Soft US payrolls data weakens dollar

A spate of US labour market reports came out a touch softer than expected last week, culminating in the headline payrolls number for June.

The data cannot be described as weak, and in fact US yields continued to head higher throughout the week, but FX markets took it as a sign that the recent dollar rally may have been overdone and popular trades were unwound. The winner of the week was the Japanese yen, rebounding sharply even as emerging market currencies sold-off, a sign that the popular trades of the year are running into headwinds and trader positions are being stopped out.

The focus for this week will be whether the recent spike in FX volatility and unwind of popular 2023 trades continues. The US inflation report for June, out on Wednesday, will also be highly important for currencies. A further softening is expected in both the headline and core indices, which may be positive for the battered US bond markets, but negative for the dollar. The May employment and monthly GDP report are also due from the UK this week, but this will otherwise be a quiet week for macroeconomic news.

Figure 1: G10 FX Performance Tracker [base: USD] (1 week)

GBP

The relentless march higher in UK rates, caused by the streak of inflation shocks and the Bank of England's newfound focus on the problem, continues to support sterling, which has strengthened its position as the best performing G10 currency year to date.

The key for this week will be the May employment report, and in particular the wage growth number. As long as the latter remains above 7%, it will be difficult for the MPC to dismiss the real risk of second round effects on inflation. At the time of writing, swap markets are eyeing a terminal Bank of England base rate of around 6.35%. While this represents a modest retracement from the peak in pricing, it is still consistent with by far the most aggressive pace of policy tightening of the major economic areas. Overall the rate environment seems to us to be conducive to further pound strength.

EUR

May retail sales and the revision to the flash PMIs for June came in softer than expected, again adding to the gloom that has started to gather over the Eurozone's economy. The former has failed to post monthly growth since January (0% in May), while the latter fell back below the level of 50 indicating contraction in June (49.9) for the first time since December. The euro was able to shrug it off for now, and we do think that there is still too much pessimism around the Chinese recovery story, which we continue to view as a clear positive for the common bloc’s economy.

This week is very light in terms of Eurozone data. For better or for worse, there is not a lot of information that will be released between now and the July ECB meeting, so speeches by central bankers, and possibly the accounts from the June Governing Council meeting on Thursday, will provide the focus for the common currency.

USD

The June payrolls report was split. The establishment survey suggested a certain weakening in the momentum of job creation (and the first downside surprise relative to the Reuters consensus in over a year) and a modest pick up in wages, while its household counterpart showed (still) lower unemployment. Nothing there, or other recent data, contradicts the view that the Federal Reserve will hike rates later in the month, a move priced in with a 90% probability by markets right now. The outlook for rates beyond then is less certain, with markets torn 50/50 over the possibility of a second 25bp hike by the Fed’s November meeting.

Once again the focus this week is on inflation. Markets are confident that the June CPI report will show a continuation of the moderating trend in the key core subindex. Given the significant sell-offs we have seen recently in fixed income markets, a dovish surprise may be more impactful both for those markets and the US dollar.

JPY

As mentioned, the yen was the best performing currency in the G10 last week, bucking a recent trend that has seen it largely underperform for a number of months. While we are yet to see direct intervention in the FX market for Japanese authorities, the verbal intervention that we have had appears to be putting somewhat of a temporary floor under the currency and preventing a material move higher in the USD/JPY exchange rate above current levels.

Whether this resilience in the yen will be sustained in the near-term may depend on communications from the Bank of Japan ahead of its next policy meeting on 28th July. Any hint that a change in the YCC policy could be on the way would be a clear bullish signal for JPY, though this appears increasingly less likely to be forthcoming just yet. There will be no major economic data releases out of Japan this week, so we suspect that the yen will likely continue to be driven by ongoing speculation surrounding the possibility FX intervention.

CNY

The yuan took a breather from its relentless sell-off last week, and managed to post some gains against the US dollar. Importantly, authorities appear to be fighting back against the currency’s weakness. Yuan fixings have been quite firm, with PBoC-backed newspaper signalling the availability of tools to stabilise the currency, while major banks again slashed rates on US dollar deposits of corporate clients. Investors were also encouraged by the resilience of the Caixin manufacturing PMI, which indicated modest expansion in June. However, the services data was very disappointing, suggesting that activity in the sector, which had been a key driver of the post-pandemic recovery, may be dying out. Today's soft consumer inflation data (0% in June), only adds to concerns about the strength of demand.

Meanwhile, US Treasury Secretary Yellen’s visit to China last week was seen as a step in the right direction to amend the relationship between the two countries. We shouldn’t get carried away, however, as there remains a wall of different issues. One of the key thorns is the ongoing tech war. Last week, China announced that it will restrict the export of gallium and germanium compounds, two key metals for the manufacturing of semiconductors. After the release of today’s inflation data, this week sets up to be relatively quiet in terms of news. Markets will keep an eye on June trade data (Thursday) and an update on house prices (Saturday).

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