US: Weaker growth & election risk leaves USD vulnerable - MUFG

Derek Halpenny, European Head of GMR at MUFG, suggests that the very surprising real GDP data for Q2, which revealed a growth rate of just 1.2%, half of what the market was expecting and just marginally better than the weak 0.8% growth rate in Q1, has resulted in the market pushing out further the timing of the next rate increase by the FOMC.

Key Quotes

“Prior to the GDP data we had assumed that the next rate increase would not be until December and we maintain that view now with reason to be cautious over reading too much into the weak Q2 GDP report. The breakdown reveals that the economy is currently highly dependent on the US consumer for growth – real consumer spending increased by 4.2% on a Q/Q annualised basis, the strongest growth rate since Q4 2014, adding 2.83ppt to overall growth. However, gross private domestic investment shaved 1.68ppt off growth – that was the largest drag on growth from that portion of the economy since Q2 2009 during the Great Recession.

The largest portion of that drag came from another liquidation of inventories by US companies – the fifth consecutive quarter of inventory drawdown, which is the first time that has happened since 1956-57. That bodes well for inventory rebuilding helping support growth in H2 at a time perhaps when consumer spending may well decelerate from the very strong Q2 reading. So while the Q2 GDP report was disappointing we believe it would be premature to discount Fed action at all this year and hence we are maintaining our view of a December rate increase. Certainly Fed rhetoric to date post-GDP suggests the markets may have over-reacted. New York Fed President Dudley stated it would be premature to rule out a 2016 rate hike while Dallas Fed President Kaplan has just stated that a Sept hike “is very much on the table”.  It is also worth noting also that 2015 real GDP growth was revised higher from 2.4% to 2.6%.

But yields in the US are understandably lower in response to the data. The 2-year UST bond yield is trading at 0.67% today, some 10bps below the average rate over the last twelve months. This will help keep the dollar weaker although a key driver of dollar strength of late has been the expectations of monetary easing abroad – that hasn’t changed and this week we are likely to see the RBA (tomorrow) cut rates and the BoE cut on Thursday. Our DXY-weighted 2-year yield spread remains elevated and suggests the relative monetary policy driver remains a supportive influence on the dollar despite the shift in FOMC expectations.

One reason why we may see out-sized moves for the dollar on negative news is the potential for US election uncertainty to play a greater role in dollar direction over the coming months. With that event now on the horizon, the prospect for the dollar advancing on good news is much less than the prospect of declines on bad news. We have lowered some of our Q3 USD forecasts to reflect this, although given our assumption of a Clinton victory on 8th November and given our view of a December FOMC rate hike, we expect a strong performance for the dollar in Q4.”