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- The Weekend Edition # 146 - Is the USD strength over?
The Weekend Edition # 146 - Is the USD strength over?
Market Recap: Fed cut incoming; Macro: Is the USD Strength over?; Retail Earnings: Who do we believe? Closing Thoughts: Great Expectations
Ayesha Tariq
August 25, 2024
Welcome to another issue of the Weekend Edition!
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Here's what we cover
Market Recap
Aug 19 - Aug 23, 2024
This week was all about Jackson Hole and Chair Powell’s speech. The hype that everyone built up around the speech was far more than the actual outcome. Yes, Chair Powell signaled that the “time has come for policy to adjust” but he left the question of 25 bps or 50 bps unanswered. But even without saying anything, he left clues as to what to expect.
For one, he talked about the dual mandate, and that now the focus was turning to the labor market. However, he did however, balance the discussion concerning the labor market talking about the cause not being layoffs but rather a reset from the over-hiring that we saw after the pandemic.
Nevertheless, traders started pricing in a higher probability of cuts and even, a 50-bp cut in September. Part of the reason may have been his mention of the fact that “downside risks to employment have increased” and that any further weakening would be unwelcome. He also added that they would support a strong labor market.
The way we see it, it would take a very weak unemployment report for the Fed to consider a 50bp cut. The Fed goes into their two-week blackout period, right after the report is released on 06 Sep 2024, so we may not get much about what they are thinking.
However, last month’s reading was unusually weak and part of that was driven by Hurricane Beryl last month. August’s report is likely to be somewhat firmer.
Chair Powell’s confirmation of cuts eventually led the market higher, with small caps leading the way. Small businesses are the most affected by rate hikes because they not only have a lower capacity to pay higher levels of interest, they usually don’t have a lot of cash in hand to earn higher interest either. So the confirmation that the easing cycle has begun will naturally give some life to small caps.
Macro - Is the US Dollar Strength Over?
Now, that the Fed’s easing cycle will most likely begin, it’s time to ask whether we’ve seen the end of the strength in the US Dollar. Over the last couple of weeks, the US Dollar Index has taken a significant beating, given that the market has been pricing in economic weakness and a jumbo rate cut from the Fed.
We think the US Dollar is not done, and has gotten oversold. With a repricing of rate cut expectations, we are likely to see the dollar gain some strength into the end of the year because:
Repricing of US Treasury 10Y Yields higher
The UST 10Y yield has recently been declining due to fears of economic weakness and declining inflation. While inflation may trend lower, the anticipated economic "weakness" might turn out not to be so weak after all. This scenario could lead to a rise in longer-end yields, while the shorter-end continues to price in Fed rate cuts. However, expectations regarding the number of rate cuts may soon be adjusted as the Fed releases its projections, potentially strengthening yields overall.
Rate Differentials with Other Major Currencies
When considering the USD Index, we look at the most prominent currency pairs. This would be the EUR, GBP, CAD, CHF, JPY and AUD. If the respective central banks of these countries cut more than the Fed, and faster, their currencies should weaken against the USD.
The European Central Bank (ECB) is expected to cut rates again in September and may do so again in November or December due to economic weakness.
In the UK, the situation is slightly different, with the economy remaining relatively stable and growing, though one more rate cut is still expected.
The Bank of Canada has already cut rates twice and might consider one more cut this year.
The Swiss National Bank has also begun easing, surprising the market with two cuts already and possibly cutting again in September.
The only two currencies showing some strength are the JPY, particularly after Ueda maintained his hawkish stance on Friday, and the AUD, as the Reserve Bank of Australia still views inflation as a serious threat.
These actions put four major currencies ahead of the Fed in their cutting cycle, likely resulting in a relatively stronger US dollar.
Geopolitical Risks
Geopolitical risks may continue to keep the USD elevated. Conflicts in the Middle East and Europe are not subsiding; in fact, they are escalating. The US Dollar remains a safe haven, second only to gold. Additionally, these conflicts are causing oil prices to spike. Since oil is priced in USD, this increases the demand for US dollars.
Economic Policy
The outcome of the upcoming elections remains uncertain. However, it is clear that regardless of the candidates' promises to lower inflation, many of their policies are inflationary. This could lead to a slower Fed cutting cycle and a stronger US Dollar. While candidates may prefer a weaker dollar, adding continued fiscal spending could actually result in a resurgence of inflation.
This brings us to the relationship between a weaker US dollar and inflation. A weaker currency tends to encourage inflation, so the Fed is likely to be cautious about the pace of rate cuts to prevent a significant weakening of the dollar. This cautious approach will only hold if the economy does not enter a recession; otherwise, all bets are off.
Near-Term Catalysts to Watch
The key catalysts to monitor in the near term are the 10Y UST Yield and the Commitment of Traders Positioning in the USD. There is still some residual bullishness, and as the chart suggests, we will likely see a reset in the US dollar only once this positioning gets washed out.
Retail Earnings - Who should we believe?
Over the last two weeks, we got a bunch of retail earnings. The most prominent ones being Walmart, Target, Home Depot, and Lowes. We also got very mixed messages from these earnings.
Walmart and Target surged post earnings as both companies talked about not seeing any weakness in the consumer. In fact, they talked about many of the consumers actually spending more on discretionary items. TJX also smashed earnings
On the other hand, both Home Depot and Lowes reported a slowdown in activity which led to a downward revision in their expectations. Even Macy’s talked about the customer becoming stretched when it comes to discretionary spending.
So who should we believe?
When you look at it, there is a pattern. The customer wants:
Convenience
A Bargain
Choice
The way I see it. Consumers have become more value-conscious. They are not going out as much anymore, as we can see from many of the restaurant earnings. So they’re buying more of their groceries at these supermarkets, which also offer other items. Their outing turns into an all-in-one trip because these places offer convenience.
Both Walmart and Target have talked about reducing their prices and TJX is a discount retailer. So customers are definitely looking for a bargain. I know I am!
With places like Walmart and Target, you have the choice of spending your money. So a person looking for a t-shirt may decide to pick it up at Target, instead of actually venturing into Macy’s because they don’t want to end up spending more. When you’re strapped for cash and you still want to buy something, you end up spending that at the supermarket because at least that way you don’t spend too much.
Walmart, Target, and TJX - all doing well actually signifies that the consumer is becoming stretched. US Growth is slowing and inflation is decelerating, which means spending is slowing. But the cumulative effects of high prices and high interest rates will continue to be a burden on the average person.
Closing Thoughts - Great Expectations
The Fed would likely consider every possibility before they start out with a jumbo cut of 50bp. While they are “confident” that inflation is trending lower, they are still not completely out of the woods, and ushering in a jolt to the US Dollar with a 50bp cut could set them off that path.
The economy is stable for now, and there isn’t an alarming level of weakness in the system for them to take the course of a 50bp cut in September, or more than 2 cuts this year. It’s likely September’s Fed Projections will make that clear, and reset some of the expectations that traders are pricing in.
Speaking of expectations, Nvidia reports this week on the 28th, after market close. Expectations are set relatively high and given what we saw from other mega-cap tech, we may see some turbulence in this week as people try to position ahead of earnings.
Have a great week ahead!
Sincerely yours,
Ayesha Tariq, CFA
There’s always a story behind the numbers.
Calendars
US Earnings Calendar
US Economic Calendar in Eastern Time (Source: Trading Economics)
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