Will What the Fed Says be More Important than What it Does?

Overview:  The focus is squarely on the Federal Reserve today. There is nearly universal agreement that it will lift the target by 25 bp. The market is inclined to see the shift as a sign that the Fed is nearing the end of its tightening cycle, and sees, at most, one more quarter-point hike. Despite the Fed's warnings, including in the December FOMC minutes, about the premature easing of financial conditions, the market has done precisely that. Moreover, the market remains convinced that a rate cut will be delivered by the end of the year. The key issue then is the Fed's response. Reiterating the December dot plot or claiming that while progress is being made, that the Fed's work is not done, may not be enough to put the proverbial toothpaste back in the tube. That said, the market often has reacted one way to the Fed's statement and another to the press conference.

If month-end positioning weighed on risk-taking appetites yesterday, the start of February has seen them return. Asia Pacific equities mostly trading higher, with more than 1% gains in Hong Kong, Shenzhen, Taiwan, and South Korea. Europe's Stoxx 600 is posting a small gain, the first this week. US futures are 0.3%-0.4% lower. Benchmark 10-year yields are a little softer in the Europe and the US. The US 10-year yield is off more than two basis points to slip back below 3.50%. The US dollar is softer except against the Canadian dollar, where it is virtually unchanged at the time this is written. Relatively narrow ranges are prevailing. The greenback also is mostly softer against emerging market currencies. Gold recovered from yesterday's test on $1900 and is trading quietly between $1923 and $1930 today. OPEC+ meeting is not expected to result in a change in output plans. March WTI recovered from a nearly three-week low yesterday near $76.55 to reached almost $79.75 today, despite API's estimate of s build of more than 6 mln barrels, which is confirmed by the EIA, would be the longest building streak since 2020. 

Asia Pacific

There are three developments in Japan to note. First, the final January manufacturing PMI was confirmed at 48.9, the same as the preliminary reading, and unchanged from December. It is the first time it has not fallen since last April and the third month below 50. Second, leaders of the LDP have frequently wanted to have a stronger military and the constitutional changes that would all it. Russia's invasion of Ukraine and China's aggressiveness in the region appears to have won over public support. The LDP's traditional emphasis on infrastructure spending may become military Keynesianism. Not so fast. Two recent polls show that Japanese voters want an election before taxes ae raised to fund the record increase in defense spending that Prime Minister Kishida has advocated. Kishida will be appearing before parliament committees over the next few weeks about his plan to boost defense spending by 60% over the next five years and double the spending to encourage people to have more children. Technically, an election is not necessary for more than two years, and support for the government (cabinet) is hovering between around 33%-39%. Second, Sony announced it will produce cameras for the US, Europe, and Japan from its Thailand facilities rather than China. Of the 2.11 mln cameras it sold last year, only 150k were sold in China. This implies a dramatic shift in output, though Sony said it will continue to export other products from China. Canon closed some production facilities (compact digital cameras and nonreplaceable lens cameras) in China last year and moved them to Japan. A year ago, Canon's CEO was projecting increased investment in China and targeting it to be its largest market overall by 2035. The picture seems nuanced. Decoupling is taking place and so is further integration.

Australia's January manufacturing PMI was revised to 50.0 from the preliminary reading of 49.8.  It was at 50.2 in December. It has been slowing since last July, but the final reading has not been below 50 since May 2020. China's Caixin manufacturing PMI edged up to 49.2 from 49.0, disappointing expectations for a recovery to 49.8. Recall that the "official" manufacturing PMI bounced to 50.1 from 47.0.  Separately, we note the poor data from South Korea and Taiwan. Both of their manufacturing PMIs are below 50 (48.5 and 44.3 respectively), and trade figures have been poor. South Korea's exports fell 16.6% year-over-year in January, and the trade deficit was a record $12.7 bln. Industrial output tumbled 2.9% month-over-month in December. Taiwan's export order fell 23.2% year-over-year in December. Its January trade figures are due next week.

The US dollar continues to trade in an exceptionally narrow range, straddling the JPY130 area. Today's range has been JPY129.80-JPY130.40. The tight trading is nearly two-weeks old and is helping the momentum indicators alleviate their oversold condition. The Australian dollar recovered yesterday after being sold to about $0.6985, a six-day low. Today, it reached almost $0.7085, and retracement (61.8%) of the losses since last week's high near $0.7140. The greenback eased to a about CNY6.7400 today after reaching CNY6.76 yesterday. Ranges have been narrow this week since the return from the holiday. The reference rate was again set close to expectations (CNY6.7492 vs. CNY6.7501).

Europe

The eurozone preliminary January CPI was softer than expected. The median forecast in Bloomberg's survey was for a 0.1% gain on the month. Instead, it fell by 0.4%. This brought the headline rate down to 8.5% from 9.2%. However, this is largely the result of falling energy prices and subsidies. The core rate disappointed by being unchanged at 5.2%. Separately, the final manufacturing PMI was unchanged from the preliminary reading at 48.8.  The German reading edged up to 47.3 from the 47.0 flash report and 47.1 in December. This blunted the impact of the French report that saw final manufacturing PMI slip to 50.5 from the preliminary estimate of 50.8 and 49.2 in December. Still, it was the first reading above 50 since August. Italy's manufacturing PMI surprised on the upside, rising to 50.4 from 48.5.  It is the best since June. Spain's manufacturing PMI also was better than expected at 48.4, up from 46.4 in December.

Given some recently poor data, several banks have warned that the Bank of England hikes by 25 bp instead of 50 bp. Still, the swaps market sees about a 75% chance, the BOE goes 50 bp instead of 25 bp. The market does not buy the economists' arguments that a quarter-point hike would mark the peak with the base rate 3.75%. The swaps market is projecting the terminal rate between 4.25% and 4.50%. At the same time, the market is pricing about a 75% chance of a cut in Q4 23. The market is more aggressive about a rate cut in the US and Canada before the end of the year. Today's developments are poor, with the backdrop of large-scale strike activity that has shut transportation and about 85% of the schools in England and Wales. The BRC warns of more inflation as its shop price index accelerated to 8.0% from 7.3% in December, which represents a new high. The January manufacturing PMI ticked up to 47.0 from the flash report of 46.7 and 45.3 in December. It has been below 50 since last August.

Buying euro pullbacks continued the pattern seen in recent weeks. Yesterday's position-adjusting saw a test on the $1.08 level, testing an eight-day low.  It recovered yesterday to settle slightly below $1.0865 and today is knocking on $1.0890 in the European morning. The $1.0940-50 remains the key to the upside. Sterling is sidelined. It is trading in an exceptionally narrow range around where is settled yesterday ($1.2320). It has not been above $1.2330 or below $1.2300 today. The intraday momentum indicators favor a push higher, but it has not been above $1.2340 since early European turnover yesterday.

America

There is a bevy of data to get through before we get to day's main event, the FOMC statement and Chair Powell's press conference. First, watch mortgage applications. They have been perky, rising for the first three weeks of the year, the longest streak since last June. Second, the methodological revisions to ADP private sector employment measure and disavowing it is attempting to forecast the national figures, market participants still do. Third, the preliminary manufacturing PMI edged up to 46.8 from 46.7.  It was the first gain in four months but the third month below the 50 boom/bust level. The manufacturing ISM has held up better but appears to be converging. January was likely the third month it has been below 50. Fourth, job openings of the JOLTS report peaked last July and have been trending lower since then. The median forecast in Bloomberg's survey sees it falling to 10.3 mln in December from 10.46 mln in November. For reference, job openings averaged about 7 mln in Q4 19. Fifth, December construction spending may surprise. Economists have mostly underestimated it last year, and we note that construction jobs have held up better than expected too. Perhaps, part of what is happening is that the spending contained it the 2021 Infrastructure and Jobs Act. Sixth, and last, US auto sales will trickle in over the course of the day. After two months of declines, economist expected a big jump in January (from 13.31 mln SAAR in December to 15.50 mln). If accurate, it would be the strongest month since May 2021 when it reached nearly 17 mln SAAR. Some softer prices may have helped demand.

Canada sees its January manufacturing PMI. Consistent with the broader slower down in the economy, the manufacturing PMI has not been above 50 since last July. Mexico also gets is manufacturing PMI. It struggled in 2021 and spent most of the first eight months of 2022 below 50, but it has now held above the boom/bust level since last August. It IMEF activity surveys have generally fared better, and they will also be reported. December worker remittances also will be reported. They typically rise in December and the median forecast is for $5 bln up from $4.8 bln in November. December 2021 was the most for the year at $4.75 bln. The high for 2022 may have been recorded in July at $5.3 bln. Brazil's central bank meets late today and the Selic rate is expected to remain at 13.75%. Lastly, Moody's cut its outlook for Peru's credit to negative from stable.

There is a broad agreement that the Fed delivers a 25 bp hike, which would lift the upper end of its range to 4.75%. The Fed funds futures has nearly discounted another quarter-point hike at the conclusion of the next meeting on March 22. A frequent pattern has been for the markets to respond one way to the Fed's statement and the other way to Chair Powell's press conference. Former Treasury Secretary Summers, who kibitzes regularly about what the Fed should and should not be doing, most recently argued that the Fed should refrain from signaling it next move. If the Fed were to do that, it would likely embolden the market and ease financial conditions even more. While the Fed's statement will likely acknowledge some slowing of inflation and preliminary signs of some easing in the labor market, but officials may not be confident that core services (excludes housing), which seems to current focus, is making much progress. Fed chairs have typically played down the significance of the "Summary of Economic Projections" (dot plot), but Powell has changed tack and says that markets should take it seriously. Seven Fed officials in December saw the upper end of the Fed funds above 5.25% at the end of this year. There were only two officials that had the year-end target below 5%. The swaps and Fed funds futures show market participants collectively see a greater risk of below 5% than above it. Lastly, we note that despite the numerous official protestations, the yield of the December Fed funds futures is still more than 25 bp below the September yield. This implies expectations for a cut remain fully discounted. 

The US dollar reversed dramatically lower against the Canadian dollar yesterday, ostensibly encouraged by the recovery in US equities and oil. The greenback poked above CAD1.3470 yesterday to set a seven-day high and then reversed to briefly tick below CAD1.3300. It slipped to about CAD1.3290 today, but the heavier tone to US equity futures is helping the greenback return above CAD1.3300. Initial resistance now may be seen around CAD1.3350, while a convincing break of CAD1.3300 targets the mid-November low near CAD1.3225. The greenback reached a four-day higher earlier today near MXN18.8725, holding below the 20-day moving average slightly above MXN18.89. It has not traded above this moving average since a few days before Christmas. The US dollar retreated from the Asian session high to test MXN18.78 in early Europe.  The intraday momentum indicators favor the dollar's upside in early North American activity and a return to the MXN18.84-86 area looks reasonable. 

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