US Dollar to Strength Even Further, Here is Why

USD: Risk aversion is mild so far but core G10 outperforms 

In the context discussed earlier in this week, I noted that the US dollar could potentially strengthen further due to reduced market activity and lower volatility. Although the dollar did experience some strengthening, this was primarily driven by risk aversion rather than yield changes. However, this trend has partially reversed, particularly following a late rally in the S&P 500 the previous night.

Federal Reserve President Harker explicitly mentioned the possibility of rate cuts in 2024, leading to a retreat in 10-year yields to around 4.00%. While there was a period of yield curve steepening, the recent dip in equities before the late rally was influenced partly by declines in bank stocks and additional signs of economic fragility in China. The 2s10s yield curve reverted by approximately 8 basis points, maintaining a significant inversion of about 75 basis points, despite the earlier steepening.

The sources of risk aversion we're observing now are not novel for the markets. The US regional banks played a pivotal role in triggering a major risk aversion episode in March, and the persistent economic challenges in China have remained a consistent factor. Consequently, it's challenging to envision this current wave of risk aversion rapidly escalating beyond its current state. However, this perspective doesn't downplay the potential headwinds posed by the US banking sector.

It's worth highlighting that nearly six months after the crisis-driven market turmoil, the support mechanisms implemented at that time continue to be effective. Recent data on the Fed's balance sheet, up to last Wednesday, revealed a further increase in the Bank Term Funding Program to a new record high of $105.7 billion. Alongside significant loans to banks via the Federal Home Loan Bank, this indicates ongoing vulnerabilities within the banking sector that could unexpectedly undermine investor confidence. At the very least, this underscores the fact that credit flow to the real economy will continue to face obstacles. Potential downgrades of major financial institutions by Moody's could exacerbate financial tightening, as a broader range of banks concentrate on strengthening their balance sheets.

FED’S BANK TERM FUNDING PROGRAM HITS A NEW RECORD 

Source: Bloomberg, Macrobond & MUFG GMR

In terms of currency performance, the US dollar exhibited strong performance both yesterday and, on a month,-to-date basis. Among the G10 currencies, the euro, Swiss franc (CHF), and Japanese yen (JPY) have been the top three performers after the dollar. On the flip side, the New Zealand dollar (NZD), Australian dollar (AUD), and Canadian dollar (CAD) have displayed the weakest performance, aligning with the typical risk-off pattern in G10 FX markets.

China's role in the risk-off trend is notable. Following weak trade data, the previous day, yesterday's inflation figures confirmed China's entry into a deflationary phase. The year-on-year Consumer Price Index (CPI) rate declined from 0.0% to -0.3%, while the Producer Price Index (PPI) stood at -4.4%. This deflationary environment is driven by subdued domestic demand, particularly as China grapples with ongoing challenges in the property market. Concerns were further heightened by missed bond payments from Country Garden. The recent strength of the dollar has somewhat diminished, partly due to a stronger-than-anticipated USD/CNY fixing by the People's Bank of China (PBoC), although the enduring influence of rate spreads not seen in over a decade will continue to exert pressure on the Chinese yuan (CNY).

Given this global context, it's highly likely that the US dollar will maintain a strong position. If risk aversion intensifies, especially leading up to the US Consumer Price Index (CPI) data release today a worst-case scenario could entail a significantly higher-than-expected CPI reading, potentially exerting further downward pressure on global equity markets. However, it seems improbable that a much stronger CPI print will materialize, particularly with rental disinflation only beginning to take effect.

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