Dollar softens but stays elevated as energy prices ease

Karl Schamotta, Chief Market Strategist

Good morning. The dollar is retreating, but remains near its highest levels since April last year, even as energy prices ease modestly and Treasury yields inch lower. Data released yesterday showed the US services sector remaining in expansionary territory last month, with strong demand adding to the strain on supply chains and raising price pressures, suggesting that the Federal Reserve may need to keep rates higher for longer.

The euro is steadying and stress in European bond markets is easing as French politicians—with varying degrees of credibility—attempt to project a message of fiscal prudence. The spread between French and German ten-year yields has narrowed to just over 130 basis points after Marine Le Pen, a hard-right leader who has long favoured more government support, proposed cutting the deficit by half a percentage point a year until France is “close to a balanced budget”, and capping public debt at 60% of gross domestic product under a “golden rule” similar to Germany’s debt brake. The pledge comes as France’s public finances come under severe strain: interest costs now exceed spending on either education or defence, and the deficit is heading towards 5.4% of output*, but the government is struggling to raise taxes or cut civil-service spending and pension benefits.

On the face of it, risks remain skewed to the downside. A renewed widening in fiscal discounts could tighten financial conditions and weigh on the common currency, as might a further unwinding in expectations for rate hikes from the European Central Bank. The currency is exposed to a potential withdrawal of Japanese investors from global markets, and to a terms-of-trade shock in the coming months as natural gas inventories are rebuilt before winter sets in. And—barring a breakthrough in the energy market outlook—there’s little likelihood of an upside rally, with the euro lacking a technology sector powerful enough to attract global capital flows or launch an artificial-intelligence buildout to rival Silicon Valley’s.

There’s little to suggest that a market pivot is in the offing. Today’s calendar is light, with US trade balance numbers, a weekly ADP payrolls estimate, and appearances by Fed officials including John Williams, Alberto Musalem, Michelle Bowman and Jeffrey Schmid on the docket. Although minutes from the Fed’s September meeting will be released tomorrow, they have likely been superseded by events.

The Japanese yen looks likely to remain on the defensive. According to Bloomberg, the Government Pension Investment Fund did not ultimately discuss raising its allocation to domestic assets at its meeting last month, undermining a narrative that had lifted the currency through late August and early September. The fund, with roughly $2tn in assets, splits its holdings roughly evenly between domestic and foreign investments, making it a major contributor to the outward capital flows that have kept the yen under pressure in recent years — and implying that any shift in its strategy could have a meaningful impact.

In our view, however, the risk-reward balance is beginning to lean against the greenback. As followers of the “imperial circle,” “milkshake,” “ouroboros,” “cleanest-dirty-shirt,” “Hotel California,” “leaf blower,” and “dollar smile” theories** of exchange-rate movement can attest, the current combination of strong US growth and tightening global financial conditions should lend sustained support to the greenback—and further gains are possible, especially if other economies start to underperform and investors pare monetary tightening bets elsewhere. But the dollar is now trading above our estimates of fair value after a hawkish repricing of the Fed’s expected path, remains expensive from a long-term standpoint, and looks overbought on a number of technical metrics. It could struggle to extend its recent gains, with even a modest improvement in sentiment likely to trigger a reversal. As always, market participants should be wary of two-way risks after a move of this magnitude.