Dollar reconnects with short-term rate differentials

Written on 07/21/2023
Team UCapital 24

The dollar has made a modest comeback as both US yields adjust higher and short-term rate spreads stay in the dollar's favour. In fact, one could argue that the dollar should even be a little higher given that two-year US yields have retraced about 50% of their drop in the first half of July and the DXY has only retraced one-third of its losses.

Price action over the past week probably shows that a switch to the disinflation trade will not be easy and will require a constant drip feed of supporting evidence – be it softer price or weaker activity data. Yesterday's drop in US initial claims clearly did not help here.

Casting around the world in quiet FX markets we see the People's Bank of China continuing to fight a weaker renminbi by printing lower USD/CNY fixings than model-based estimates suggest.

"Despite credible calls for a lower renminbi to support growth and battle deflation, it seems Chinese policymakers prefer to keep renminbi losses contained and prevent a "sell China" mentality building. The PBoC's battle against a stronger USD/CNY is a slight dollar negative in quiet summer markets, especially should it extend to outright dollar sales," ING analyst Chris Turner said.

Today's session should be a quiet one as the market prepares for US Federal Reserve, European Central Bank and Bank of Japan meetings next week.  Regarding the BoJ, expectations of any Yield Curve Control policy tweak seem very low - "perhaps too low" - given that the 30-year Japanese government bond yield is drifting lower and the forward market prices 10-year JGB yields at 50bp in three months and at only 55bp in six months.

"These 10-year yields should be priced a lot higher were the market expecting a policy change. USD/JPY may well drift to the 141.15/142.00 area before next Friday's BoJ meeting."

DXY can probably trade a 100.50-101.00 range today.