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Dollar pushes higher on US exceptionalism in growth and rates

The euro is weakening against the dollar after the European Central Bank executed an (arguably) dovish rate hike and updated numbers showed the US economy growing more quickly than expected in the second quarter. High-beta currencies like the Australian and Canadian dollars and the Mexican peso are up, while other risk proxies – like the VIX equity “fear index” and the Merrill Lynch Option Volatility Estimate (MOVE) bond market measure – are trending down as markets buy into a “Goldilocks” scenario for the economy, with growth remaining relatively robust even as inflation pressures subside.

North America

The US economy expanded more quickly than forecast in the second quarter, bolstering expectations for a higher-for-longer plateau in rates from the Federal Reserve. Numbers released by the Bureau of Economic Analysis this morning showed real output growing at a 2.4 percent annualized rate in the April-through-June period, smashing expectations for a 1.8-percent gain.

Consumer spending remained robust,rising 1.6 percent, with outlays on services growing at a 2.1-percent pace in the quarter, down slightly from the first quarter, and goods spending climbing 0.7 percent after expanding at a 6 percent rate previously. Real final sales to domestic purchasers – a measure that removes trade and inventories, and is used by economists to estimate the robustness of domestic demand – climbed at a 2.3 percent pace, down from 3.5 percent in the first quarter, but still indicative of powerful underlying growth. Trade played an unusually-balanced role: net exports subtracted 0.12 percent from overall growth – but rising inventories offset this by adding 0.14 percentage points.

Yesterday’s Federal Reserve decision was, shall we say it… boring. As had been widely anticipated, the central bank raised its benchmark lending rate by a quarter-point and left its official statement broadly unchanged, with semantic adjustments pointing to a modest improvement in the growth outlook.

But odds on a rate hike at the September meeting are higher this morning after Chair Jerome Powell did his best to warn that policymakers could keep tightening if inflation pressures fail to decisively subside in the months to come. “It is certainly possible we would raise the funds rate at the September meeting if the data warranted, and I would also say it’s possible that we would choose to hold steady at that meeting,” he said, noting that two jobs reports, two consumer price updates, a second-quarter employment cost index, and a slew of other economic data would help assess determine whether additional rate hikes are needed when policymakers meet again.

From a bottom-line perspective, yesterday’s data-contingent Fed outlook and today’s hotter-than-expected growth data should help support risk assets in the short term, while also raising the likelihood of another US rate hike in the autumn months. The dollar is reading its own obituary once again. 

Europe

In this morning’s decision, the European Central Bank raised rates as expected and refused to provide firm guidance ahead of its September meeting, but also appeared to shift in a more dovish direction than markets had anticipated.

Policymakers lifted all of the institution’s benchmark rates by a quarter point for the ninth consecutive meeting, but several arguably-dovish adjustments were made in the accompanying statement: Officials said “the Governing Council’s future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary to achieve a timely return of inflation to the 2 percent medium-term target” – a slight update on language that previously said “rates will be brought to levels”. In an interesting turn of phrase, policymakers acknowledged weakening price pressures, saying “inflation continues to decline” but noted rates are “still expected to remain too high for too long”. And a sentence saying “past rate increases continue to be transmitted forcefully: financing conditions have tightened again and are increasingly dampening demand, which is an important factor in bringing inflation back to target,” was added, potentially helping put the conditions in place for a pause at the September meeting.

The decision comes after a slew of purchasing manager indices and a closely-watched bank lending survey showed the economy entering a downturn, suggesting that the central bank risks tightening into a downturn, repeating policy errors made in 2008 and 2011. The euro is coming under mild selling pressure as we go to pixels, suggesting that markets are trimming bets on further tightening – marking a dramatic turnaround from a few months ago, when European central bankers were expected to keep raising rates well beyond the Fed’s last move.

Asia Pacific

Asian currency markets saw relatively subdued trading overnight as market participants braced for today’s Bank of Japan decision. Kazuo Ueda & Co. are widely expected to stay on hold, making no adjustments to the country’s loose-money posture – but hedging activity is rising as worried market participants take out tail-risk protection against a surprise.

The yuan is holding steady on growing suspicions around official intervention efforts, with a sentence in the official politburo readout suggesting that the renminbi should be held “basically stable at an equilibrium level” warning market participants not to push the dollar exchange rate too far. Authorities have repeatedly set the onshore fix higher than expected, and recently adjusted rules allowing companies to access offshore borrowing in a streamlined manner – a step that might be more symbolic than useful (Chinese rates are lower than their foreign equivalents), but one that helps signal greater willingness to backstop the currency.

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