The new year
began with a bang. Rising inflation, less government bond buying, and
anticipation of more central banks tightening, fueled a substantial rise in
interest rates and a dramatic drop in equities. The geopolitical backdrop also
lent itself to a weakening of investor confidence.
The US 10-year
Treasury yield rose by more than 25 bp, the most since last February. The
German benchmark yield rose above zero for the first time since mid-2019,
albeit briefly. The yield on the 10-year Japanese government bond pushed
a little above 17 bp for the first time in nearly a year and has not been
above- 0.20% in six years. After peaking near $18.5 trillion in December
2020, the amount of negative yielding bonds fell almost $9 trillion in January,
the lowest since March 2020.
The market is
pricing in more aggressive central bank tightening than it had at the end of
last year. The implied yield of the December 2022 Fed funds futures
contract rose by about 55 bp in January. It has four hikes discounted this year and is confident that the first hike is delivered on March 16. There is
more. The market is pricing in about a 2 in 3 chance of a 50 bp hike in
March and is pricing in around a 75% chance 125 bp this year rather than
100 bp. The market has moved to nearly discount six hikes by the Bank of Canada
this year. At the end of last year, a little more than five hikes were
expected. The market leans heavily (~70%) that the Bank of England raises rates five times rather than four. On New Year's Eve, the market was
solidly pricing in four hikes.
The Federal
Reserve, the Bank of England, and the Bank of Canada will complement their rate
hikes with passively reducing their balance sheets by not fully reinvesting
maturing principle. To normalize the use of the central banks’ balance
sheets, it is essential that they are used when necessary and unwound
quickly. Compared to after the Great Financial Crisis, it will happen
more quickly this time. The Bank of England has indicated that when the
base rate reaches 50 bp, which looks likely at the February 3 meeting, it will
allow its balance sheet to begin shrinking. This will happen almost immediately
with a large maturing issue in March.
Equities
struggled in the face of rising interest rates and stretched valuations.
There also seemed to be a rotation out of growth and toward value. This
can be seen by the slump in the US NASDAQ, which has approached bear market
territory (20% decline from the record high set last November). In
contrast, the Dow Industrials set a record high on January 5th and the pullback
approached the "technical correction" of 10%. Note that in the
second year of the presidential term, going back to 1934, the average drawdown
is about 16%. Over the last five terms, going back to 2002, the average
is a drawdown of 15.8%.
Consider that the
Russell 1000 Growth Index is off about 11.3% this year, while the Russell 1000
Value Index is off less than a third as much. We should not draw any hard and fast
conclusion about 2022 based on the January performance, but the Value Index has
not outperformed the Growth Index for a year since 2016.
The European
Central Bank and the Bank of Japan are expected to be laggards in this cycle,
but the market anticipates some movement. There is about 20 bp of tightening
priced into the euro swap curve over the next year. That is about twice
what was discounted at the end of last year. Speculation of an early Bank
of Japan move was dashed by Governor Kuroda. It seems unlikely that the BOJ
raises rates until after Kuroda's term ends in April 2023.
Another dimension
of the international investment climate that further crystallized was the
monetary policy divergence with China. The People's Bank of China
delivered a small (10 bp) cut in the key medium-term lending facility to
2.85%), the first reduction since April 2020. This was followed up by the
second 10 bp cut in the one-year loan prime rate in as many months. The
rate of the five-year loan prime rate, a benchmark for mortgages, was shaved to
4.60% from 4.65%. It is also allowed other money market rates
fall. Officials have signaled more policy support will be forthcoming but
hopes for a cut in required reserves before the Lunar New Year holiday were
disappointed. Mainland markets will re-open on February 7. The
policy divergence that some had thought would be particularly negative for
China was offset but the record trade surplus and portfolio capital into its bond
and stock markets.
The surging
Omicron form of Covid has adversely impacted economies even though it appears
less fatal than earlier mutations. The widespread infection though has
disrupted work, delayed a return to offices in many countries, including the
US. Some countries, like Japan, have re-imposed some restrictions until
the middle of February. The rate of infection seems to be passed its peak
in the US and UK, but the impact will likely shave Q1 GDP. China's zero
tolerance has led to city-wide lockdowns ahead of the Olympics (Open Ceremonies
February 4) and stressed supply-chains.
The geopolitical
backdrop remains fraught with risk in Europe. Russia has amassed troops
and artillery along its border with Ukraine. Moscow is under the
impression that bringing NATO to the Russian border contradicts earlier
assurances. It has been clear, well before the annexation of Crimea
(2014) that Putin would not easily accept Ukraine and Georgia to join
NATO. Russia argues that Ukraine stealthily joined NATO in all but
name. Ukraine has been supplied with weapons and has conducted joint
exercises with NATO.
There seems to be
a widespread consensus against conceding a sphere of influence in eastern and
central Europe to Russia. Any suggestion to the contrary is dismissed as
appeasement, with allusions to Hitler. Yet, without Russia feeling secure,
security in Europe will remain elusive. Therein lies the tragedy that is
Europe. It has been a source of instability for well over a decade. The
threat of economic and financial sanctions may not deter Putin because it is an
existential issue.
The US bilateral
goods trade with Russia is about $30 bln a year. Europe's total bilateral
trade is more than four-times greater. The asymmetry fosters different
sensitivities to economic sanctions. This seems to be the case with
removing Russia from the SWIFT system. Also, unlike the US and UK, German law
prevents selling armaments to countries engaged in conflict. However, the
new German government seems willing to put the Nord Stream pipeline as a
possible sanction target if Russia invades Ukraine.
An unintended
consequence of the US approach to Russia is that in encourages Moscow (and
Beijing) to develop chits that can neutralize. Russia has threatened to
put troops in Cuba and/or Venezuela. Recall that the 1963 Cuban Missile
Crisis was resolved when Russia dismantled its missiles in Cuba and the US
removed its missiles in Turkey. China's Belt-Road Initiative is making
headway in the Caribbean and parts of central and South America. Brazil
is not formally a member of the BRI, but it is one of biggest recipients of
China's development funds in the region.
Emerging market
currencies were more resilient than one would have expected given the
aggressive turn by the Federal Reserve and the risk-off sentiment reflected in
the equity market volatility. The JP Morgan Emerging Market Index managed to
eke out a fractional gain through January 28 even though it fell by 1% in the
last full week of January. Latam currencies were in favor. They
accounted for the top four performing emerging market currencies (Chilean peso,
Peruvian sol, Brazilian real, and Colombian peso).
The Chinese yuan
rose to its highest level in almost five years but reversed lower at the end of
the month, ahead of the Lunar New Year holiday. It also rose to record highs on
a trade-weighted basis. However, the sentiment toward Chinese stocks and
bonds appears to have dimmed recently, and among asset managers, Brazilian
assets are preferred. This may take some upside pressure off the
yuan. Brazil raised rates aggressively last year and is thought to be
near a peak, making the bonds a favorite overweight. Its equity market is
heavily weighted toward commodity producers, which is also a popular
theme.
Bannockburn's
World Currency Index fell by almost 0.5% in January, reversing December's
gain. All the currencies but the Brazilian real fell against the dollar
in January. The real rose by almost 3.5%. Net-net, the Chinese yuan
fell less than 0.1%, making it the second-best performer. The Australian
dollar and Russian rouble were the weakest. They fell 3.8%-4.0%.
In the big
picture, our GDP-weighted currency index rose sharply after the initial
reaction to the pandemic. It peaked in June 2021 and ground lower until
November. It "corrected" higher through mid-January and has
begun weakening again over the last couple of weeks. It appears to have
scope to fall another percentage point or so, consistent with additional dollar
strength.
Dollar: The first
half of January proved particularly challenging. The dollar broke higher
against the yen to start the month and quickly unwound the gains. Then the euro broke out of its mostly $1.12-$1.14 trading range only to fall back.
The two main drivers of the foreign exchange market broadly were the risk off
signaled by the stock market volatility and the more aggressive expectations
for Fed policy. In past cycles, the dollar has generally rallied ahead of
the first rate hike and then retreats when it is delivered. This fits
very much into the "buy the rumor, sell the fact" type of activity
with which we are familiar. Our concern remains that the Fed waited too
long to taper and that the headwinds facing the economy are stronger than
appreciated. The budget deficit is now expected to fall by about five
percentage points. It took a couple of years after the Great Financial
Crisis to achieve that. Oil prices have more than doubled in the past
year or so. The last three recessions were preceded by a doubling of oil
prices. The rebuilding of inventories has been a tailwind for growth in
recent quarters. It cannot be counted on as much going forward. The
pent-up savings are being drawn down, especially in lower and middle income households.
Euro: Often the
euro-dollar exchange rate appears to be sensitive to the two-year interest rate
differential between the US and Germany. The US premium in January rose
by about 40 bp around 180 bp. At the
end of 2019, the US premium was almost 225 bp. The previous 40 bp
increase took nearly two and a half months (mid-October to end of December last
year). Of course, it does little to explain the euro's upside breakout to
$1.1485 in the middle of January. Still, it helps draw attention to the
divergences at work. Consider that while the US economy, spurred by
strong inventory rebuilding, grew almost 1.7% quarter-over-quarter in Q4, the
German economy, the biggest in the euro area, contracted by 0.7%. The
virus appears to be a drag on activity at the start of Q1. The January
composite Purchasing Manager's Index fell more than expected and stands at its
lowest level since February 2021. It has fallen in five of the past six
months. The swaps market is discounting a hike in Q4, while
the Bloomberg survey of economists finds that the first hike is not expected until early
2023. We continue to see risk of the euro falling toward the $1.10
area.
(January 28 indicative
closing prices, previous in parentheses)
Spot: $1.1150 ($1.1370)
Median Bloomberg One-month
Forecast $1.1175 ($1.1325)
One-month forward $1.1160 ($1.1350)
One-month implied vol 6.0% (5.1%)
Japanese Yen: The exchange rate's
correlation with US 10-year yields (30 days, percentage change) fell about 0.3
from above 0.8 in December. The volatility in the equity market appears
to have been a significant disruption. Early in January, the correlation
with the S&P 500 rose to its highest level since March 2020, a little above
0.5, but by the end of the month, it had fallen back to the level seen in December
near 0.3. The greenback initially extended December's gains to
reach JPY116.35, its highest level since early 2017, but as equities losses broadened
and deepened, it was sold back down to around JPY113.50 where a base was
forged. For the first time since 2014, the Bank of Japan shifted its
assessment of inflation. It no longer said that the risks are skewed to
the downside. Instead, it suggested the outlook is generally
balanced. Many observers are looking for a rise in Japan's CPI and core
measure when the cuts in mobile phone charges drop out of the 12-month
comparison in April. Still, BOJ Kuroda pushed hard against expectations
of policy normalization. While the market is pricing in no change,
the 10-year yield has risen and may challenge the BOJ's yield curve control
efforts. As January drew to a close, Japan's 10-year yield rose above 17
bp, its highest in a year. The YCC policy caps the 10-year yield at
0.25%, but it may not respond if it thinks a move is temporary. Still, if
global yields continue to rise and drag up Japan's yield, the YCC is a
potential flashpoint for officials and investors.
Spot: JPY115.25 (JPY115.10)
Median Bloomberg One-month
Forecast JPY115.15 (JPY114.80)
One-month forward
JPY115.20 (JPY115.05) One-month
implied vol 6.1% (5.4%)
British Pound: Sterling continued
to recover from the 2021 low set in mid-December (~$1.3165) and peaked near the
200-day moving average in mid-January around $1.3750. The broad dollar
recovery saw cable fall back to $1.3360. The Bank of England meets on
February 3. It was widely expected to lift the base rate by 25 bp to 0.50%.
This is also the level that it had previously indicated would start the balance
sheet unwind. The first element will be the end of recycling maturing
proceeds. Over the course of the January, the swaps market has shifted
more toward five hikes this year instead of four. Unresolved negotiations
about the Northern Ireland protocol and the "sticky wicket" that may
be threatening the political future of Prime Minister Johnson do not appear to
be having much market impact. Indeed, sterling has risen to its best
level against the euro since the pandemic first struck.
Spot: $1.3400 ($1.3530)
Median Bloomberg One-month
Forecast $1.3450 ($1.3495)
One-month forward $1.3395 ($1.3535)
One-month implied vol 6.5% (5.9%)
Canadian
Dollar: The
Bank of Canada is expected to pursue the most aggressive monetary policy within
the G7 this year. The swaps market is discounting 160 bp of hikes over
the next 12 months. Although the central bank did not hike in January,
which we had thought likely, by indicating that the output gap had closed, it
signaled that its tightening cycle would start at its next meeting (March
2). Still, the adjustment of views, saw Canada's two-year premium over
the US fall to around eight basis points, the least since last April.
Despite campaign promises and previous commitments, Canada's budget deficit is expected to fall dramatically. It was a little more than 13% of GDP in
2021 and is projected to fall below 3% this year (Bloomberg survey). The
Bank of Canada forecasts a 4% expansion this year. The IMF and OECD
concur (4.1% and 3.9%, respectively). The risk environment is also an important
factor in the exchange rate. The correlation of the Canadian dollar to
the S&P 500 (percentage change over the past 30 sessions) reached a five-month
high at the end of 2021 near 0.75. It has fallen steadily to about
0.25.
Spot: CAD1.2770 (CAD 1.2635)
Median Bloomberg One-month
Forecast CAD1.2690 (CAD1.2625)
One-month forward
CAD1.2765 (CAD1.2640) One-month
implied vol 7.1% (6.4%)
Australian Dollar: The combination of
risk-off and aggressive turn by the Federal Reserve drove the Australian dollar
below important support around $0.7000. However, at losing around 3.7% in
January, we think the Australian dollar is oversold and is poised to recover
smartly when risk appetites stabilize. From a technical perspective, it
moved nearly three standard deviations below its 20-day moving average.
In terms of positioning, in mid-January speculators in the futures market had a
record net short Australian dollar position. It has only begun being
trimmed. From a policy point of view, the central bank meets first
thing on February 1 and is likely to adjust its forward guidance. While
confirming the end of its bond buying operations, the RBA may also soften its
opposition to a rate hike sooner than the 2023 that Governor Lowe has
suggested. The swaps market has about 45 bp of tightening priced in the next
six months.
Spot: $0.6990 ($0.7265)
Median Bloomberg One-Month
Forecast $0.7090 ($0.7245)
One-month forward $0.6995 ($0.7270)
One-month implied vol 10.4% (8.0%)
Mexican Peso: January was a month of two
halves for the peso. It ground a bit higher to test its 200-day moving
average (for the dollar this was around MXN20.30). But, as risk soured,
the peso trended lower in the second half. The more aggressive Fed tone
helped lift the dollar to its best level in roughly six weeks, a little above
MXN20.80. The central bank, with a new governor, meets on February
10. Headline inflation was above 7% in November and December. The
biweekly updates suggest it probably remained above there in January. The
swaps market has about 100 bp of tightening priced in for the next three
months. A 50 bp hike would establish Rodriquez's anti-inflation
credentials, but the economy is fragile, without much fiscal support.
Given the more aggressive approaches by the central banks in other Latam
countries, including Brazil, Chile, Colombia, and Peru, it may be
understandable when the Mexican peso has underperformed in the region in recent
weeks (except against Argentina, which reduce rates). Disappointment could see
the dollar rebound into the MXN21.20-MXN21.45 area.
Spot: MXN20.80 (MXN20.53)
Median Bloomberg One-Month
Forecast MXN20.78 (MXN20.66)
One-month forward MXN20.90 (MXN20.62) One-month
implied vol 10.6% (11.0%)
Chinese Yuan: The yuan's
gains to a record high against its trade-weighted basket and its best level
against the dollar since April 2018 came despite official efforts to stem the
rise. The record trade surplus, almost $95 bln in December alone and
foreign portfolio inflows seemed to offset divergence of monetary policy
concerns. The Regional Economic Cooperation Partnership free-trade
agreement tariff reductions begin in earnest in February and its impact is expected
to be positive. The PBOC reduced some key rates on the margin, but
it was the more the aggressiveness of Fed tightening that the market discounted
after the FOMC meeting that may have put in the dollar's bottom near
CNY6.32. Despite somewhat faster growth than expected reported for Q4 21
(1.6% instead of 1.2%), domestic growth challenges remain, including the
restructuring of the property sector. With consumer prices pressures subdued,
official have shifted toward promoting new lending and local government
spending. The lockdowns associated with the virus threatens additional
economic (and supply chain) disruption in the first part of the year. In
late January's update, the IMF revised down its forecast for Chinese growth
this year to 4.8% from the 5.6% projection made last October, citing Covid and
financial stress.
Spot: CNY6.3615 (CNY6.3560)
Median Bloomberg One-month
Forecast CNY6.3895 (CNY6.3680)
One-month forward
CNY6.3820 (CNY6.3830)
One-month implied vol 3.1% (3.3%)
Disclaimer
Reviewed by Marc Chandler
on
January 31, 2022
Rating:
