Dollar Smile
Are global macro conditions suggesting we are moving towards the middle of the dollar smile? With China’s economic outlook stabilising and foreign investor positioning extremely underweight, capital could start flowing back into Chinese assets. The lack of attractive investment alternatives outside the U.S. had previously supported USD, but the recent fiscal and monetary stimulus measures in China are shifting that narrative. Perhaps it is time to reconsider structural USD longs.
Fed Expectations
Powell explicitly pushed back against a 50bp rate cut by year-end. Following the September 50bp reduction, market pricing has turned structurally more dovish, partly on the assumption that the Fed would not want to underdeliver on easing if a 50bp move is priced in by the FOMC meeting. Powell stated the base case is two 25bp cuts by year-end, signaling his discontent with excessive dovish expectations.
Despite this, the Fed Funds Future curve still prices in 70bp of cuts by December, implying that markets expect soft data to force another Fed surprise. The near-term balance of risks may be tilted to the upside for the dollar, as markets reassess the likelihood of aggressive easing.
ECB Outlook and EUR/USD Dynamics
The ECB is now highly likely (84% probability) to cut rates in October, as the eurozone inflation outlook weakens. The EUR-USD 2-year swap rate spread has widened further in favor of the dollar, now at -110bp, down from -85bp in mid-September. If weaker inflation prints continue in Germany, France, Spain, and Italy, the ECB will have little reason to hold back on easing.
Even ECB President Christine Lagarde struck a more dovish tone, signaling increased confidence in disinflation. Comments from other key policymakers this week, including Isabel Schnabel and Philip Lane, will help clarify the ECB’s stance.
If eurozone inflation underwhelms and US payrolls disappoint, EUR/USD could remain stable in the 1.11-1.12 range in the first half of October, rather than breaking out higher.
US Payrolls
Friday’s jobs report is the biggest binary event of the week. Consensus expects 146k job gains and a 4.2% unemployment rate.
- Recent labor unrest suggests this may be the last clean reading of the US employment market before the Fed meets in November.
- Job openings data on Tuesday is expected to show August vacancies near the lowest level since early 2021.
- Industry surveys, including the ISM manufacturing survey (Tuesday) and services index (Thursday), will provide additional insights into private-sector hiring trends.
Note on JPY Longs
With the election of Shigeru Ishiba markets are pricing in a more likely chance of a December hike. Traders should beware volatility on news at the start of week as policies get laid out. Ishiba has made some contradictory statements this week. “I don’t think we should be talking about interest rates in a situation where we still can’t say for sure that deflation has been defeated,” Ishiba said during an interview with Fuji TV.
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