In Run-Up to US Elections, By Default USD Strength Could Continue

Markets

US yields closed this week’s opening session 8.3 bps (2-yr) to 11.3 bps (10-yr) higher. For the US 2-yr yield, it was the highest close since mid-August and above the strong 4%-resistance area. The US 10-yr yield finished above 4.2%, completely erasing the August market-meltdown setback to 3.6% mid-September. Don’t go searching for any eco data to explain yesterday’s dynamics. Once September US eco data (payrolls, CPI inflation, retail sales) ruled out the need for the Fed to stick to its bold opening move, focus gradually turned from the November 7 Fed meeting to that other key event the same week, November 5 US presidential elections. Both candidates continue to be neck and neck in the polls. As we near ballot date, markets especially prepare for the potentially most eruptive outcome which would be a Trump win. Recall that a Trump presidency would add $7.5tn to an already yawning $22tn cumulative deficits over the next decade (Harris: +$3.5tn). These bloated public finances in an interest rate environment which can no longer be labelled by acronyms like ZIRP of NIRP cry for a return of credit risk premia. We see the same thing happening in Europe, with underperformance of bonds from countries like France and Belgium compared to countries who have finances better in check (eg Portugal, but also Italy for the moment). In theory, such worries should trigger more bear steepening of yield curves. The relatively strong increase at the front end of the US curve might be linked to comments from Minneapolis Fed Kashkari who wondered whether the neutral rate is higher still (economic resilience) than policy makers currently take into account (already a reset compared to pre-pandemic levels) and who stressed that rates will be higher if deficits go to the moon. The latest upleg in US yields has been primarily driven higher real rates instead of inflation expectations. German yields shadowed the US move yesterday, with yields ending the session 7.2 bps (2-yr) to 9.9 bps (10-yr) higher. On FX markets, the dollar closed at its best level against the euro since the weak July payrolls report (Aug 2). EUR/USD changes hands at 1.0820, preparing for a test of 1.0778 support. In the run-up to US elections, by default USD-strength could continue not only because of yield and economic divergence, but also because of a negative Trump-premium for the USD’s counterparts fearing a very hawkish trade policy. We expect current market to continue today given the thin eco calendar (only Richmond Fed business survey). Speeches by BoE Bailey and ECB Lagarde are wildcards for trading.

News & Views

Brazil’s central bank chief Campos Neto sees “this huge de-anchoring” of inflation expectations from the 3% target as he explained last month’s decision to return to rate hikes to 10.75% after the 4-month pause that followed a cutting cycle (from 13.75% to 10.50%). The inflation convergence towards target has stalled, he said. Services inflation is a particular worry and a tight labour market indicates that it needs to be monitored closely. It’s “a puzzle” to the central bank governor why the labour market continues to be this strong. He said the fiscal narrative is only part of the answer. With economic growth having consistently surprised to the upside, Campos Neto thinks there is a structural element as well following the range of reforms implemented over the past 5 to 10 years. The central bank’s next meeting is November 6, in between the US elections and the Fed meeting but that doesn’t necessarily means they won’t act, especially with the Brazilian real hovering close to record lows (USD/BRL 5.7).

Bank of England rate setter Megan Greene in an Op-ed for the Financial Times said she favoured a gradual approach to monetary easing. Her comments contrast with those of governor Bailey who called for a more activist stance. Greene said rate hikes have spurred consumers to save more. This higher-than-historical savings rate of >10% easily tops that in the US (5%) and was also driven out of precaution in the wake of successive (pandemic and energy) shocks. Real consumption as a result is a mere 1.5% above pre-Covid levels compared to 13% in the US even as British real incomes have been rising for more than a year now. For Greene there’s a risk that lowering the policy rate may trigger the exact opposite move, releasing pent-up demand that’s currently stored in savings. One opposing risk factor is the full impact of higher mortgage rates that has yet to pass through. But given the uncertainty, Greene said the central bank should move cautiously.