Potential Brexit Breakthrough Helps Sterling, while France and Spain Report Stronger Price Pressures

Overview: There are two important developments. First, the stronger than expected February inflation reports from France and Spain have sparked a jump in European interest rates and the swaps market is beginning to price in a 4% terminal rate by the European Central Bank. The deposit rate is now at 2.50% and is widely expected to rise to 3.0% in the middle of next month. Second, a tentative agreement to resolve the dispute over the Northern Ireland protocol has helped lift sterling. The US dollar is mixed and poor GDP figures are weighing on the Swedish krona, the weakest among the G10 currencies today, while rising rates weigh on the yen following the large contraction in Japan's industrial output (-4.6%) that was not completely offset by the stronger retail sales (1.9%), which appear to have been flattered by tourism. 

Asia Pacific equities were mixed, with China, Japan, South Korea, and Australia posting modest gains, while most of the other large bourses fell. Europe's Stoxx 600 is little changed after yesterday's 1% advance. US equity futures are steady to a little firmer. European 10-year benchmark rates are mostly 6-8 bp higher, while two-year yields are 5-7 bp higher. The 10-year US Treasury yield is a couple of basis points firmer near 3.94%. Gold snapped a five-day decline yesterday but has given the gains back and made a marginal new low for the year, slightly below $1805. April WTI is up about a dollar, and it could be the third advance in four sessions. US natgas bottomed last week slightly below $2, gapped higher yesterday to reach $2.74 and is consolidating so far today. Europe's benchmark remains in its trough, straddling the 50-euro mark.

Asia Pacific

China's economic recovery is gaining ground and the forecasts for tomorrow's PMI looks for more gains. The composite was below the 50 boom/bust level in the last three months of 2022 (finishing at 42.9) but jumped back to 52.9, the highest since last June in January. The February reading is expected to rise further as the manufacturing and service PMIs likely rose. It will be reported early on March 1.

Weaker auto production in the face of sluggish demand in the US and Europe dragged down Japanese industrial output last month. The 4.6% decline more than offsets the minor 0.3.% and 0.2% gains reported last November and December, respectively. It a larger than expected drop. Separately, Japan reported dramatic 1.9% increase in January retail sales. The median forecast in Bloomberg's survey projected a 0.4% increase. The influx of tourism (1.5 mln, the most in three years) appears to have helped fuel the strong gains. Japanese retail sales rose by an average of 0.3% last year and fell by 0.9% in both January and February 2022. This quarter consumer spending is expected to slow (0.8% vs. 2.0% in Q4 22) while private investment is expected to recover (from -2.1% to 1.2%).

Australia reported a Q4 22 current account surplus of A$14.1 bln, more than twice expectations. The surplus in Q4 21 was A$9.7 bln. Since 2019, Australia has been recorded a current account surplus (A$17 bln in 2021, A$11.2 bln in 2020, and A$1.7 bln in 2019). Before then, Australia reported a chronic current account deficit. Among other things, report will feed into expectations for the Q4 GDP figures, which will be reported the first thing Wednesday (0.8% quarter-over-quarter is the median forecast in Bloomberg's survey). It will be helped by improving net exports (-0.2% in Q3). Separately, Australia reported 1.9% rise January retail sales, recovering from the 4.0% drop in December. Australian retail sales rose by an average of 0.6% in 2022. and jumped 1.7% last January.

The dollar is extending its gains against the Japanese yen and has reached JPY136.85, a new high since the December surprise. It has met the (38.2%) retracement objective of the decline in last October's high (~JPY152), which is found near JPY136.65. It is approaching the 200-day moving average (~JPY137.20). We have suggested the risk extends toward JPY140.00. Despite favorable data, the Australian dollar is struggling. It has so far held above yesterday's low slightly below $0.6700, but the attempt to bounce was cut short at $0.6750. The five-day moving average is about $0.6760, and we suspect the Aussie needs to resurface above $0.6785 to stabilize the tone. The US dollar reached a little above CNY6.9730 yesterday before reversing lower and settling near CNY6.9440. It pulled back to almost CNY6.9300 today in a largely consolidative move. Last Friday's low was closer to CNY6.9115. The PBOC set the dollar's reference rate lower than expected (CNY6.9519 vs. CNY6.9533).

Europe

With weaker dollar to begin the new week, sterling appeared to get a bigger lift following news that the EC and UK Prime Minister Sunak reached a deal that has been rumored for more than a week. The more than 0.9% gain was sterling's biggest advance since January 6. The Windsor Framework appears to achieve two things. First, it allows for goods that travel from Britain to Northern Ireland and planning on staying there would not be subject to routine checks. The goods destined for Ireland would be subject to greater controls. Second, there is some diminishing but not complete removal of a role for the European Court of Justice. A "Stormont brake" is introduced that allows the assembly in Northern Ireland to identify changes to EU rules that could have "significant and lasting" impact. The agreement also paves the way for the UK to rejoin the EU's scientific research and funding initiative (Horizon project).

There is still a key hurdle. While technically, legal scholars argue, it does not need to be put to a Parliament vote, but Sunak has promised one and it may be difficult to avoid it. As of last week, the Democratic Unionist Party in Northern Ireland, which is blocking the sitting of the new assembly over the protocol, and key members of Sunak's Conservative Party refused to endorse it. Still, the opposition Labour Party is more sympathetic. It votes may ensure eventual passage, which would be seen as weakening Sunak and the Conservatives.

Firm French and Spanish inflation figures have spurred a jump in European interest rates with two- and 10-year yields rising mostly 5-8 bp and sparking talk of a 4.0% terminal rate by the ECB. French February EU harmonized CPI rose to a new cyclical higher of 7.2% with a 1% gain in the month. Separately, it also reported a larger than expected jump in consumer spending last month (1.5% vs. 0.4% median forecast in Bloomberg's survey). Spain's EU harmonized CPI measure also rose by 1% last month, lifting the year-over-year rate to 6.1%. The median forecast in Bloomberg's survey anticipated a small slowing to 5.7% from 5.9%.

The euro recovered yesterday from a little below $1.0525 to $1.0620. It edged a little higher today to $1.0625. It found support in late Asia near $1.0580 and saw the highs in early European turnover. Initial resistance is seen in the $1.0640-60 area. Sterling extended yesterday's gains to probe the $1.21 area, where options for GBP320 mln expire today. It frayed the 20-day moving average (~$1.2080) but has not closed above it since February 1. The $1.2120 offers the potential nearby cap. Support in Asia was found around $1.2025. Separately, the Swedish krona has been knocked lower by a disappointing Q4 GDP figure. The economy contracted by 0.9% (median forecast in Bloomberg's survey was for a 0.6% decline in output) and Q3 growth was revised to 0.2% from 0.6%. Lastly, Hungary's central bank meets shortly and is expected to keep its base rate steady at 13%.

America

Inventories and net exports flattered Q4 GDP, just like they had been a drag in H1 22. Today's data will show why the Q4 performance is unlikely to be repeated. January's advance goods trade balance like deteriorated and inventory. Wholesale inventories rose by an average of 0.5% in Q4 22 and is expected to have risen by 0.2% last month. Retail inventories which around a third smaller than wholesale inventories, are expected to have increased by 0.1% in January after a 0.5% in December and averaged that in H2 22. Also, on tap today are house prices. The year-over-year pace, according to S&P CoreLogic Case-Shiller, peaked in March last year, as the Fed was preparing to hike rates for the first time, at a year over year pace of 20.82%. By November, it slowed to 7.69%. Anecdotal reports suggest the price erosion has not ended. The month-over-month decline in the 20-city composite is expected to have fallen for the sixth consecutive month in December. There are few Fed surveys and the Conference Board's consumer confidence survey, but they are not typically market movers. The ISM surveys have more influence in the market, and they will be reported later this week.

Fed-speak heats up. Through the end of the week, six different officials speak. Governor Jefferson opined yesterday that labor compensation was slowing. Today's Chicago Fed President Goolsbee speaks, and he is a voting member of the FOMC this year. He is rumored to be among the candidates for the vice-chairman position that was vacated by Brainard when she became the Director of the National Economic Council. We are somewhat skeptical, and as the White House has shown with its nomination to head the World Bank, it can successfully keep its cards close to the vest, as it were. Goolsbee is perceived to be less inclined for aggressive measures now, though his appointment to the Chicago Fed means that he did not submit a December dot for the Summary of Economic Projections. Minneapolis Fed President Kashkari, a monetary activist who still favors aggressive action and Governor Waller, a noted hawk, speak Wednesday and Thursday.

Canada's Q4 current account deficit was a little smaller than expected at C$10.4 bln instead of C$11 bln. More notable was the revision to Q3 22 deficit to C$8.4 bln from C$11.1. Still, it may not due much to change expectations for today's estimate of Q4 GDP. It is seen slowing to 1.6% (quarterly annualized rate) from 2.9% in Q3. We suspect the risk in on the downside. Mexico reports a smaller than expected January trade deficit of $4.125 bln. Although it is the biggest shortfall since last August, it is about 2/3 the size of the January 2022 record monthly deficit (~$6.3 bln). Imports fell for the fifth month (~-3.4%) while exports fell for the first time since last October. January is seasonally a soft month for Mexican exports. For example, they fell by almost 13.7% last month, and nearly 29% in January 2022 and 24.2% in January 2021. 

The US dollar recorded an inside day yesterday against the Canadian dollar, and today's price action has been confined to yesterday's range (~CAD1.3535-CAD1.3625). Friday's range was roughly CAD1.3530-CAD1.3665 and may be the key to the near-term outlook. Still, the most powerful directional cues may come from performance of US equities. While the market debates higher for longer in terms of policy rates, the Bank of Canada has declared a pause, which appears to put it at a disadvantage. Meanwhile, the greenback continues to consolidate in its trough against the Mexican peso. It briefly traded below MXN18.30 last week. The mini-short-squeeze before the weekend lifted it to about MXN18.5050. Although we still like the peso on a medium-term perspective, we suspect the consolidative phase may be extended and the dollar can perform a little better in the near-term.

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