prime rates,
and then the PBOC cut the previous benchmark one-year Medium-Term Lending
Facility Rate by 20 bp (to 2.30%). More economic measures look necessary if
Beijing is to reach its growth target of 5%. Efforts to curb Chinese
export penetration is spreading from high income countries to more in the
Global South. The unwinding of carry-trades and the broad dollar weakness,
especially against the yen, seemed to bolster the yuan more than the formal and
informal measures that officials rely on to manage the exchange rate. The
dollar sunk to nearly CNH7.14 after the disappointing US employment data, its
single biggest daily decline since March 2023. The price action reaffirms our
sense that the yuan's exchange rate is largely a function of the broad
direction of the dollar and the state of carry-trade strategies. The US TIC
data showed Chinese investors sold a record $42.6 bln of long-term US
securities (Treasuries, agency, and corporate bonds, and equities). In the
first five months Chinese investors divested nearly $80 of US securities. At
the same time, China announced measures that discourage equity short sales and
are considering dramatically raising the fees associated with high-frequency
trading.

Spot: CNY7.17 (CNY7.2675) Median Bloomberg
One-month forecast: CNY7.2150 (CNY7.2615) One-month
forward: CNY7.11 (CNY7.13665) One-month implied vol: 4.9%
(4.8%) 

Disclaimer 

Source: August 2024 Monthly