Capital and Commodity Markets Strain

Overview:  The capital and commodity markets are becoming less orderly.  The scramble for dollars is pressuring the cross-currency basis swaps.  Volatility is racing higher in bond and stock markets.  The industrial metals and other supplies, and foodstuffs that Russia and Ukraine are important providers have skyrocketed.  Large Asia Pacific equity markets, including Japan, Hong Kong, China, and Taiwan fell by 1%-2%, while South Korea, Australia, and India managed to post modest gains today.  Europe's Stoxx 600 is off more than 2.5% to bring this week's loss to a little more than 6%.  It has risen only one week so far this year. US futures are around 0.7% weaker.  The 10-year US Treasury yield is near 1.78%, a five-basis point decline on the week.  The 2-10-year yield curve continues to flatten and is slipping below 30 bp today.  European benchmark yields are 2-4 bp lower today and 14-16 bp lower on the week.  The Australian and New Zealand dollars are outperforming in the foreign exchange market.  Both are up around 0.5% today and nearly 2% and 1.4% for the week, respectively.  The euro and Swedish krona are off around 0.6% to bring the weekly drop to 2.2% and 4%, respectively, and bring up the rear.  Central European currencies continue to fare the worst among emerging market currencies. Other freely accessible emerging market currencies are falling in sympathy.  Latam currencies are performing best this week, with the Colombian peso (~4%) and the Brazilian real (~2.5%) coming into today.  Gold is firm, pushing against $1950, the high for the week.  It has spiked to $1975 last week.  April WTI is recovering from yesterday's 2.6% decline.  It is up more than 18% this week.  US natural gas is rising around 1.5% today to bring the week's gain to 7%. Europe's benchmark is extending its advance and is up about 85% this week, after a 27% gain last week.  May wheat is limitedly up and extends this week's gain to over 40%.  Although iron ore dipped (still up nearly 15% for the week) and copper is a little softer too (up ~6.7% this week), aluminum is at record highs and other industrial metals are firm.  

Asia Pacific

A powerful argument is sweeping across the financial markets and political discourse.  In its essence it says that as a consequence of the sanctions on Russia's central bank and banning most major Russian banks from SWIFT will encourage other countries, and especially China to find alternatives to the dollar.  Fed Chair Powell acknowledged that it could accelerate China's efforts.  However, unlike other observers, Powell acknowledged that China has been trying to do so "for some time."  They have their own messaging system, but few use it.  The same is true of the European payment system for that matter.   Of course, China chafes in a world that is still very American and dollar centric. Yes, it would like an alternative, but no they haven't found one. And that "some time" that Powell referred to is more than a decade. The large multi-year energy agreement struck between China and Russia will be settled in euros, not dollars.  Yet, the EU and UK (and others) have also sanctioned Russian banks, banned trading with the Russian central bank, and the eviction from SWIFT.  In this regard, the alternative to the dollar cannot be the euro.    

The Asian Infrastructure Investment Bank, a Chinese initiative for which it is a 27% shareholder, has frozen Russian and Belarus activities. Russia is the third-largest shareholder (6%) after China and India. Russia has one of the five vice presidents and oversees bank lending. When the AIIB was launched, the US did not want its allies joining, but many in Europe did and NATO countries account for almost a quarter the votes.  The World Bank has also halted programs for Russia and Belarus.  

There were two high-frequency data points to note.  First, Japan's January unemployment rate unexpectedly ticked to 2.8% from 2.7%.  As the PMI (composite below 50 for the second consecutive month) and other data have shown, the world's third-largest economy is struggling here in Q1.  The job-to-applicant ratio jumped to 1.20 from 1.16.  It is the highest since May 2020, giving hope that of a recovery in Q2.  Second, while inflation is not a problem in China or Japan, price pressures are accelerating in South Korea.  February CPI rose by 0.6% to lift the year-over-year rate to 3.7%.  The median forecast in Bloomberg's survey was for a 3.5% pace.  The core stands at 3.2%, up from 3% and also stronger than expected.   The central bank does not meet until the middle of April and the market appears to have largely priced in another 25 bp hike.  It lifted rates twice last year and one this year. 

The dollar is little changed against the Japanese yen around JPY115.40.  It has been confined to about a third of a yen range above JPY115.25.  The greenback settled last week near JPY115.55.  Since it broke out and even since the US warned an attack could happen at any moment on February 11, the yen has been largely sidelined.  The Australian dollar, in contrast, has been a chief beneficiary.  Today it reached $0.7375, its highest level in four months.  It closed above its 200-day moving average (~$0.7325) for the first-time since last June.  A trendline drawn off last year's highs comes in near $0.7425 at the end of next week.  It is above the upper Bollinger Band (~$0.7335) and closed above it for the past two sessions.  When the markets turn more volatile, the relative stability of the Chinese yuan is frequently underscored.  Narrower than usual dollar ranges dominated yesterday and today (roughly CNY6.3160-CNY6.3210).  The greenback has slipped a touch this week (~0.02%) for the fourth weekly decline and sixth time in this year's eight weeks.  The PBOC set the dollar's reference rate at CNY6.3288, well above market expectations (Bloomberg survey) for CNY6.3238.  

Europe

Weaker exports and imports saw Germany's January trade surplus narrow to 3.5 bln euros from a revised 6.6 bln surplus in December.  Exports fell 2.8%.  The market looked for a 1% gain.  Imports were off 4.2%.  The market had anticipated a 2% gain.  Germany's 2021 trade surplus average 14.4 bln euros a month.  It was slightly lower than the 15.0 bln monthly average in 2020.  However, before the pandemic, Germany was reporting an average monthly surplus of around 19 bln euros.  

While most of the eurozone aggregate data is reported after a few national reports, not so with today's January retail sales.  German, Italian, and Spanish reports have not been released.  Still, the aggregate figure was much weaker than expected.  The 0.2% increase contrasts with the 1.5% median forecast (Bloomberg survey).  It would seem to reinforce ideas of a cautious ECB next week despite the surge in inflation reported earlier this week (5.8% vs 5.1% in January). 

The euro has fallen by a little more than 3% against the Swiss franc this week.  Before the US warning about the impending invasion on February 11, the euro was near the year's high around CHF1.06.  It is approaching CHF1.01 today.  The euro's loss this week is the largest since mid-January 2015, when the Swiss National Bank lifted its cap on the franc, and the euro fell a dramatic 17.2% that week. 

The euro set the high for the year on February 10 near $1.15 before the US warning.  Today's low was 1/100 of a cent above $1.10.  Although we had highlighted the risk of $1.1000-$1.1050, it does not appear to be the bottom of the euro.  Below $1.10 the next important chart area is seen around $1.08-$1.0850.  Recall that the low in March 2020 was near $1.06. The lower Bollinger Band is near $1.1045 today.  Initial resistance is seen by $1.1070 and then $1.1100. Sterling has swung in a $1.3270-$1.3440 range in recent days.  The lower end is also the low for the year.  The 2021 low was sent last December near $1.3165. Before that, there may be support near $1.3200.  The lower Bollinger Band is near $1.33 today.   

America

The US monthly employment data is often among the most important data points in the monthly cycle.  However, its significance is often for the policy implications.  In this week's testimony before Congress, Fed Chair Powell has signaled a 25 bp hike at the mid-March FOMC meeting.  Although St. Louis Fed's Bullard, and his former head of research Waller, who is now a Fed governor, seemed to make the strongest case for a 50 bp hike, we suspected that they did not represent the leadership.  NY Fed Williams since shortly after taking the post has generally reflected the leadership’s views and since around the middle of last month suggested that the case for a large move at the lift-off was not compelling.  Of course, and Powell made it clear, a 50 bp move later in the cycle remains an option.  Powell suggested the balance sheet was on the backburner.  Yet he indicated that the pace would be discussed at the upcoming meeting.  Earlier this week, the head of the Fed's market operations, suggested that maturing Treasury issues would range from $40 bln to $150 bln a month, with the average of about $80 bln. Maturing MBS securities could average around $25 bln a month.  We suspect that what Powell was referring to was that there the immediate focus is on rates.  The Fed funds target could be raised three times before the balance sheet roll-off may start (assuming early H2).  

In any event, surveys look for 400k-425k rise in February nonfarm payrolls.  A note of caution comes from the decline in employment component of the services ISM (48.5 vs. 52.3).  Hourly earnings are expected to have accelerated to 5.8% year-over-year from 5.7%, while the average work week may have increased to 34.6 hours from 34.5.  The unemployment rate is forecast to slip below 4%.  Even if the job growth is a bit softer than the median, the general impression of a tight labor market is unlikely to be challenged. 

There are two other developments to note.  First, the US premium over Germany for two-year borrowings have risen to about 218 bp today.  It is almost 25 bp higher for the week, which is the fourth consecutive weekly advance.  It stood at 155 bp after the January employment data on February 4.  Second, the US State Department joined the chorus yesterday suggesting that a nuclear deal with Iran was close, even though several issues are unresolved.   The International Atomic Energy Agency's direct general will meet Iranian leaders in Tehran this weekend.  Some news accounts indicated that Iran only wants to accept euros for its oil.  Despite the talk about the dollar's petro-currency status, the transactional demand for dollars is a small part of the overall dollar turnover.  Consider that a week's turnover (volume) in the foreign exchange market is enough to cover world trade for a year. This is to say that the main force driving the dollar are capital flows, not trade flows. 

The Bank of Canada will likely announce next month its balance sheet strategy which may begin in May.  The US dollar briefly dipped below CAD1.26 yesterday, but the breakout, like some many others this year so far, proved premature.  The greenback returned to almost CAD1.27 yesterday and looks set to test nearby resistance around CAD1.2750.  The upper end of the range is around CAD1.28.  The US dollar has closed above it once this year.  The Mexican peso is under pressure.  The US dollar is at new highs for the week near MXN20.85.  The high for the year was set in late January by MXN20.9150.  Note that the upper Bollinger Band is closer to MXN20.79.  Mexico is not in a position to capitalize on the surge in oil prices, and the peso, the only emerging market currency to trade 24-hours a day often serves as a liquid proxy for the EM FX asset class.  

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