Treasury Buyback Moves Dollar Lower

MACRO FRAME

Fiscal dominance has returned to the market, though underlying concerns over the deficit and debt burden are driving investors to demand more risk premium in an environment with persistent inflation. Meanwhile, yields have broadly taken a backseat to equity market performance as corporate earnings growth and expectations have set up bullish conditions to continue through the remainder of the year.

STOCK INDEX FUTURES

Equity index futures are rebounding in a cautious trade after Thursday’s rout; the long end of the yield has not been contained as markets head into next week’s PCE data, Jackson Hole symposium and Nvidia quarterly results. The next major test is today’s PMI data, which is expected to show private sector activity to continue to expand. The underlying earnings picture remains constructive, which is why several strategists have raised the year-end S&P targets to 8,100. Fund managers remain bullish on the equity market, per the latest Bank of America Global Fund Manager Survey. The dominant view is that the economy will experience a no landing outcome rather than any sort of slowdown. Equity positioning reported that mangers are a net 56% overweight in equities, the strongest reading since late 2021, while cash allocations remain low. Earnings are expected to grow by double-digits over the next year to the highest level since 2021. Those dynamics support a rally through the remainder of the year but also argue for higher-for-longer interest rates.

Watch point: Despite tech volatility, the earnings backdrop suggests bullishness, though a September rate hike remains a near-term risk.

CURRENCIES

US DOLLAR: The USD index is lower at 98.74. The Treasury’s move to artificially lower rates and risk premium draws several parallels to Japan, where attempts to limit rising yields have resulted in a marked depreciation of the yen. Artificially lowering yields results in currency depreciation because if bond prices cannot move lower, the foreign exchange price of owning US debt has to adjust via currency depreciation in the dollar. Additionally, the move to increase buybacks highlights that the administration is unlikely to address the underlying problem, being the large deficit and rising debt. The Fed’s minutes revealed concerns about inflation, with many policymakers ready to raise rates, though most expect inflation to slowdown in the second half of the year. Investors will await the Jackson Hole Symposium next week for further clues on Fed policy. Given the lack of forward guidance and still-firm underlying inflationary pressures, a September rate hike remains firmly on the table.

Watch point: The market remains doubtful over a September hike, though the risk of a move upwards in policy should not be discounted given the current inflationary backdrop.

EURO: The euro is 0.10% higher at $1.1690, its strongest level in three months. S&P Global’s PMI figures showed that manufacturing in Germany rose past market expectations, mainly driven by an increase in output, new orders, and export sales, all of which expanded at their fastest pace since early 2022. On the inflation front, input cost pressures remained elevated by historical standards but eased slightly from July. The Eurozone composite PMI rose to a nine-month high, mainly supported by Germany’s manufacturing performance. Companies increased headcount, while price pressures pointed to a gradual moderation.

The US Treasury’s buyback announcement has offered the euro support as the market adjusts to the “cap” on bond prices by depreciating the dollar, while the broader message feeds into a lack of confidence in the US Treasury and administration’s making any progress on the deficit and national debt. Money markets are pricing an 95% chance of a hike in September against 35% for the Fed. Traders are pricing around 40 bps of further ECB tightening this year.

Watch point: Broader price direction will be subject to Fed-ECB policy expectations, which is likely to be favorable to the EUR in the near-term.

BRITISH POUND: Sterling is little changed at $1.3640, a six month high. British retail sales fell in line with forecasts in July; retail sales dropped 0.5% from June, while annual sales growth slowed to 1.6% from a downwardly revised 3.8%. Elsewhere, PMI data showed UK’s composite index rise in August, above market expectations that it would drop. Growth was supported by the services providing sector, which offset a slowdown in the manufacturing sector. Headcount at businesses continued to drop, nearing two years of consecutive monthly declines. Input costs rose due to high fuel prices and wages, driving output charge inflation to rebound.

UK inflation rose in July, but the composition still points more to an energy-led headline bump than a renewed inflation spiral. Headline CPI rose to 2.9% YoY in July, up from 2.6% in June; the figures matched consensus forecasts though were higher than the BoE’s 2.8% forecast. Labor data pointed to a broad cooling in hiring and wage pressure, reinforcing the case for the Bank of England to remain on hold despite markets still pricing some tightening by year-end. Markets are priced for 26.5 of tightening by year-end. For the BoE, the central question is whether energy costs create durable second-round effects in wages and services pricing.

JAPANESE YEN: The yen is firmed 0.17% to 158.78 yen per dollar. CPI data for July showed price pressures rose in line with estimates, with headline CPI at 1.9% YoY, while core rose 1.8% YoY. Elsewhere, PMI data showed a continuation of expansion in the services and manufacturing sector. For the yen though, broader forces are determining price action. Underscoring the debt-overhang risk facing the yen, the spread between Japanese and Chinese 10-year yields has moved decisively in Japan’s favor in recent months. Under normal circumstances, this relative yield improvement would support the yen. Instead, the currency has continued to depreciate, a reflection of mounting investor unease over Japan’s fiscal outlook. Failure to hike at the September meeting could pressure the yen back toward the 160 area. Markets are pricing a 66% chance of a September hike after the July meeting revealed a more hawkish debate, but a failure to validate those expectations could renew pressure on the currency.

Watch point: Failure to raise rates at the Bank of Japan’s meeting could see the yen drop toward the 160 level.

AUSTRALIAN DOLLAR: The Aussie is 0.76% higher at $0.7165, heading for its longest weekly winning streak in six years. Weak labor data (employment fell by 15,800 in June vs. forecasts of a gain of 15,000) suggested softness in the labor market, which was likely welcomed by the Reserve Bank of Australia, which could offer some relief on inflationary pressures. Still, the data is unlikely to weaken the RBA’s tightening bias, as Q3 inflation figures will serve an outsized role in determining whether or not the ban raises rates this after. Markets imply only a 17% chance of a hike in September.

Watch point: June’s hiring figures have offered some relief on inflationary pressures, though ongoing pass-through into broader prices is likely to be in focus in upcoming data.

TREASURY FUTURES

Yields are little changed across the curve as traders continue to adjust portfolio’s following the Treasury’s announcement. The 30-Year yield is at 5.26%, 5 bps below its post GFC high reached on Monday. The Treasury Department’s move to double the size of its buyback operations for longer-dated debt sends a message that the administration is not comfortable with the upward trend in yields, but the market has responded in a way that signals it needs to do much more to ease financial conditions. The underlying problem of a rising deficit and massive debt load are unlikely to be addressed by the administration. Compounded by the rising supply of corporate bonds and persistent inflationary worries, investors are likely to continue to demand more risk premium in Treasuries, setting up conditions for yields to resume their uptrend. While some comparisons have been drawn to the Fed’s quantitative easing and questions have been raised over whether the Treasury of Fed will have greater influence on the market, it should be noted that the $4 billion buyback is not mean to be a driver of macroeconomic policy and is substantially smaller than the Fed’s $120 billion per month purchasing after the pandemic.

The latest Bank of America Global Fund Manager Survey showed that 39% of managers are underweight bonds, which is in line with historical values suggesting that no immediate panic from funds to retreat from government debt. The Treasury’s announcement overshadowed the latest FOMC minutes, which revealed governors are divided over whether to raise rates. While most members expect inflation to slow in the second half as energy and tariff effects faded, they saw risks as skewed upward. The chief concern is that persistent inflation could influence household expectations, wage-setting, and firms’ pricing behavior. Markets are pricing a 31% chance of a hike next month and see 23 bps of total tightening by year end.

Watch point: For Fed policy, without any forward guidance, the September decision will likely remain a close call.

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