Head of FX Strategy
Summary: The dollar index (DXY) uptrend is starting to get challenged despite the blowout headline jobs report on Friday and the safety bid on Monday following the tragic events over the weekend. Fed members are also turning less hawkish and focus shifts to inflation data this week which could continue to fuel the higher-for-longer narrative. Meanwhile, the slide in Israeli shekel was stalled by central bank intervention.
The dollar index closed lower last week after steady gains in the last 11 weeks, despite Friday’s blowout NFP report on the headline. The index started the week with a bid coming from a rush to safety after the unfortunate developments in the Middle East region over the weekend. However, that Monday bid was also not sustained and the DXY index is now struggling to hold on to its 106 support. Does that mean that the dollar uptrend may be coming close to an end?
We have highlighted before that clear signs of deterioration in the US economy will be needed to reverse the dollar uptrend. But all we have got for now is the strong NFP report and a further uptick in geopolitical tensions. While that should have underpinned another leg of strength in the dollar, the message coming across from the price action is one of exhaustion. Fed speaker, including some of the hawkish ones, have started to talk down the case for another rate hike as markets do the job for the Fed. Jefferson and Logan (usually a hawk) – both FOMC voters – yesterday acknowledged that the move in yields and its impact on tightening financial conditions may mean that the Fed may not have to do as much. The commentary saw dovish repricing in money markets with just a 12% probability of a hike being priced in for November (from 30% earlier) with the first full rate cut seen in June 2024.
Meanwhile, even as USD upswing room may be starting to weaken, a clear downtrend could evade until economy weakens enough to let the Fed loosen its higher-for-longer message. Saxo’s fixed income strategist Althea Spinozzi has also continued to highlight reasons to stay defensive and stick to the front-part of the yield curve. She thinks that the 10-year and 30-year Treasury auctions this week could provide support to declining yields. With US fiscal deficit still a concern, abundant Treasury supplies and risks of further escalation in the Israel situation could continue to provide support for the dollar. Risk assets are also likely to remain under pressure as high yields start to hurt the economy, and dollar exposure continues to serve as a hedge.
After jobs and geopolitics, focus may also be turning to US inflation numbers due this week. Bear steepening of the yield curve in the recent weeks suggests that markets are still more concerned about inflation remaining high in the long run than the risk of a recession in a near term. Meanwhile, the rise in oil and gasoline prices recently is pushing headline inflation higher. After the surge to 3.7% YoY in August, consensus now expects some cooling in headline inflation to 3.6% YoY as oil prices steadied somewhat in the month.
Core CPI is also likely to be pulled lower due to the decline in rents and shelter inflation, but some of the other services categories such as car insurance and medical services could remain sticky. Consensus expects core CPI to cool to 4.1% YoY in September from 4.3% in August. While that means overall disinflation trends could remain intact, taking too much comfort from a soft inflation print may be premature given the uncertainty around commodity prices with the geopolitical landscape facing fresh risks. Fed is unlikely to hike rates in this volatile environment, and barring any strong upside surprises, rates may likely stay on hold at the November meeting. But as long as economic data does not weaken, Fed will keep pressing on its higher-for-longer message. Meanwhile, other key data such as advance US GDP (due on 26 October) and PCE (due on October 27) will be on watch ahead of the FOMC decision on 1 November.
That leads us to believe that a higher-than-expected core CPI print could give further legs to the higher-for-longer narrative, boosting USD further and weighing on JPY as well as risk sensitive currencies like AUD and NZD. However, a softer-than-expected print will just reaffirm what the markets have already priced in – an extended Fed pause.
The Israeli shekel has come under pressure after the weekend attack from Hamas. Prior to the attacks as well, the controversial plans by the Israeli government to reform and weaken the judiciary have weighed on the currency, but weekend events brough USDILS to its highest levels since 2016.
The Bank of Israel (BoI) announced yesterday that it is prepared to sell up to $30 billion from its $203 billion FX reserves to support the shekel, and this could also be extended by $15 billion through swap mechanisms. This helped USDILS to drop back towards 3.92 from highs of 3.9622 yesterday. Israel’s central bank could continue to smoothen the volatility given its large FX reserves.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
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