Week Ahead: Politics Pushes Aside Economics

[Redator]

The combination of the policy mix advocated by the woman who is most likely to become the next prime minister of Japan and a series of disappointing German economic data amid a political crisis in France helped lift US dollar. Many trend followers and short-term market participants were caught the wrong way, and the short squeeze accelerated the dollar's advance. Significant technical damage had been inflicted on the euro, sterling, the yen, and Canadian dollar...until Friday. Since returning from its extended national holiday on Thursday, China announced three measures that escalated the tensions between Beijing and Washington. It tightened its export controls of rare earths and processing technology (effective December 1), imposed export restrictions on the export EV batteries and associated technology (effective November 8), and will being levying s special fee on American ships docking at its ports (effective October 14). To be clear, Washington thought it had established dominance of the semiconductor supply chain and had weaponized it for several years against China. Beijing, in effect, leap-frogged over the US and signaled that its control over rare earths gave it escalation dominance in semiconductors, and therefore AI, which require rare earths,   

An irate President Trump threatened "massive tariffs" (100%) on China and threatened to pull out of the APEC meeting later this month, where he and President Xi were going to talk. The fact that they were to meet at APEC instead of a holding a bilateral summit was already a sign of trouble. The US response triggered sharp equity losses, which will likely be felt in Asia on Monday. Europe's Stoxx 600 dropped 1.25% before the weekend. The dollar saw its weekly gains pared but it still settled higher against all the G10 currencies. Meanwhile, the US federal government remains closed. How and when it re-opens remains elusive. Politics, in Japan, Europe, and between the Washington and Beijing may eclipse usual drivers of the foreign exchange market, especially given the mostly light economic calendar in the week ahead. 

US

Drivers: The rolling 30-day correlation between changes in the Dollar Index and changes in the US two- and 10-year yields is around 0.50, the upper end of this year's range. The two-year yield recorded five-month lows in September near 3.46% and is now hovering near 3.60%. The 10-year yield recorded its five-month low on September 17, when the Fed delivered its first rate cut of the year, near 3.99%. It has not settled below 4% since early April but has not been above 4.20% since early September. With the Fed funds futures market nearly fully pricing in a cut later this month and a little more than an 80% chance of another cut in December, the pendulum of expectations is unlikely to swing much further without more data. 

Data: With the federal government still shut, data will be limited to data from the Federal Reserve System. This includes the NY and Philadelphia Fed's monthly survey and the Fed's Beige Book prepared for the meeting later this month. Federal Reserve Chair Powell has often referred to the Beige Book. 

Prices: The Dollar Index reached 99.55 last week, its best level since August 1. We had frame it initially as a correction to the decline from the August 1 high through the marginal new multi-year low recorded when the Fed cut on September 17. However, the combination of the policy mix advocated by the woman who is likely to be Japan's next prime minister and a continued string of disappointing German economic data, amid continued concerns about developments in France, turned it into something larger. However, the escalation of the US-Chinese tensions rippled through the capital markets ahead of the weekend as President Trump threatened "massive" tariffs" on China and dampened expectations for a meeting with Xi later this month. The DXY was sold on the news and tested 98.85. Support is in the 98.25-50 area. Losses through there could see 97.50. 

EMU

Drivers:  Over the past 30 and 60 sessions, the changes in the euro are more correlated with changes in the US two-year yield than with changes in the spread against Germany. The 30-day and 60-day rolling correlations with the changes in the US two-year yield is near -0.50 and -0.62, respectively. The correlation with the changes in the differential is 0.45 and 0.55 for the 30-day and 60-day periods, respectively. Meanwhile, the speculative (non-commercial) in the futures market has one of the largest net long euro positions since last August, which itself was the most in three years. 

Data: The eurozone reports the aggregate industrial production and trade data for August. The four largest members reported a contraction in August industrial output. Outside of the preliminary aggregate CPI report, the aggregate data seems to rarely move the euro. The German ZEW survey (October) will likely show that the assessment of current conditions remains in the trough, while expectations remain near recent highs. The divergence is among the greatest since pandemic. In any event, the signal that market has understood from ECB officials is that the bar to another cut is remarkably high. The swaps market acknowledges this and has no more than a 1-in-3 chance of another cut discounted. 

Prices: The euro slid almost 1.1% last week, its largest weekly loss in two months. The losses were steeper, but the euro recovered from around $1.1555 and reached $1.1630 after President Trump threatened "massive tariffs" on China. The close above $1.16 helps stabilize the technical tone but a move above $1.1650-60 is needed to boost the chances a low is in place. 

PRC

Drivers: While Beijing succeeds in keeping the yuan broadly stable against the US dollar, the rolling 60-day correlation between changes in the Dollar Index and the changes in the greenback against the offshore yuan has been above 0.60 since early August. Previously, from mid-May through late July the correlation was between 0.20 and 0.30. In a firm US dollar environment, the yuan tends to perform better. This was the case in July, the only month so far this year that the dollar rose, and last week, the offshore yuan was the strongest currency in the Asia Pacific region. 

Data:  China will likely report its September lending data, direct investment (and recall that retained earnings are regarded as direct investment), and the politically sensitive trade figures. There has been much in the traditional and social media about China's trade surplus, and 40 years ago, it was Japan's surplus that spurred protectionism in the US and Europe. This helped topple GATT and reform it and the conflict-resolution mechanism in the creation of the World Trade Organization (for which US presidents of both parties have blocked the appointment of appellate judges and thereby helping weaken the institution). China reports September CPI and PPI figures in the middle of the week. The deflation is expected to moderate slightly. Producer prices may have fallen 2.3% year-over-year after a 2.9% decline was reported in August. If so, it would be the mildest deflation since February. CPI was positive in 2024 with the exception of January. This year, it has been in deflation territory in five of the first eight months. If anything, consumption has improved this year, but many observers frame the falling CPI in terms of weak consumption. Instead, we see food prices having greater impact than often acknowledged. In any event, the median forecast in Bloomberg's survey sees consumer price deflation narrowing to -0.2% from -0.4% in August. 

Prices: The dollar traded at its best level against the offshore yuan (~CNH7.1535) since late August in the middle of last week. When mainland markets re-opened last Thursday, the dollar retreated to around CNH7.1240. However, President's Trump's threat before the weekend saw the yuan weaken even as the dollar pulled back more broadly. The greenback surged to new session highs near CNH7.1485 before stabilizing. 

Japan

Drivers: The policy mix that the new LDP president and soon-to-be prime minister advocates loose monetary and fiscal policy has eclipsed the impact of the change in US yields on the exchange rate. The Minister of Finance took the first step on the intervention escalation ladder with words of caution about excessive and one-way moves. It may have helped stabilize the yen ahead of the weekend after the yen fell apparently have not commented about the exchange rate developments that fueled a nearly 4% decline in the yen last week, the biggest weekly loss since early October 2024. The dollar has risen against the yen in six of the past seven weeks. 

Data:  Japan's preliminary estimate was that industrial output fell 1.2% in August after falling the same percent in July. It will update its estimate on October 16. It underscores one of the two main reasons that explain the cautiousness of the BOJ under Governor Ueda to normalize monetary policy, even as it reduces its balance sheet (which now also includes the slow sales of equity ETFs). The economy is fragile. The median forecast in Bloomberg's survey is that the economy stagnated in Q3. The BOJ also may be hesitant to raise rates because inflation may be overstated by the role of food. In August food prices were 7.2% higher year-over-year. If food, not just fresh food, and energy were excluded, CPI would be very stable at 1.6% for the past six months. 

Prices: The dollar settled near JPY147.50 on October 3 and briefly pushed above JPY153.25 before the weekend. Some profit-taking after Finance Minister Kato's cautionary comments after the greenback reached an eight-month high saw the greenback sold to around JPY152.40. However, President Trump's new tariff threat on China saw the dollar drop to JPY151.50. The JPY150.70 area is the (38.2%) retracement of this month's gains. The (50%) retracement is slightly below JPY150. Last year, MOF’s Kanda suggested a 10-yen rule, which identifies the magnitude of a move in a month that could spur intervention. The dollar traded near JPY145.50 on September 17. The 10-yen rule suggests the market would turn more cautious if JPY155.50 was approached in the week ahead. 

UK

Drivers: Sterling has rarely been more sensitive to the dollar's broad direction than it is now. The rolling 30-day correlation of changes in the sterling and the Dollar Index is near -0.90. The 60-day correlation is around -0.85. The rolling 60-day correlation of changes in the sterling and the US two-year yield is around -0.50, but the correlation with changes in the UK's two-year yield is around -0.30. 

Data: There are two highlights in the coming week. On Tuesday, the UK reports on the labor market. The labor market has generally been slowing. The ILO-measure of the UK unemployment rate has risen from 4.1% at the start of 2024 to 4.4% at the end of last year and 4.7% in three months through July. Wage growth has slowed, and it has slowed to less than 5% for the first time since mid-2022, but several BOE officials want to see more progress. On Thursday, August's monthly GDP will be reported, with the details. Recall that the economy stagnated in July. On a quarterly basis, the UK economy grew by 0.7% in Q1 and 0.3% in Q2 (the median forecast in Bloomberg's survey for Q3 is 0.2%). The cumulative monthly figures were 0.9% in Q1 and 0.2% in Q2. 

Prices: Sterling's price action last week inflicted serious technical damage. Sterling was sold through the September lows (~$1.3325-35), which could mark the neckline of a topping pattern. After falling to almost $1.3260 before the weekend it recovered smartly as the greenback was sold broadly following the escalation of US-China trade conflict. Sterling recovered to $1.3370. The close above the September lows help stabilize the technical tone. Overcoming resistance in the $1.3400-25 area would boost the chances a low is in place. 

Canada

Drivers: The Canadian dollar has not been as sensitive to the broad US dollar movement in over a year. The 60-day rolling correlation of changes in the Dollar Index and US dollar-Canadian dollar exchange rate is near 0.75. It has not been below 0.60 since the end of April. The 30-day correlation is around 0.60. The year's low was recorded in early February slightly below 0.20. The exchange rate has become less sensitive to the changes in the US two-year yield. The 30-day correlation has fallen to almost 0.30 from 0.60 at the end of September. The 30-day correlation with the two-year spread is slightly below the year's high near 0.50. 

Data: Canada reports September housing starts and existing home sales. Neither these nor wholesale sales capture the market's attention. The international securities transactions draw some attention. Foreign investor interest in Canada's bonds and stocks has fallen off this year. Through July, foreign investors have bought about a net of C$4.4 bln of Canadian financial assets. In the first seven months of 2024, they invested nearly C$103 bln.

Prices: Canada created 106k full-time jobs last month, the most since June 2023 and to barely was able to halt the Canadian dollar's recent slide that took it to lows not seen since late April. The US dollar rose to almost CAD1.4035 before the Canadian employment data sent it CAD1.3975, unable to fall back below the 200-day moving average. The odds of a rate later this month were pared to about 38% from 57% the previous day and 60% a week ago. A convincing break of the CAD1.4040 area could target the CAD1.4150-65 area. Support may be found in the CAD1.3935-50 area, but a break of CAD1.3900 is needed to suggest a top may be in place. 

Australia

Drivers: The Australian dollar is the most sensitive to the US dollar's broad direction since the middle of last year. The rolling 60-day correlation of the changes in the Australian dollar and the Dollar Index is around -0.80 and the rolling 30-day correlation is about -0.78. The Aussie is also sensitive to changes in the US two-year yield. The inverse correlation over the past 30 days is about a little more than - 0.40 and the 60-day correlation is a little less than -0.50. The correlation with changes in the US-Australia two-year interest rate differential is less robust, near 0.25 and 0.40 for the 30- and 60-day periods, respectively. 

Data: Thursday Australia reports its September jobs data. Through August, Australia has created a little more than 103k jobs (~276k in comparable 2024 period), of which less than 80k have been full-time positions (216k in the same 2024 period). At 4.2% in August, the unemployment rate is in the middle of this year's range. It was at 4.0% at the end of last year. The futures market sees the November meeting as nearly a coin toss but given the robust growth of private sector credit (7.2% year-over-year in August) and household spending (5% year-over-year in August), we see the odds as somewhat lower. 

Prices: The Australian dollar was crushed before the weekend as US-Chinese tensions mounted. China is by far Australia's largest trading partner, but it is deeply anchored in the US-led military alliance. Rising tensions between Washington and Beijing aggravates Australia's seemingly untenable position. Its 1% loss before the weekend made the Aussie the worst performer in the G10. It marginally took out the September low near $0.6485. The downside risk may extend toward the late August lows near $0.6415. The 200-day moving average is near $0.6420 and the (38.2%) retracement of this year's rally is slightly above $0.6400. 

Mexico

Drivers: The rolling 30- and 60-day correlation between the changes in the US dollar-Mexican peso exchange rate and the Dollar Index is near 0.75. They have not been higher in most that a decade. The correlation of changes in the exchange rate and the US two-year yield is somewhat less robust at around 0.30 and 0.25 over the past 30- and 60-days, respectively. The exchange rate is more sensitive to the performance of the Mexican stock market than US rates. The 30-day correlation is near 0.50 and the 60-day correlation is around 0.36.

Data: Mexico has a light economic calendar in the week ahead. The most important data point is September nominal wages (August 7.3% year-over-year), but the market impact tends to be minor. 

Prices: The slide in US equities before the weekend amid the escalation of US-Chinese tensions sent the peso to its lowest level since September 11. The dollar recorded the low for the week on Thursday near MXN18.30 but the surge on Friday took it to almost MXN18.59. The (50%) retracement of the dollar in September is slightly above MXN18.53. The next retracement (61.8%) is near MXN18.61. The unexpected weakness in Mexico's August industrial output did it no favor. Rather than increase by 0.4%, which was projected by the median forecast in Bloomberg's survey, August industrial output fell by 0.3%, bringing the year-over-year contraction to 3.6% from 2.7%. 

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