The US dollar was driven higher in September by two main factors. The first was the anticipation of the Federal Reserve continuing to move toward tapering before the end of the year. Investors have discounted one hike and part of a second one next year. To be sure, the US is not leading the move away from maximum monetary stimulus. Norway hiked rates last month, and the Reserve Bank of New Zealand will likely do so this month.

Not coincidentally, the Norwegian krone was the best-performing major currencies against the dollar last month until the very end when the Canadian dollar edged past it. The Bank of Canada and the Reserve Bank of Australia have already begun the tapering process. The Bank of England appears to be signaling a hike in early 2022, though it has been playing up the risks of a move before Christmas. However, those moves are different from the Federal Reserve, the European Central Bank, or the Bank of Japan.

The second driver was the shift in risk appetites. The pullback in stocks and bonds seemed to help the dollar against the Scandinavian and dollar-bloc currencies, as well as the emerging market complex. Of course, risk tolerance is often a function of other developments. The idea that peak monetary and fiscal policy is broadly at hand (with notable exceptions) may have encouraged profit-taking after substantial run-ups in recent weeks and solid year-to-date performances. 

By many measures, stocks looked vulnerable. The S&P 500, for example, was up seven months in a row before last month's setback. Europe's Dow Jones Stoxx 600, which is less tech-sensitive, also advanced for the seven months through August to reach record highs. Japan's Topix reached its best level since 1990. There were also concerns about the Chinese property market, where the demise of Evergrande weighed heavily on the sector. Many investors were concerned about the contagion through the banking and shadow banking exposures. Still, these seem exaggerated, and references to a "Lehman moment" or the Great Financial Crisis are out of place.

One of the implications of peak monetary and fiscal support is that growth has peaked. This has been a thread that has been woven into our commentary over the past several months. US growth appears to have peaked in Q2, and Europe, maybe Q3. Due to the extended state of emergency and the prospects for a substantial fiscal package (one of the exceptions to the general pattern), Japan's recovery could begin in earnest in Q4 but may really be an H1 2022 story.

The preliminary September PMIs showed that activity in the US and Europe had moderated. The US composite PMI fell for the fourth consecutive month in September (initial reading) and at 54.5 is the lowest since September 2020. Many economists have revised down US growth forecasts for Q3. Negotiations are ongoing, and it appears that the infrastructure initiative will be considerably smaller than President Biden sought. The preliminary September eurozone composite PMI stands at 56.1, a five-month low, after peaking at 60.2 in July.

Many businesses report ongoing supply chain disruptions that lead to later deliveries and more expensive goods. Auto production and sales have been particularly hard hit and are also drags on consumption and growth. Rising prices may also deter some sales. The cost of transporting goods from Asia to Europe and the US has skyrocketed. The shortage of containers outside of Asia has raised the cost of storage around the rail yards and ports. An under-appreciated drag to growth is coming from the rise in energy prices. It may seem counter-intuitive, but the dramatic rise in the cost of energy is not inflationary as much as a tax, and a regressive one at that. One of the apparent regularities that we have noted before is that the last three business downturns in the US, before the pandemic, were proceeded by a doubling of the price of oil.

The April 2020 drop of oil prices below zero was a fluke and was not truly representative. Instead, since the eve of the US election last November, the price of crude has doubled. From as recently as Ides of March, the price of natural gas has more than doubled, as well. The jump in oil and gas prices has been over-determined: factors include the storms in the Gulf of Mexico, droughts that reduce the supply of hydroelectricity, the lack of wind in other parts of the world, like the UK, Russia possibly playing politics to force the controversial Nord Stream 2 pipeline into operation, China rebuilding its inventories, slow rebound in US shale producers, pessimism regarding the US and Iran returning to compliance with the nuclear agreement, and of course, the unpredictable and uneven rebound in demand.

September was an important month for central bank meetings. Forecasts and forward guidance were updated. The Federal Reserve gave its strongest hint to date that tapering will likely start in November and be completed around the middle of next year. More Fed officials see a hike next year, but half do not. The ECB recalibrated its bond purchases. The fight is shifting to the size and flexibility of the Asset Purchases Program that predated the emergency facility and will continue after the PEPP winds down next March. The Bank of England maintained its hawkish rhetoric and fanned speculation of an early hike.

Norway became the first high-income country to raise rates. The Reserve Bank of New Zealand expected to follow suit on October 5. The Reserve Bank of Australia will make its announcement several hours earlier. In September, it decided to proceed with tapering plans (to A$4 bln a week from A$5 bln) and extending the purchases at least three months, through mid-February 2022, even though the economy appears to be contracting. The composite PMI has been below the 50 boom/bust level each month in Q3. The median forecast in Bloomberg's survey anticipates a loss of almost 2% of output quarter-over-quarter. The Australian dollar was the weakest of the major currencies last quarter. The 3.6% decline brings the year-to-date loss to a little more than 6.0%.

Toward the end of October, two G7 central banks meet: the Bank of Canada, October 27, and the ECB the following day. The Bank of Canada will offer updated forecasts and may taper further. It is buying C$2 bln a week of federal bonds and may bring to C$1 bln, which some officials have suggested maybe neutral. The market appears to be pricing in the first hike in Canada around the middle of next year and two moves by the end of Q3 22. Despite the 2.2% depreciation of the Canadian dollar in Q3, it is the only major currency to gain against the greenback this year (~0.35%).

The European Central Bank is unlikely to break new ground at its October meeting. Its current forecasts go out through 2023, but recently, there have been claims about what the models may show later. Apparently, several ECB members think that the staff projections updated in mid-September are too low (1.7% in 2022 and 1.5% in 2023). The ECB staff will update and extend the forecasts to 2024 in December. The next big debate at the ECB is not about the Pandemic Emergency Purchase Program. That will wind down next March. Instead, the challenge is over the pace and flexibility of the pre-pandemic facility, the Asset Purchase Program (currently ~20 bln euros a month). The is no urgent need to resolve the issue until next year.

Bismark once quipped that in a democracy, one should not see the way laws or sausage are made. It is especially true of US fiscal policy. Brinkmanship tactics require going to the brink, and that is where it went. It managed to extend spending authorization less than 12 hours before the government would be shut down. The stopgap measure ends in early December. Meanwhile, the debt ceiling restraint looms large. It is not clear how it is resolved, yet investors are largely looking through it outside of the T-bills that expire around the middle of October. It seems to reflect a faith that the US would not do something as foolhardy as missing a debt payment. The optics are poor, disruptive, and doubly so during a pandemic, but the material economic impact is marginal. 

Most of the world's currencies depreciated against the dollar in September. As a result, the Bannockburn World Currency Index (BWCI), a GDP-weighted basket of the dozen largest economies, fell for the second consecutive month. Only two currencies in the index appreciated against the dollar in September, the Russian ruble (~2% weighting) rose by 0.7%, and the Chinese yuan (21.7% weighting) rose 0.25%. The worst performer in the index was the Brazilian real, which despite aggressive rate hikes by the central bank (three 75 bp, followed by two 100 bp moves, and the promise of another at least 100 bp), the currency fell a little more than 5.4%. At the end of August, it was up about 0.75% for the year.

Brazil had been a market favorite earlier this year, and positioning seemed to work against it. The political climate discourages foreign investment. The drought, which has hit the hydroelectric grid, adds to the rise in energy and food costs, fueling inflation. It was also partly emblematic of the sentiment toward emerging markets more broadly. Their currencies were mainly out of favor in September, and the JP Morgan Emerging Market Currency Index fell almost 3%.

The major currencies in the BWCI fell against the dollar in September. A dramatic Canadian dollar bounce on the last trading day of the month pared its losses to about 0.5% for the month, the best performer. The Australian dollar recouped nearly a third of its monthly losses at the end of the month to finish down off around 1.25% lower. Sterling and the euro each lost about 2%. Since the eve of the FOMC meeting (September 21), the Canadian dollar has been the only major currency to have risen (~1.1%).

Dollar: The Federal Reserve has confirmed what the market has been anticipating since early this year. It is prepared to taper before the end of the year and likely will announce it at the next FOMC meeting that concludes on November 3. The market has fully discounted a hike next year, for which the Fed itself is split. In fact, it has about a 30% chance of a second hike, something that only three of the 18 Fed officials anticipate according to the last Summary of Economic Projections (dot plot). The more hawkish stance appears to have been the key factor driving the dollar higher in late September. However, more immediately, fiscal policy is the focus, though investors appear to be looking through it, as many find it inconceivable that the US would default on its debt. At the last minute, spending authorization was granted, but only until early December when the fight will be taken up again to prevent a government shutdown. Treasury Secretary Yellen warned that her room to maneuver around the debt ceiling, which limits the ability to service obligations related to past spending, maybe exhausted around the middle of October.

Euro: The euro was turned back after briefly trading above $1.19 on the back of the disappointing August US jobs report. The divergence of the likely trajectory of monetary policy is seen as a critical weight on the euro. The ECB could be a year or more behind the Fed in raising rates. The US 2-year premium over Germany is approaching 100 bp, a level it has not been over since the pandemic struck. At the end of 2019, the spread was closer to 220 bp. It may take several weeks before the next German government is formed. Still, the tail risks have ebbed, and broad continuity is likely even with a modest tilt toward greater environmental action. There is some talk that an off-balance sheet green investment bank would allow for the "black zero" of fiscal policy to be retained. The euro fell to new lows for the year low at the end of September, near $1.1565. A break of the $1.1500 area, the midpoint of the rally from March 2020's low (~$1.0635) to the high set ironically as the demonstration turned violent in Washington DC on January 6 (~$1.2350), could spur a test on $1.13.

(Septembr indicative closing prices, previous in parentheses)

Spot: $1.1580 ($1.1810)

Median Bloomberg One-month Forecast $1.1660 ($1.1810) 

One-month forward $1.1585 ($1.1820) One-month implied vol 5.1% (5.4%)

Japanese Yen: The LDP chose Suga's successor as party leader, and therefore, Japan's new prime minister pending a formal vote in the Diet. Within the narrow confines of the Liberal Democratic Party, there will be a great degree of continuity. As the LDP often does, a new fiscal stimulus package is expected in Q4 that could be as large as JPY30 trillion (~$270 bln)o ostensibly to close the output gap. Separately, the large factions within the LDP, including the one associated with former Prime Minister Abe, have long advocated a more robust defense policy, and China's aggressiveness in the region has been seized upon as the opportunity to press their case. The dollar-yen exchange rate appears to be driven more by the US Treasury market than domestic developments in Japan. The jump in US yields, especially after the FOMC meeting ensured the first monthly rise since March. As September wound down, the dollar briefly traded above JPY112 for the first time since late February 2020. The 2020 high was around JPY112.25, and the 2019 high was close by (~JPY112.40).

Spot: JPY111.30 (JPY110.00)

Median Bloomberg One-month Forecast JPY111.00 (JPY110.00)

One-month forward JPY111.25 (JPY109.95) One-month implied vol 5.6% (5.3%)

British Pound: The hawkishness of the Bank of England surprised market participants and initially lent sterling support. With inflation well above the 2% target (headline and core above 3.0%), the BOE intimated that it needed it could hike rates while it is buying bonds (QE). Since the BOE is expected to complete its bond-buying this year, the market had to price in the risk of a hike in Q4. The implied yield of the December 2022 short-sterling (three-month) interest rate contract rose to new highs for the year around 25 bp. That suggests the market has nearly priced in a 15 bp hike, or the unwinding its last cut in 2020. This seems a stretch. The furlough wage subsidy program finished at the end of September, and the impact will take time to sort out. Growth appears to be faltering, and the composite PMI has fallen for four consecutive months through September to its lowest level since February. The energy shock that is being widely experienced is hitting the UK particularly hard by the less flexible labor market on this side of Brexit. The army has been enlisted to deliver petrol. The UK Chancellor of the Exchequer will present next year's budget (October 27). It is expected to project a halving of the 2021 deficit (9.5% of GDP). The risk is that the monetary and fiscal tightening is delivered and weakens the economy. On the other hand, the market could correct its overshoot to anticipates less BOE tightening. Neither scenario appears sterling-friendly. 

Spot: $1.3475 ($1.3755)

Median Bloomberg One-month Forecast $1.3630 ($1.3790) 

One-month forward $1.3480 ($1.3760) One-month implied vol 7.1% (6.2%)

Canadian Dollar: Prime Minister Trudeau's election gambit did not pay off. For the second consecutive election, the Liberals lost the popular vote but secured a plurality of seats in Parliament. Trudeau again leads a minority government but has tacked to the left on the environment and fiscal issues. The Bank of Canada continues to project the output gap will close around the middle of next year. Not coincidentally, the market anticipates the first hike then as well. The trajectory of the policy mix (less accommodative monetary policy and more stimulative fiscal policy) tends to support the currency. September was the third consecutive monthly gain for the US dollar. The exchange rate is sensitive (correlation) to the general risk appetite (S&P 500 proxy) and oil prices. The S&P 500 snapped a seven-month rally, while oil (WTI) rallied more than 10%. That the Canadian dollar spent most of the month on defense suggests that the influence of equities and the risk appetite outweighed the positive impulses for rising commodity prices, especially oil.

Spot: CAD1.2680 (CAD 1.2610) 

Median Bloomberg One-month Forecast CAD1.2580 (CAD1.2560)

One-month forward CAD1.2685 (CAD1.2615) One-month implied vol 6.9% (7.3%) 

Australian Dollar: The recovery from the year's low set on August 20, just ahead of $0.7100, ran out of steam in early September, close to $0.7480. It spent most of the month trending lower and returned to the $0.7170 area before jumping at month-end. Despite a likely economic contraction as the extended lockdown cripples activity, the RBA reduced its bond purchases (A$4 bln vs. A$5 bln a week) through at least mid-February 2022, which was extended from mid-November. Two prices main prove problematic for Australia. The first is the surge in house prices (~20% year-to-date), despite the extended lockdowns in Sydney and Melbourne. The IMF is urging macroprudential checks, like lending curbs, via tighter debt-income and loan-to-value ratios. The second is the price of iron ore, which accounts for around a fifth of the country's exports. The price found some support late in September after falling about 40% in Q3 before bottoming on September 22. Long-term contracts may give Australia buffer, but this is a severe terms-of-trade shock. Australia put the free-trade talks with Europe at risk by its strategic decision to terminate the French conventional submarine contract for a nuclear deal with the UK and US. Although the French ambassador to the US returned, the one to Australia has not. The Reserve Bank of New Zealand meets on October 5 and is expected to be the second high-income country after Norway to hike rates. There has been some speculation of a 50 bp move, but this never seemed credible. The divergence of the trajectory of monetary policy between Australia and New Zealand drove the Australian dollar down nearly 5% against the New Zealand dollar from mid-June through mid-September. Position adjustments into the month- and quarter-end helped the Aussie recover (~1.7%) in the second half of September to finish a new high for the month.

Spot: $0.7230 ($0.7315)

Median Bloomberg One-Month Forecast $0.7290 ($0.7360)

One-month forward $0.7235 ($0.7320) One-month implied vol 9.0 (8.5%)

Mexican Peso: The peso fell by about 2.3% since the FOMC meeting before recovering from a three-month low at the end of September. Its year-to-date loss to bring its year-to-date loss to about 2.8%. Its weakness was in line with the JP Morgan Emerging Market Currency Index, which by about 2.6%, making it the biggest monthly loss since March 2020. The dollar's broad strength on the back of rising rates seemed to be the main culprit. Earlier in September, it had appeared that the central bank would pause in its tightening cycle after hiking in July and August. However, price pressures continue to accelerate, and the peso's weakness, falling to new three-month lows, seemed to have forced Banxico's hand. The market appears to be pricing in about 100 bp of tightening by the end of Q1 22. Meanwhile, Mexico's trade balance has deteriorated sharply. The three-month average through August (~-$2.4 bln) is the largest since 2008. The impact has been blunted by the record worker remittances that are even larger.

Spot: MXN20.64 (MXN20.07)

Median Bloomberg One-Month Forecast MXN20.41 (MXN20.06)

One-month forward MXN20.74 (MXN20.16) One-month implied vol 11.0% (9.9%)

Chinese Yuan: What seems like a second cultural revolution in China, where President Xi is reasserting the Communist Party and state over various aspects of society, has spooked. The demise of one of the largest property developers, Evergrande, is a separate issue, but Beijing appears opportunistically to take advantage of the debt crisis to restructure the sector, which broadly measured, accounts for almost a third of GDP. Chinese stocks have so far escaped little scathed by the developments, and the Shanghai Composite eked out a slight gain (0.03%). Hong Kong listings bore the burden, and the Hang Seng was among the weakest markets in the world, falling nearly 5.6% in September, bringing the year-to-date loss to 9.75%. Rising energy prices and a slowing economy can still prompt the PBOC to support the economy. Mainland markets are closed October 1-7, during which the yuan is likely to remain broadly stable. The prisoner swap with Canada shortly after the Canadian elections may help set the stage for a Xi-Biden meeting.

Spot: CNY6.4450 (CNY6.4605)

Median Bloomberg One-month Forecast CNY6.4470 (CNY6.46155) 

One-month forward CNY6.4725 (CNY6.4750) One-month implied vol 3.4% (3.5%)