GemForex - weekly analysis

Another week has passed, and what a week it was, with the main protagonist, the big dollar gaining considerably in value, and forces us to answer the question of once again whether the greenback is close to its peak. The answer can be found in the main drivers of the dollar's strength. Lets jump in! 

The Dollar

The first is the Fed's tightening expectations, which are unlikely to be lowered in the near term, especially after Chairman Jerome Powell recently reiterated his commitment to reducing inflation despite the potential economic damage. We have highlighted how monetary policy has an increasingly less pronounced direct impact on currency movements: this is quite clear when looking at most European developed currencies/central banks. However, the broader effect of the Fed's tightening of expectations on global risk sentiment means that continued aggressive rhetoric will do little to reduce the instability of risky assets, and this should continue to fuel demand for the dollar as a safe currency. 

Nevertheless, a stronger-than-expected print in the PCE core price index would be positive for the dollar, while a troubling weakness in personal consumption could potentially weigh on Wall Street.

The energy crisis and a faster deterioration in the economic outlook outside the U.S. were also crucial drivers of dollar strength. Here, the latest developments in the conflict between Russia and Ukraine are unlikely to make markets more optimistic for the time being, and activity surveys continue to point to a gloomy outlook for the eurozone. In China, sentiment about the yuan remained bearish, and the People's Bank of China took further steps today to try to shore up the yuan by imposing a 20% risk retention requirement on foreign exchange forward sales.

Most importantly, turmoil in British markets due to fiscal concerns - triggering an emerging sell-off in the pound (more in the GBP section below) - further stimulates the rush to dollars and has a spillover effect. effect on other procyclical currencies. Even if the other drivers of the rising dollar begin to lose some strength (highly unlikely as discussed above), expect the dollar to remain very well supported until we see some stabilization in the gold market and the pound.

US publications begin Tuesday with durable goods orders and the closely watched consumer confidence gauge. There will also be a slew of housing data, including new home sales for August. Current home sales will follow Wednesday. Housing indicators have been mixed lately, so next week's numbers may shed better light on how severe the slowdown actually is.

Friday will see the all-important personal income and spending report, which includes PCE inflation figures as well as spending and consumption data. After the Fed sent a clear policy message at its meeting, this data set is unlikely to change much in terms of the outlook.

The Euro

And as the euro just cannot catch a break lately, whether it is the energy crisis or the Fed outsmarting the ECB, there are always problems around the corner, and this week they could come in the form of political risks. In the big news of the Week, Italians went to the polls Sunday to elect a new government.

 It comes after the collapse of Mario Draghi's technocratic government in July, which led to early elections. Italy's election results were in line with expectations overnight: the right-wing coalition led by Giorgia Meloni won a solid majority in both the Senate and the House. While the euro is trading weaker this morning, The process of forming a government will take a few weeks, and the markets will focus closely on the choice of key ministers (especially finance and foreign ministers) as an early test of Meloni's commitments to respect EU budget rules and Italy's stance on international politics. But markets worry about what this could mean for EU-Italy relations, how it could fuel fascism, and the risk it poses to Draghi's formulated economic recovery. The implications of a Meloni-led government may not be immediately apparent, as it has promised to be careful with the country's finances and avoid confrontations with the EU. Nevertheless, Italian government bond yields may rise next week if the right-wing alliance does indeed win a majority.

Questions may arise at some point about EU relations, which could favor an increase in the BTP-Bund spread, although downside risks to Eurozone peripheral bonds stem mainly from quantitative tightening discussions at the European Central Bank and gold market spillovers, currently. In FX, the euro faces more significant challenges given the energy crisis and geopolitical uncertainty: we may need to see an escalation in the confrontation between the EU and Italy before a political risk premium is embedded in the euro.

Today, on Monday, we will hear from a plethora of ECB speakers. President Christine Lagarde will testify before EU lawmakers, but we will also hear from Joachim Nagel, Luis de Guindos, Fabio Panetta, Pablo De Cos, and Mario Centeno. It still seems unlikely that an aggressive inclination will lead to sustained support for the euro.

Any widening of peripheral yield spreads could weigh on the euro, although there could be some support for the single currency on Friday based on the latest flash CPI estimates for the eurozone. Overall inflation is expected to have risen to a new record of 9.4% in September. The aggressive soundbites from ECB policymakers have become progressively louder in recent weeks, and that could be more from President Lagarde when she testifies before the European Parliament on Monday. As long as policymakers maintain this rhetoric, it should prevent the euro from falling too far below parity.

In other data, business surveys consisting of the economic sentiment indicator and the German Ifo gauge of business climate on Thursday can also be watched for clues on how fast the eurozone economy is losing momentum.

The Cable

Another 4% sell-off in GBP/USD today Monday and a 28% rise in implied volatility in a week now means that this sell-off in sterling is officially disorderly. The problem for sterling now is to determine which policy shifts are viable to support the pound - indeed, if the UK authorities decide that the pound should be supported.

A reversal in fiscal policy seems highly unlikely just a few days after the new British government announced its series of tax cuts and policy liberalization.

The British government unveiled last week the second-largest tax cut budget in its history, which will be funded entirely by borrowing. British bond yields shot up after the announcement, a sign that investors are more concerned about the implications of rising debt than about stimulating growth. This leaves the pound even more exposed to risky episodes than it already is.

The final UK GDP figures for the second quarter due this Friday could also be significant if there is an upward revision to the initial estimate of -0.1% q/q, which would allay fears that the UK economy is already in a technical recession.

The Yen

Just as markets thought the Fed could not get more aggressive, it did just that. Although the Fed did not accelerate its pace of tightening in September as some had expected and the final interest rate in the dot plot was not that far off from that of the market, Jay Powell was the most convincing so far in his press conference that the Fed will do what it takes to bring inflation back to 2%, even if it takes a hard landing to get there.

Both government bond yields and the U.S. dollar extended their gains in the aftermath, but the latter's uptrend now faces some unexpected challenges. The Japanese government finally decided to intervene in the currency market after the yen breached the 145 level, ordering the Bank of Japan to carry out a yen-buying operation.

“There is no change to our stance that we will respond to market moves as needed,” Japanese Finance Minister Shunichi Suzuki said on Monday per Reuters. The policymaker also mentioned that he is concerned about speculative moves behind the weakening yen.

Bank of Japan (BoJ) Governor Harihuko Kuroda said on Monday that the Japanese Ministry of Finance's intervention in the foreign exchange market was the appropriate move to address excess volatility. “Recent yen declines were one-sided and rapid, so they were negative for the economy,” Kuroda added. “The uncertainty over Japan's economy is extremely high, we must keep the ultra-easy policy to support the economy.”

The intervention has provided short-term relief to the JPY and so does the announcement that Japan will reopen to foreign tourists, but with the discrepancy between rates in Japan and the rest of the G10 countries only rising in the months to come, we believe that the USD/JPY will turn higher ahead.

What will stop the weakening of the JPY is a shift in monetary policy from the BoJ or a 180-degree shift from all other G10 central banks. The shift from the BoJ could easily come when the current BoJ Governor Kuroda retires in April 2023. We thus expect the JPY, which is the worst G10 performer against the USD this year, to recover most of its losses next year.