Curve steepening to play the US slowdown; DXY outlook
Yesterday’s ISM non-manufacturing miss (actual: 52.6, consensus: 55.0) stirred further fears that a US slowdown is already underway. Market participants were already on alert after ISM manufacturing numbers nudged to a decade of low of 47.8 underscoring the global manufacturing slump. However, it appears that manufacturing weakness has spilt over the US services sector, suggesting that US growth may be closer to stall speed. With US resilience being questioned, the global growth narrative has turned more pessimistic.
The US Treasuries curve has bull steepened for two straight sessions with the 2Y/10Y spread touching 14bps (from 4bps on Monday) as rate cut bets intensified. 2Y yields pushed to a new fresh low for the yield as the market bets that the Fed will cut another two times by the end of 2019. Comparatively, 10Y yields are still hovering above 1.50% (some 10bps above its recent low). While betting that the Fed will underwrite the slowing economy makes some sense, we think that investors are becoming uncomfortable with duration risks. Notably, inflation expectations (as measured by the 10Y breakeven) are now below 1.5%. Meanwhile, we suspect that the fiscal drumbeat will turn louder in 2020 if the slowdown persists and could cause underperformance for long-end USD rates. We see further steepening in the coming months.
FX: A tug of war between a weakened USD and its weaker DXY components
The US dollar is wary of another disappointment in tonight’s US data. Consensus is too optimistic about a rise in US nonfarm payrolls to 145k in September from 130k in the previous month. For the comparable periods, the ISM employment sub-indices have retreated to 50.4 from 53.1 for non-manufacturing and to 46.3 from 47.4 for manufacturing. ADP employment slowed to 135k in September while August was revised down to 157k from 195k. The USD Index (DXY) has scope to correct down towards 98 after its rise in the third quarter.
It is however premature to call an end to the USD’s uptrend that started in 2Q18. The major components of the DXY – the euro and British pound – are still vulnerable to multiple downside risks. Eurozone recession fears have heightened with the odds of a German recession, prolonged Brexit uncertainties and a potential US-EU tariff war. The European Central Bank has recognised that its dovish measures would not be enough and has joined France’s call for a fiscal union to bolster the EU economy. Increasingly, the Bank of England is also seen needing to cut rates and possibly restart asset purchases too. Overall, expect the DXY to be caught in tug of war between a weakened USD and its weaker components.
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