August 27: Three Questions for the Week Ahead

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we'll be watching: 

1. Could rising policy expectations put more momentum behind the dollar steamroller?

We’re not quite sure how he managed it, but Jerome Powell succeeded in out-hawking already-hawkish markets yesterday. The greenback surged higher after the Federal Reserve Chair provided a fairly explicit form of forward guidance, saying the central bank plans to keep raising rates and intends to keep them elevated as it fights the biggest inflationary threat in a generation. 

Other Fed speakers, including committee voting members John Williams and Loretta Mester, are likely to echo Mr. Powell’s comments in the days ahead, helping to anchor terminal rate expectations upward - and strong economic data could provide additional support, raising market-implied odds on a three-quarter-point rate increase in September. 

The Conference Board’s measure of consumer confidence, out on Tuesday, probably jumped from 95.7 to nearly 98 in early August as gas prices fell and economic conditions improved. Data from July should show the number of job openings falling, but remaining far above pre-pandemic norms. Weekly jobless claims on Thursday are expected to stay stable, while the Institute for Supply Management’s manufacturing survey will almost certainly reflect an economy that is still in expansionary mode. 

Traders are also unlikely to short the dollar into Friday’s non-farm payrolls report, which could reinforce the fact that central bankers are hiking into a historically strong labour market. Economists think the unemployment rate fell to 3.4 percent as the country generated another 290,000 jobs in August — on top of the 528,000 added in July. 

But the euro could be bolstered by growing talk of a jumbo-sized move at the next European Central Bank meeting, by hawkish noises from Isabel Schnabel at today’s Jackson Hole panel, or by a smooth reopening in the Nord Stream 1 pipeline. The pound could rise as the likelihood of government support for energy-strapped households climbs in the final days of the Conservative leadership contest. The yuan and commodity-bloc currencies in its orbit might gain as the sound of liquidity sloshing through the pipes of China’s financial system grows louder. 

And traders could grow more skeptical about the degree to which forward guidance delivered at Jackson Hole can be relied upon over longer time horizons.

In 2020, Mr. Powell laid out the tenets of the central bank’s “flexible average inflation targeting” framework, pledging to avoid raising rates when prices rose. Less than six months later, policymakers were laying the foundation for a tightening in policy. Last year, the talk was of temporary price pressures. Four months later, “transitory” became a dirty word as officials worried about a structural shift in inflationary conditions. 

These shifts suggest that to an important extent, speeches at Jackson Hole reflect central bank policy goals in the here and now - not how those objectives might shift in the future. As such, we think the dollar steamroller is running on borrowed time. Expectations for a Fed policy pivot in 2023 are likely to recover at some point - driving an erosion in interest differentials against other majors. 

Arthur C. Clarke once said “the future isn’t what it used to be”. When it comes to central bank policy, it never is. 

-  KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

2. Would an Iran deal be a Big Deal?

Last weekend, oil prices fell on hopes the Biden administration would resurrect the Iran nuclear deal, and then soared on Monday as the Saudis threatened a possible OPEC+ production cut. Although the White House has warned, “we’re not there yet”, glimmerings of an end to the saga might become visible in the coming week. 

The immediate impact of a deal might be limited anyway. Iran has been exporting crude at a discount in grey markets despite sanctions, with estimates varying from 500,000 to 900,000 barrels per day. Production has fallen since the US pulled out the deal in 2018 -- from 4.5 million barrels then, to 3.3 million now. It will take time to rebuild infrastructure, especially if the oil majors stay wary of yet another policy flip-flop. Iran does have substantial volumes in storage that could hit markets. But even with an accord, the country would likely take the opportunity to deliver supply gradually at a higher “legal” price.  

The bigger issue -- for now -- is demand. The US driving season typically peaks by August, with gasoline usage falling thereafter. Rationing and recession in a Europe short of gas could hit discretionary petroleum demand as well. And China is grappling with a multi-pronged slowdown as it fights coronavirus, a troubled housing market, and a drought-driven drop in power generation simultaneously.

Over the short-term, a deal with Iran would add an additional complication for markets already juggling multiple uncertainties but is unlikely to be a game changer. Over a longer horizon, Iran’s return to oil markets could help stabilize global supply as demand recovers from the stresses of the last two years.

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

3. What kind of September will the real remember?

Brazil will post data on second-quarter growth on Thursday.  The consensus sees growth increasing 0.9 percent quarter-on-quarter, but weak sales and production figures from the period could mean a downside surprise. Even if the number disappoints, markets are likely to see a weak print as a lagging indicator from a troubled trimester.  They are focused instead on two huge events in October – a possible end to central bank tightening and the two-round election featuring rightist President Jair Bolsonaro, socialist ex-President Lula, and assorted minor candidates

At its last meeting, the central bank left open the option of one small final hike at its October 26 meeting. Easing price pressures and a stabilizing US rate backdrop have led head Roberto Campos to hint the bank could hold rates at 13.75 percent.

Lula is running 10 -14 points ahead, but he still may not clinch an absolute majority on October 2. Pollsters also see the ex-President winning a potential head-to-head matchup on October 30, but Bolsonaro has bounced from abysmally low ratings and markets may fear tension between rounds.  The incumbent has threatened in the past that he will treat any loss as a “fraud,” but independent electoral oversight and White House warnings against skullduggery lead us to believe things will go smoothly.

Heading into September, traders hope local rates have peaked. While jittery about the conduct of the election they seem less worried about Lula’s politics -- he is campaigning as the moderate markets came to love in the 2000s. One difference could be that Lula first term had a strong tailwind from a China-led commodity boom. Will China be a headwind this time? Maybe a little, but peak inflation, high real rates, and a glimpse of the end of Fed tightening could still add up to positives for the Brazilian real.

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

MONDAY

EUR European Central Bank Speech, Lane 

TUESDAY

USD Federal Reserve Speech, Barkin

CAD    Current Account Balance, Q2

USD    Conference Board Consumer Confidence, August

USD    Job Openings and Labor Turnover Survey, August

USD    Federal Reserve Speech, Williams

WEDNESDAY

EUR Consumer Price Index, August

USD    Federal Reserve Speech, Mester

CAD    Gross Domestic Product, June

USD    Department of Energy Weekly Inventories

THURSDAY

EUR Unemployment Rate, July

BRL    Gross Domestic Product, Q2

USD    Weekly Jobless Claims

USD    ISM Manufacturing, August

FRIDAY

USD Non-Farm Payrolls, August

USD    Unemployment Rate, August

USD    Factory Orders, July

USD    Baker Hughes Weekly Rig Count

COUNTERPARTIES

Some of this week's most interesting and informative reads on the state of the global economy:

“Every week, the people who trade electricity in the UK get to quiz the managers of the national grid for an hour. The conference call, which anyone can monitor, offers an insight into what the men and women on the front line of the power market are worried about. Listening to them is getting scarier by the week — and suggests keeping the lights on this winter will be a lot more challenging than European governments are admitting.”

Bloomberg: Listening to European Electricity Traders Is Very, Very Scary

“But the best A.I. systems are now so capable — and improving at such fast rates — that the conversation in Silicon Valley is starting to shift. Fewer experts are confidently predicting that we have years or even decades to prepare for a wave of world-changing A.I.; many now believe that major changes are right around the corner, for better or worse.”

NY Times: We Need to Talk About How Good A.I. Is Getting

“…the one certainty is that governments will have to become and remain much more involved in shaping the structure of the energy economy. Not just in terms of fiscal support, but in terms of managing the consequences of extreme volatility.”

Financial Times: The Strange World of Energy Prices

“The problem occurs when an economy undergoes many years—even decades, in China’s case—of rapid growth, expanding liquidity, and soaring real estate and asset prices. Under such circumstances, entities that tend to take on too much risk are never disciplined, and year after year they systematically outperform those that take on more prudent levels of risk.”

Carnegie Endowment: China’s Overextended Real Estate Sector Is a Systemic Problem

“Basically, the idea here is that America produced a lot of highly educated people with great expectations for their place in American society, but that our economic and social system was unable to accommodate many of these expectations, causing them to turn to leftist politics and other disruptive actions out of frustration and disappointment.”

Noahpinion: The Elite Overproduction Hypothesis

“It turns out the sanctions weapon has flaws. One is the time lag. Blocking access to tech the West monopolises takes years to bite, and autocracies are good at absorbing the initial blow of an embargo because they can marshal resources. Then there is the blowback. Although the West’s GDP dwarfs Russia’s, there is no wishing away Mr Putin’s chokehold on gas. The biggest flaw is that full or partial embargoes are not being enforced by over 100 countries with 40% of world GDP.”

The Economist: Are Sanctions on Russia Working?

“Economies of scale are common in manufacturing, in agriculture, in transportation, and in process industries. But they seem to be very uncommon in construction.”

Construction Physics: Why Are There So Few Economies of Scale In Construction?