Fundamental Forecast for the US Dollar: Neutral
- The ongoing erosion of US real yields, thanks to rising inflation expectations and stagnant US Treasury yields, proved to be a negative influence on US Dollar price action – like it was for much of 2020.
- For now, without a corresponding rise in US Treasury yields, we’ve seen the start of a tantrumless taper, if you will. If you haven’t read the note, The Scary Fed Number Everyone is Talking About, you might be interested in doing so to get more context about where the Fed currently stands.
- According to the IG Client Sentiment Index, the US Dollar has a mixed bias heading into the first week of June.
US Dollar Stumbles Out of May
The US Dollar (via the DXY Index) did not have a good month of May, despite favorable seasonality conditions otherwise. The ongoing erosion of US real yields, thanks to rising inflation expectations and stagnant US Treasury yields, proved to be a negative influence on US Dollar price action – like it was for much of 2020. Now coming off of what should have been its best month of the year, the US Dollar remains vulnerable for further downside.
But the best hope for a more significant US Dollar turn around would be if commodity prices are able to pullback while US economic data outperforms, provoking a churn towards higher US nominal yields and lower inflation expectations, would which otherwise lift US real yields.
Evidence of Shifting Fed Policy?
The Federal Reserve will be keeping rates low and stimulus flowing for the foreseeable future. At least that’s what the conventional wisdom has been in recent weeks. But what started with a small quip in April may now be something more significant: markets are beginning to react to the Fed’s interpretation of incoming inflation data – or lack thereof.
Federal Reserve Interest Rate Expectations (May 28, 2021) (Table 1)
True, as has been the case for weeks, Fed funds futures are pricing in around a 10% chance of a change in Fed rates through January 2022. But beneath the surface, there has been seemingly scary high volumes across the Fed’s open markets desk, suggesting that liquidity is being drained from the system. For now, without a corresponding rise in US Treasury yields, we’ve seen the start of a tantrumless taper, if you will. If you haven’t read the note, The Scary Fed Number Everyone is Talking About, you might be interested in doing so to get more context about where the Fed currently stands.
US Treasury Yield Curve (1-year to 30-years) (February 2020 to May 2021) (Chart 1)
A lack of rise in US Treasury yields coupled with increasing inflation pressures throughout May, as measured by the 5- and 10-year breakeven rates, has dragged US real yields lower. Even with the nascent taper efforts starting to become more public, the Federal Reserve has been signaling quite strongly that it still believes the recent rise in inflation pressures is but only transitory.
If rising near-term inflation expectations start to outpace gains in US Treasury yields, the US Dollar is in trouble (especially considering the US Dollar’s lack of rally when US real yields edged higher in the second half of the month). The economic calendar may hold the US Dollar’s fate in the coming days.
US Economic Calendar Loaded with Risk
The first week of June brings the usual cornucopia of event risk for the US Dollar. The economic calendar is supersaturated with event risk, likely giving traders plenty of opportunities to catch bouts of volatility in USD-pairs over the coming days after a quieter final few days of May heading into the long holiday weekend:
- On Tuesday, June 1, the final May US manufacturing PMI will be released as will the May US ISM manufacturing index. April US construction spending data is due, and Fed Governor Brainard will speak later in the afternoon session. The Atlanta Fed GDPNow growth tracker for 2Q’21 will be updated for the first and only time during the week.
- On Wednesday, June 2, weekly US mortgage applications data are due in the morning, while the afternoon will see the release of the Fed Beige Book, plus speeches from Atlanta Fed President Bostic and Chicago Fed President Evans.
- On Thursday, June 3, the May US ADP employment change report will be released following the weekly US jobless claims figures. Later in the morning, the May US ISM non-manufacturing PMI index will be released. In the afternoon session, Atlanta Fed President Bostic and Fed Vice Chair Quarles will give speeches.
- On Friday, June 4, Fed Chair Powell will speak first thing in the morning ahead of any data releases. May US nonfarm payrolls and the May US unemployment rate figures are due alongside May US wage growth figures. Later in the morning, May US factory orders figures will be released.
A Closer Look at the May US Nonfarm Payrolls Report
The main issue for the US Dollar when it comes to the May US Nonfarm Payrolls report is whether or not the US labor market regained its momentum after a disappointing April report. After all, the prior month’s reading came in at +266K against an expectation for a round +1000K (or +1M) jobs added.
Market participants are indeed expecting that May reading will show a strong rebound, given that jobless claims continue to trend lower and vaccination rates have improved, leading to many lockdowns and/or restrictions otherwise to be lifted. Consensus forecasts are looking for a reading of +650K, which should help the unemployment rate (U3) drop further lower from its still-lofty 6.1% level. Meanwhile, the US labor force participation rate is still a meager 61.7%.
Atlanta Fed Jobs Growth Calculator (May 2021) (Chart 2)
According to the Atlanta Fed Jobs Growth Calculator, the US economy needs +761K jobs growth per month over the next 12-months in order to return to the pre-pandemic US labor market of a 3.5% unemployment rate (U3) with a 63.4% labor force participation rate.
Atlanta Fed GDPNow 2Q’21 Growth Estimate (May 28, 2021) (Chart 3)
Based on the data received thus far about 2Q’21, the Atlanta Fed GDPNow growth forecast has been slightly upgraded. “The second quarter of 2021 is [+9.3%] on May 28, up from [+9.1%] on May 27…the nowcast of second-quarter real gross private domestic investment growth decreased from [+25.1%] to [+20.7%], while the nowcast of the contribution of the change in real net exports to second-quarter real GDP growth increased from [-1.68%] to [-0.90%].”
The next update to the 2Q’21 Atlanta Fed GDPNow growth forecast is due on Tuesday, June 1 following the US ISM manufacturing index and the US construction spending report. This will be the only update of the forecast this week.
For full US economic data forecasts, view the DailyFX economic calendar.
CFTC COT US Dollar Futures Positioning (May 2020 to May 2021) (Chart 4)
Finally, looking at positioning, according to the CFTC’s COT for the week ended May 25, speculators slightly increased their minor net-long US Dollar positions to 2,780 contracts, up from 2,684 contracts held in the week prior. US Dollar positioning has been hovering around fairly neutral levels for the past three months. But the fact of the matter is that the last time the futures market was at similar positioning levels, the DXY Index was trading closer to 96.00 (closed May 28 at 90.06).
— Written by Christopher Vecchio, CFA, Senior Currency Strategist