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6 October 2021

FX Daily: A bullish dollar cocktail is being mixed

Surging energy prices and what central bankers plan to do about them dominate FX markets right now. With market-based measures of US inflation expectations breaking out to the upside any good news on US jobs this week should see short-term US rates and the dollar strengthen. Currencies of the big energy importers and dovish central banks to underperform.

USD: Strong ADP today could get the dollar going

Surging energy prices remain the top story in financial markets right now. Brent is trading close to $83/bl as OPEC+ plays it steady on supply increases and gas prices continue to surge as Asian and Europe fight over gas shipments. Fears of a cold winter in the northern hemipshere and historically low gas inventories, especially in the UK, leave the gas market very tight indeed.

As we have been discussing over recent weeks, the currencies of the big gas exporters Norway and Russia have been out-performing, especially since they are backed by hawkish central banks. Dmitry Dolgin released a fascinating analysis last night, noting that Russia's Finance Ministry mandatory monthly FX purchases will only be around 40% of the expected current account surplus over coming months, which is a Rouble positive.

How central banks respond to this energy price spike will be a key driver of FX rates over coming months. We know that the US economy is at the forefront of closing output gaps and that the Fed is minded to take its foot off the monetary accelerator over coming quarters. The Fed's relaxed stance may, however, be coming into question. The Fed frequently tells us that despite welcome growth and employment trends and 5%+ inflation, inflation expectations remain well-anchored. Well looking at market-based expectations of US inflation, - e.g. the 5Y5Y forward inflation swap or the 10 year TIPS - inflation expectations have broken decisively to the upside over recent days.

We are also starting to see the US yield curve steepen again and a term premium return to the US 10 year Treasury yield. Backed by a hawkish set of Dot Plots at its September meeting, we think a bullish cocktail is being mixed for the dollar. Add in any strong employment data and market expectations may swing towards Fed projections of a steepish three year tightening cycle starting next year. Thus look out for ADP data today. Any upside surprise to the 430k consensus figure could lift short-term US rates and the dollar.

We favour a test of big multi-month DXY resistance at 94.50/70 this week.

Elsewhere, the RBNZ hiked rates 25bp to 0.50% overnight, matching the market's expectations. Policymakers also remained quite optimistic on the economy, saying that the recent Covid restrictions did not materially change the medium-term outlook outlined at the August meeting. Ultimately, this allows markets to stick to their pricing of one more hike this year (in November), which is also our base case. This should provide some support to NZD, which however remains more vulnerable than other commodity currencies like AUD, CAD and NOK to swings in risk sentiment as it cannot draw many benefits from rising energy prices.

EUR: ECB lacks the mercantilist touch

While the ECB may be welcoming the lowest levels of the trade-weighted Euro since February 2020, the ECB is leaving European businesses vulnerable to the energy price surge. The ECB's stance is at complete odds to their Chinese counterparts, who are engineering a stronger Renminbi to secure strategic commodity imports as cheaply as possible. This divergence in policy has seen EUR/CNY drop 7% this year, with no sign of this trend changing anytime soon. Indeed, it may accelerate if the dollar breaks higher - which seems the risk over coming months.

The recent period of EUR/USD consolidation has done nothing to reverse last week's technical break lower in EUR/USD and 1.1500 beckons.

GBP: Responsive BoE seen helping GBP

Despite the growing narrative that the UK economy is heading back to the 70s, GBP is performing quite well. EUR/GBP remains near its low at 0.8500, while Cable is clinging on above 1.36. Driving that support we suspect is the view that the BoE has said it is prepared to tighten monetary policy over its forecast cycle. Higher energy prices are directly feeding into BoE tightening expectations and supporting the pound. Even though that tightening may ultimately be a policy mistake it looks far too early for that to hit GBP. Indeed, flat or inverted yield curves are generally positive for currencies and the currency sell-off only materialises once the tightening is ready to be reversed.

Expect EUR/GBP to stay near the lows at 0.8500, while Cable may well stall at the 1.3650 area and we favour the stronger dollar dragging it back to 1.34 and potentially 1.32.

PLN: MPC may disappoint some hawkish pricing

Surging inflation in Poland has seen the market re-price the Polish tightening cycle over the last month. Money market rates have adjusted higher by 25bp at the short-end of the curve and by close to 150bp out at the three year area. Yet our Polish team continue to see the Polish MPC as one of the most dovish in the region and even though the market prefers a first hike at the November meeting rather than today, we suspect hawkish pricing is prone to disappointment.

EUR/PLN risks lie to the upside today, while PLN/HUF looks set to reverse lower driven by a more hawkish NBH.

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