The dollar remains the nicest house on a crumbling street

Economic and political turmoil abroad kept the dollar index relatively steady this week. In Britain, after just six weeks in office, Liz Truss resigned as prime minister. Her plans to cut corporate and individual income taxes despite 10.1% annual inflation led to market turmoil. She now holds the title of shortest-serving prime minster in U.K. history. Former Chancellor, Rishi Sunak, will succeed her. His plan is the opposite of Truss’s; he plans to cut government spending and potentially increase taxes to cover a $45 billion equivalent government deficit. As a former hedge fund manager and experienced treasury official, the market reacted positively when Sunak won the contest to succeed Truss after a volatile week. His policies should help to ease inflation and work with, rather than against, the U.K. central bank.

Meanwhile in Japan, the yen fell to its lowest level against the dollar since 1990 on Thursday. In contrast to the high levels in other countries, Japan’s Consumer Price Index remains around 2%. As a result, Japan’s central bank has remained committed to keeping interest rates low and continues to purchase government bonds to ensure a short-term policy rate of -0.1% and a 10-year government yield of between 0.0% and 0.25%. On Thursday, as the 10-year Japanese government bond exceeded 0.25%, the Bank of Japan conducted unscheduled bond buying to bring yields back down. This unexpected movement is what primarily contributed to the USD-JPY rate hitting 150. Japan intervened in currency markets in September to defend the yen by purchasing it with U.S. currency reserves. Some market participants are speculating the Bank of Japan could defend the yen again since Japanese Finance Minister Shunichi Suzuki has repeatedly warned the government could step in to support the currency in coming weeks.

In the U.S., the 10-year yield hit another 15-year high of 4.2826% as the market continues to speculate on how aggressive the Federal Reserve will be at next week’s policy meeting. Despite the rise in consumer prices, retail sales were reported as 0.0% month over month in September after rising 0.4% in August. Since retail sales figures are not adjusted for inflation, a 0% gain suggests that persistent inflation in combination with the Federal Reserve’s rate hikes may finally be starting to reduce consumer demand. The largest declines were primarily in discretionary spending such as furniture (-0.7%), sporting goods/hobbies (-0.7%), electronics (-0.8%), and miscellaneous store retailers (-2.5%). The one exception to this pattern was a 1.4% decrease in expenditures at gasoline stations.

Despite consumers spending less in September, adjusted for inflation, the job market remains very robust. For the week ending October 21, first-time filings for unemployment insurance were down for the second consecutive week in a row at 290,000. Meanwhile, continuing claims fell to their lowest level since the COVID-19 crisis began. They dropped to 2.48 million for a decline of 122,000 from the prior week. The strong labor market along with a relatively strong economic backdrop has the market anticipating two additional 75 basis point hikes, one next week on November 2 and another on December 14. As of right now, the market is expecting the Fed Funds rate to peak at 475-500 basis points by February 2, 2023 and remain there until September 20, 2023 before slowly falling over the next few years towards the Fed’s 250 basis point longer run Fed Funds target. These expectations are reflected in the 10-year 1m USD-SOFR CME Term swap below.

For investors chasing real yields, the relatively strong economic backdrop, strong labor market, and aggressive Federal Reserve make the U.S., and dollar by proxy, a relatively safe haven in an increasingly uncertain world. In other words, the dollar is the nicest house on a crumbling street.

For corporations, the inverted forward curve continues to allow for a cash pick-up with the use of a pay-fixed swap in the short term at the expense of a cash payout in roughly three years, assuming forward rate expectations are accurate. Corporations could also use the relatively strong dollar to purchase foreign entities at a discount, utilizing USD cash reserves, local debt, or derivatives such as cross-currency swaps to synthetically mirror local debt. To maintain the favorable dollar rate until the target purchase is complete, forwards, options, and deal-contingent derivatives are frequently explored.