Investors Shaken by Rising Rates

Overview: The surge in US interest rates and sharp losses in US stocks sent the dollar broadly higher in North America yesterday. The $42 bln of two-year notes auctioned by the US Treasury saw the highest yield in more than a quarter-of-a-century (4.67%) and it still produced a small tail. Sterling, helped by its own surprisingly strong data, was the only G10 currency to have gained against the surging dollar. Still, no important technical levels were breached, though the greenback rose to nearly seven-week highs against the Canadian dollar. The US dollar also rose to new highs for the year against the Japanese yen before settling at about JPY135.00.

Rising US rates and falling stocks are the main driver and the FOMC minutes later today are the focus. While the US economic calendar is light today, Fed speakers return tomorrow, and the data highlight is the PCE deflator on Friday. The major US equity indices lost at least 2% yesterday and are little changed today. However, global equities were dragged lower, with sharp losses in Japan, Korea, and India. Europe's Stoxx 600 is off about 0.85%, the third largest swoon this year. European bond yields are mostly 1-2 bp higher. The G10 currencies are mostly heavier, but the yen and Swiss franc are slightly firmer, while the New Zealand dollar is virtually flat despite the 50 bp hike. Among emerging market currencies, the Mexican peso continues to shine, but nearly the rest are softer. Gold is holding above yesterday's $1830 low but is not making much of a recovery. April WTI is extending its pullback for the sixth consecutive session to trade below $76.

Asia Pacific

The Reserve Bank of New Zealand slowed the pace of its tightening by hiking the overnight cash target rate by 50 bp to 4.75%. It continues to see a peak at 5.5%, but now it is seen in Q4 23 rather than Q3. While headline inflation is easing, the central bank argued the core rate is too high and employment is "beyond the maximum sustainable level." The RBNZ said it was too early to assess the impact from the cyclone and the fiscal response. It continues to see an economic contraction beginning in Q2 but expects it to be short and shallower. The next meeting is on April 5 and the swaps market sees about a 50% chance of another 50 bp move. The New Zealand dollar initially traded higher in response, reaching about $0.6250 from about $0.6215 but has given it back to trade little changed on the day.

Japan's January services producer prices edged up to 1.6% year-over-year. They peaked last June at 2.1%, and had slowed to 1.5% pace, the lowest since Q1 22. They averaged about 2.1% in the few months before Covid struck. The inflation focus in Japan is not about service prices but goods prices, not about producer prices, but consumer prices. The national consumer prices will be released early Friday. The Tokyo CPI warns of another jump in the national figures and the median forecast (Bloomberg survey) is for a 4.3% year-over-year pace. This would be a new cyclical high and could very well prove to be the highwater mark. Next week Tokyo's February CPI will be released. It does a good job of anticipating the national figure. We look for government subsidies, the appreciation of the yen on a trade-weighted basis, and the decline in energy and wheat prices to ease price pressures.

The dollar reached nearly JPY135.25 yesterday, a new high since last December's BOJ surprise. While it has held today, the greenback found support around JPY134.55. With US rates little changed, the exchange rate is seen consolidating. For the second consecutive session, the 10-year JGB pushed above its 0.50% cap. The BOJ bought bonds and offered five-year low-cost loans to banks to buy government bonds. The Australian dollar edged closer to $0.6800, slipping fractionally through last week's low. The 200-day moving average is about $0.6805. The $0.6780 area marks the (38.2%) retracement of the rally from the middle of last October's low (~$0.6170) and is the next important chart area. The greenback rose to almost CNY6.90 today, its best level since January 4 and slightly through the 200-day moving average (~CNY6.8885). The reference rate was set at CNY6.8759, tightly against expectations (CNY6.8760).

Europe

In a process that is difficult to disentangle cause and effect, or perhaps as an example of reciprocal causality, the weakening euro, rising yields, and widening peripheral premiums within the eurozone go hand-in-hand. The euro has moved back toward $1.06, which it has not traded below since January 6. The 10-year German Bund yields more than 2.50% and is challenging the high from the end of last year (~2.57%), which has not been seen in a dozen years. It is a similar story with France's 10-year yield, but almost 50 bp higher. Italy's 10-year yield is approaching 4.50%. Last year's peak was near 5.00%. Spain's 10-year yield peaked at the end of last year slightly above 3.65%, an eight-year high. It moved above 3.50% yesterday. Italy's 10-year premium over Germany pushed above 190 bp yesterday for the first time in over a month. Its two-year premium widened to above 50 bp, which it had not seen since January 2. Spain and Portugal's premium over Germany has also widened, but not as much as Italy.

Italy's debt burden makes it particularly vulnerable, yet there is another consideration too. Italy's 2021 and 2022 budget deficit is likely to be revised up next week when the stats office assesses the impact of the tax credits initially aimed to encourage green building renovations. The cost has been estimated to in excess of 110 bln euros. There were various elements and the one that was terminated was called "the super-bonus." It was not well-targeted and the use of tradeable (between financial institutions and businesses) helped create the environment for misuse. That said, the initiative did appear to bolster the construction sector in 2021 and helped set the stage for a broader economic recovery. It had been enacted by the coalition government led by Prime Minister Conte from the Five-Star Movement. Former Prime Minister Draghi intervened to curb some of the program's excesses, and last week the Meloni government stopped the program altogether. A key judgment call that the Eurostat may decide, is whether the tax credits are "payable" or "non-payable" which will determine how the cost will accounted; whether is front-loaded or amortized over several years.

The euro peaked on Monday a little above $1.07 and has been sold to about $1.0625 today. Last week's low was slightly below $1.0615. A break of the $1.0600 opens the door to a potential move toward $1.0460-$1.0500. There are options for 1.3 bln euros at $1.0550 that expire today. The intraday momentum indicators are oversold but with the FOMC minutes later today, the North American market may show limited enthusiasm for the euro. Resistance may be seen in the $1.0640-50 area. Sterling posted an outside up day yesterday by trading on both sides of Monday's range and settling above its high. It reached almost $1.2150 and has been sold to about $1.2065 today. Initial support is seen near $1.2050. On the top side, the $1.2100-20 area may offer a nearby cap.

America

The string of constructive US economic data continued yesterday and drove interest rates higher. It seems US rates are being driven higher more by the data than Fed's rhetoric. The flash composite PMI rose above the 50 boom/bust level for the first time since last June. It stands at 50.2 and is due to the recovery in the service PMI to 50.5 from 46.8.  Separately, the Philadelphia Fed's non-manufacturing survey also improved in February to 3.2 from 6.5.  The manufacturing sector is doing less well, which was a clear pattern in the eurozone and UK flash reports. The US flash manufacturing PMI rose to 47.8 from 46.9.  It is the second consecutive month that the weakness moderated. The Empire State manufacturing survey and the Philadelphia Fed survey picked up similar contractionary impulses from the manufacturing sector. Elsewhere existing home sales disappointed. The median forecast in Bloomberg's survey called for a 2% increase in January, but instead they fell by 0.7% and the December decline was revised to -2.2% from -1.5%. Existing home sales have not increased since last January and 4.00 mln unit (SAAR) is the slowest since 2010.

Today, there may be keen interest in the FOMC minutes from the meeting earlier this month that delivered a 25 bp hike. As seems rather common recently, the market had one reaction to the Fed's statement and decision and then reversed during Powell's press conference. The message from the Fed is that price pressures remain, and it will take more than moves to reach a level of restriction that it will be comfortable pausing. After a clear campaign to bring the target rate above is seen as the long-run appropriate level, officials believe the pace of tightening can return to a more normal pace of 25 bp. Some of the discussion, like easing of financial conditions may be less relevant. Also, the market has dramatically scaled back ideas of a Fed cut late this year. The last meeting of the year is on December 13. The January 2024 meeting concludes on the last day of the month. The market's bias toward a cut saw the implied yield of the January contract fall to more than 40 bp less than the September contract most recently on February 2. It stood at 18.5 at yesterday's settlement, the smallest discount since early last October.

Weaker than expected Canadian retail sales, excluding autos in December, coupled with the more modest increase in price pressures may have lent support to the Bank of Canada's pause that was being questioned after the recent unexpectedly strong employment report. Headline inflation rose by 0.5% (0.7% was expected), allowing the year-over-year rate to fall below 6% for the first time since last February. The base effect suggests the rate is likely to fall sharply over the next couple of months. The US two-year yield shot up 11 bp to 4.73% as it approaches last year's high reached in early November near 4.80%. The two-year Canadian yield was dragged up by eight basis points. However, the more significant weight on the Canadian dollar was from the broad risk-off move. The correlation between changes in the S&P 500 and the Canadian dollar on a 60-day rolling basis is little changed since the start of the year around 0.75.  

The US dollar is extending its gains against the Canadian dollar. It has reached CAD1.3560, its best level since January 6. Options for about $475 mln at CAD1.3550 expire today. The CAD1.3600 area offers the next chart area, but the year's high was set near CAD1.3685. The gains in Europe have stretched the intraday momentum indicators and initial support is seen at CAD1.3520-30. The Mexican peso is one of the few currencies gaining on the greenback today. The US dollar recovered yesterday to around MXN18.4830 after testing the five-year low near MXN18.3350 seen last Friday and Monday.  It held MXN18.48 today and slipped back to MXN18.4135. A consolidative session seems likely. 

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