How Further Will the US Dollar Correct?

Bonds experienced another tumultuous trading session, yet this time around, yields headed in a downward direction. This shift was partly attributed to a less-than-ideal ADP payroll report (known for its unreliable predictive power), which acted as a deterrent against further selloffs. However, it's essential to note that the temporary respite in the bond market and the dollar's corrective movement could be excessively dependent on the anticipation of disappointing job data. In different financial realms, the Riksbank may have provided hints regarding the dual role it intends to play in the field of foreign exchange hedging.

USD

US bond markets took a breather in the recent session, as 10-year yields retreated below the 4.75% mark, reversing their earlier climb to 4.88%. The slowdown in private ADP payrolls played a role in halting the bond sell-off, with hiring dropping from 180k to 89k in September, significantly below the consensus estimate of 150k. It's worth noting that market reactions to ADP figures continue to baffle me, as they possess almost no predictive power for actual payrolls. In fact, ING economists have observed an illogical inverse correlation: weak ADP figures often translate into strong official payrolls.

The ISM services index indicated a modest slowdown across all survey measures, although they remained comfortably above the expansionary threshold of 50. Interestingly, there's a divergence with the S&P PMI, which ostensibly poses similar questions to the same group of companies but reports flat activity at 50.1, in contrast to the ISM's more optimistic reading of 53.2.

In the FX market, attempts at a dollar correction aren't gaining much traction. The recent shift in interest rate differentials following the bond sell-off has made the dollar a tough sell, and cautious trading ahead of the upcoming US payroll data release isn't helping matters.

Market pricing continues to lag the FOMC dot plot expectations, with rates projected to be 15 basis points lower by the end of 2023 and a more significant 50 basis points lower by the close of 2023. Although the 2-year USD swap rate corrected by 10 basis points yesterday, dropping below the 5.0% mark, it appears overly reliant on the assumption of soft job figures (even though, as discussed, ADP is not a reliable predictor). Ultimately, there remains scope for a more hawkish repricing at the front end of the USD yield curve, and the dollar continues to face substantial upside risks.

The DXY may find stability around 106.00 today, as markets assess whether jobless claims can continue their trend of surprising on the downside (which is bearish for bonds and positive for the dollar). Additionally, several Federal Reserve speakers are scheduled to deliver remarks, most of whom are hawks, thus likely providing further support for the possibility of another rate hike.

In terms of US politics, the removal of House Speaker Kevin McCarthy appears to have had minimal impact on FX markets. However, risk assets such as equities may experience turbulence if potential successors struggle to garner sufficient support, resulting in a prolonged process. In such a scenario, defensive currencies like the yen or the Swiss franc may find support, as concerns about US political instability could overshadow the dollar's safe-haven role, especially if it's accompanied by risks to economic growth and a consequent dovish repricing of Fed expectations.

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