The
global business and financial climate continue to be shaped by four forces as
the New Year begins: Covid, elevated price pressures, the divergence of
monetary policy, and the general reduction of fiscal stimulus.
A year ago, the hope was that the vaccine
would help us overcome the coronavirus, whose origin remains as mysterious as
the deadly influenza a century ago. The hope now is that the Omicron mutations
and T-cells in the body, rather than the vaccine per se, render the virus
considerably less lethal. Still, it has been sufficient to disrupt some economic
activity and extend the working from home or hybrid model for many.
The virus-induced deflation of 2020
morphed into its opposite in 2021 to the degree that surprised policymakers and
market participants. Many countries are experiencing their highest
producer and consumer inflation level in a generation. Although policymakers
have shifted away from calling the pressures transitory or temporary, that
still seems to be the consensus view among central banks and economists. Of
course, some observers disagree in no uncertain terms. However, pricing the
derivatives market showed them to be a minority, though vocal.
New Zealand and Norway hiked rates twice
last year and will continue in 2022. The UK lifted rates in December, and the
market expects another hike in February. This would raise the base rate to 50
bp, which is the threshold to begin letting the balance sheet run off. With
significant maturities in March, the Bank of England will likely be the first
to allow its balance sheet to shrink. Many see the next major
central bank to lift rates as a close call between the Bank of Canada and the
Federal Reserve. The market favors a March hike by the Bank of Canada. The
accelerating tapering will allow the Federal Reserve to theoretically hike
rates at the March 15-16 meeting, assuming the bond-buying is finished by then.
Governor Waller and San Francisco President Daly have suggested it as a
possibility.
The European Central Bank, the Swiss
National Bank, and the Bank of Japan will lag behind to raise interest rates.
The ECB's buying by Pandemic Emergency Purchase Program will slow and end in
March. The pre-existing Asset Purchase Program will be bumped up (from 20 bln
to 40 bln euros) in Q2 before being reduced to 30 bln euros in Q3 and 20 bln
euros in Q4. In any event, the ECB's forward guidance remains the same. The APP
purchases are open-ended and will continue until shortly before rates are
raised. President Lagarde and other ECB officials have convinced
the market that a rate hike in 2022 is unlikely.
With the franc near six-year highs against
the euro and headline and core inflation around 1.5%, the Swiss National Bank
has little direct economic need to lift rates. Still, one cannot help but
wonder about the implication of having policy and bond yields below zero for
such an extended period. With Swiss federal debt to GDP below 40%, its version
of quantitative easing is to buy foreign bonds and equities. It may have helped
slow the franc's appreciation, but it has not reversed it. Since mid-September,
the franc has appreciated around 5% against the euro.
The Bank of Japan has quietly reduced the
amount of stocks, corporate bonds, and government bonds that it buys. It may be
nearly undetectable in the markets, which illustrates the importance of the
signaling channel for this still novel form of easing. To be sure, deflationary
forces have been hidden by the rise of food and energy prices. While the
headline CPI in November reached its highest level (0.6%) since before the
pandemic struck, consumer prices were off 0.6%, excluding fresh food and
energy. The GDP deflator has averaged about -1.1% in Q2 and Q3, pointing to the
strongest deflationary forces in a decade.
Fiscal policy, like monetary policy, is in
flux. Japan, with its more than 200% debt of GDP, and the central bank's
balance sheet more than 130% of GDP, and its deflationary pressures, is the
only major country the OECD expects to report a greater budget deficit in 2022
than in 2021 (6.9% vs. 6.4%). It estimates the US budget deficit falls to 5.3%
of GDP from 12.5% may need to be upgraded for the failure of Biden's Build Back
Better initiative. While there may be an eventual agreement on a smaller
package, the Earned Child Tax Credit is set to expire in mid-January, and the
green efforts will be diluted at best.
The OECD expected the UK's deficit to fall
from 9.1% of GDP to 5.4%, but that was before the latest aid offered in the
wake of the surge in Omicron and the work-from-home mandate. Both sides of the
scissors open, spending will be more and growth likely slower, producing a
larger budget deficit relative to the economy. The eurozone's deficit is
expected to fall to 3.8% of GDP from 6.7% in 2021. Still, the risk is that the
spike in energy prices and the surge in Covid before the Omicron variant was
sequenced will slow economic activity.
Governments will be issuing less debt, and
central banks will be buying less. The ECB, BOJ, UK, and the Federal Reserve
all own more than a third of the outstanding debt of their respective governments.
Banks are being forced to hold more government bonds for regulators' purposes.
The 100 largest US pension funds are reportedly on track to hit 100% of their
funding ratio for the first time since 2008. This has fueled a shift to bonds,
and some estimate it could be as much as $300 bln. The buy-and-hold market
segments are critical. This, in turn, impacts the amounts available for trading
and use of collateral.
Even with the dramatic drop in European
benchmark (Dutch) natural gas prices ostensibly on the back of several cargoes
from the US in the second half of December (~66%), it is still nearly 2.5 times
more expensive than a year ago. In 2020, natgas prices rose by more than 60%.
In the US, natural gas prices are up a little less than 50% in 2021 but fell by
more than a third in the past two months. Oil prices were driven lower (~20%)
in November by a combination of several large consumer countries led by the US
and demand concerns, in light of the surge in the virus, but recouped around
2/3 of it in December. The risk seems to be on the upside as supply appears
constrained by the lack of investment in OPEC and non-OPEC countries.
Geopolitics loom large at the turn of the
year. Russia has amassed large forces near Ukraine, and US officials have warned
that an invasion looks likely in early 2022. Putin has chosen this time, after
the US withdrawal from Afghanistan, with Europe dependent on Russian gas and
the US buying Russian oil, to press hard for a sphere of influence in eastern
Europe. Biden and Putin appeared to talk more in December than they have for
the past year, but the key may be the January 12 meeting between Russia and
NATO.
The US also warns that China's aerial
harassment of Taiwan looks like a prelude to an invasion. Most experts believe
it is not imminent, but some see a simultaneous move if Russia invades Ukraine
as a possible scenario. Through its Belt-Road Initiative and some friendly
governments, Beijing has a growing presence in the Caribbean (Barbados,
Jamaica, Cuba). A third geopolitical challenge emanates from Iran. Tehran may
secure sufficient fissile material to manufacture a nuclear weapon in the first
part of the New Year.
There are several elections in 2022 that
will capture the attention of investors and businesses and could have
significant policy implications. The presidential election in Italy (January)
and Austria (April?) may reveal the political dynamics that could shape the
next parliamentary elections (by 2023 and 2024 for Italy and Austria,
respectively). The German presidential election will reflect the political
dynamics that led to the new center-left governing coalition. The strong French
presidential model within the parliamentary system gives the April election its
significance. Macron faces a strong challenge from the right but
without Le Pen's baggage.
Australia has yet to fix the date of its
general election, but May 21 seems likely. The Liberal-National coalition
appears on the defensive, but the polls show a tight contest. Climate change,
the economy, and the policy response to the virus are the main substantive
issues. In November, the US midterm elections are critical in shaping the
political and economic agenda for the next two years. Polls and PredictIt.Org
point to the likelihood that the Democrats lose both houses of
Congress.
This would seem to undermine the authority
Biden needs in negotiating to resolve the geopolitical challenges. Commitments
based on executive action, which can easily be unwound by the next
administration, may not satisfy US allies and rivals. Moreover, it will make it
more difficult for the US to pass the legislation necessary to implement the
international tax reform (15% minimum for the largest businesses and revenue
sharing).
Among the emerging market countries, presidential
contests will be held in South Korea (March), the Philippines (May), and
Colombia (May). However, the Brazilian election (Oct) is the most important for
investors. The contest looks likely to pit former President Lula against the
current President Bolsonaro. The risk is for post-election drama. Lastly, China
will hold its 20th National Congress in October. The notable outcome is
expected to be a third term from President Xi. This is seen by many as a
foregone conclusion.
Emerging markets had a difficult time in
general in 2021, and the international environment will remain challenging as
2022 gets underway. The MSCI Emerging Market Index (equities) fell by around
5.3% in 2021, and the JP Morgan Emerging Market Currency Index fell by almost
9.2%. The premium over Treasuries widened. The combination of a less
accommodative Federal Reserve and the slowdown in China acts as a powerful
headwind. In addition, higher energy and food prices pose challenges for most.
Many emerging market countries raised interest
rates in 2021. Rate hikes in Latam were spurred by price pressures, not strong
growth impulses. Policy was tightened in central Europe, too, amid price
pressures and better growth profiles. Some countries, like Russia and Brazil,
have been particularly aggressive in raising rates, and they will likely finish
in the first half of 2022. Developing Asia has faced less pressure from prices
or the market to tighten, except South Korea. It doubled its key seven-day repo
rate twice in 2021 to 1.0%. The market is pricing in another 50 bp of hikes in
2022. Other developing countries in East Asia will likely be withdrawing
accommodation, including India, Indonesia, Malaysia, and Thailand.
Bannockburn's GDP-weighted currency index rose by about 0.50% in December to pare the year's loss to 1.3%. Position-adjusting seemed to dominate the price action of the last couple of weeks, and in this context, it meant dollar sales. The strongest in the index was the Mexican peso, with around a 4.6% gain, helped by a larger than expected 50 bp rate hike. The Australian dollar clawed back about 2% after losing 5.25% in November. Sterling advanced nearly 1.8%. Its gains were scored after the setback following the 15 bp rate hike on December 16.
For the year, only two currencies in the basket appreciated against the dollar, the Chinese yuan (~2.4%) and the Canadian dollar (~0.65%). The yen's 10.3% depreciation was the most. Brazil and South Korea battled it out for second place. Still, the diverging performance in December gave the won the dubious honor of the second-worst performer in the Bannockburn World Currency Index. The won finished the year with an 8.6% loss, while the real lost nearly 6.8%. The euro's 6.8% loss was the most for the major currencies in the index after the yen. The Australian dollar fell by about 5.5%.
As the New Year begins, the
uncertainties of the virus, the stalling of Biden's Build Back Better
initiative have seen the dollar move sideways to weaker in the last couple of
weeks. The 2-year interest rate differential that was moving into the greenback's
favor stalled too. For most major currencies, this is a crucial metric to
monitor. Our work shows that the US 10-year yield is more important for the
yen's exchange rate.
Dollar: The US dollar trended higher for most of 2021.
Who would have guessed that after trending lower in all but the first quarter
of 2020, that the Dollar Index would put in its low as the rioters stormed the
Capitol? The expected divergence in monetary policy sustained the greenback
against the euro and yen. Also, as Fed Chair Powell noted, US yields may be low
but are still attractive compared with European and Japanese yields (which have
more than $12 trillion of negative-yielding bonds). The market has a great deal
of good news discounted, with the Fed funds and swaps market pricing in nearly
75 bp in hikes in 2022. The market sees about a 2/3 chance of a hike at the
March meeting. The other issue that will divide hawks and doves is when to stop
reinvesting maturing issues. Biden is expected to nominate three new members to
the Board of Governors, and it may have a women majority for the first time.
The risk is on the upside for the headline and core CPI and PCE deflators in
January and February, and then the comparisons may become more favorable. The
pullback of fiscal stimulus will be felt almost immediately, and the pent-up
savings have largely been absorbed. The presidential extension of the
moratorium on student loan repayments from February until May is worth an
estimated $15 bln. While it is important to some households (about 1-in-8
people in the US have student loans), it is a small offset. Economists
(Bloomberg survey median) and the Fed median forecast see 3.9% and 4.0% growth,
respectively. We suspect the risk is on the downside. There is a notable
divergence between the Fed and the market's inflation expectations. The median
from the Fed's latest exercise sees the headline PCE deflator rising 2.6% in
2022 and the core increasing by 2.7%. The median in Bloomberg's survey projects
a 3.5% increase next year in the headline and 3.3% in the core measure. Here we
find ourselves in the middle. Broadly speaking, we suspect that the dollar's
high is not yet in place and look for a more sustained pullback in the second
half of the year as the economy (we expect) slows toward trend.
Euro: The surge in the Delta variant and
higher energy prices were already prompting officials and private-sector
economists to push the EMU's growth prospects from Q4 21 into 2022 before the
surging Omicron variation took hold. The ECB staff forecasts and
the median forecast in Bloomberg's survey converge at 4.2% growth in 2022,
slightly above estimates for US growth. Here, too, the risk is that growth
disappoints. Still, the market is not entirely convinced by the ECB's rhetoric
that the deposit rate will finish 2022 unchanged at minus 50
bp. Aside from the economy, the EC faces challenges from the unresolved
Brexit-related negotiations with the UK and trying to secure primacy of EU law
in central Europe, and the threat from Russia and its ally Belarus. According
to the OECD's Purchasing Power Parity calculations, the euro remains the most
under-valued currency it tracks, a little more than 25% below fair value. It is
slightly more under-valued than it was before the pandemic struck. The US paid
nearly 220 bp more than Germany to borrow for two years at the end of 2019. It
bottomed around 80 bp in mid-February 2021 and finished the year near 140 bp,
the year's high. We suspect the US premium will rise further in the coming
months and has the potential to push the euro to a new low of around
$1.10.
(December indicative closing prices,
previous in parentheses)
Spot: $1.1370 ($1.1335)
Median Bloomberg One-month Forecast
$1.1325 ($1.1375)
One-month forward $1.1350 ($1.1375) One-month
implied vol 5.1% (7.1%)
Japanese Yen: Japan is an exception among the
high-income countries. Its budget deficit is expected to be larger in 2022 than
in 2021, and the swaps market implies a slightly lower interest rate than is
currently prevailing. The Bank of Japan and the median economist forecast
(Bloomberg survey) project growth of 2.9% in 2022. The central bank sees core
inflation (CPI, excluding fresh food) at 0.9%, while the market sees it
returned to the pre-Covid pace of 0.7%. The yen was the weakest major currency
in 2021, depreciating slightly more than 10% against the dollar. The
combination of the yen's weakness and rising commodity prices, especially oil,
saw Japan's trade balance fall back into deficit in 2021. The OECD's PPP model
sees the yen roughly 13.5% below fair value, second only to the euro in terms
of under-valuation. The divergence in monetary policy, in general, appeared to
be the main drag on the yen. That said, the exchange rate is more sensitive to
the movement of the US 10-year yield than the 2-year. The exchange rate appears
to be nearly twice as sensitive (60-day rolling correlation of difference) to
the 10-year Treasury yield than the S&P 500 (proxy for risk appetites).
Since around mid-October, the greenback has been chopped in a
JPY112.50-JPY115.50 range. Rising US rates could help lift the dollar into a
JPY117-JPY120 range.
Spot: JPY115.10 (JPY113.10)
Median Bloomberg One-month Forecast
JPY114.80 (JPY113.30)
One-month forward JPY115.05 (JPY113.00) One-month
implied vol 5.4% (8.2%)
British Pound: The Bank of England became the first G7
central bank to hike rates since the pandemic and is poised to do so again
before another moves. The swaps market has 100 bp of tightening discounted for
2022, with the first move anticipated at the February 3 BOE meeting. That move
is seen raising the base rate to 50 bp, which is the threshold to stop
recycling the maturing holdings purchased during quantitative easing. The UK
then is poised to be pursuing the most aggressive monetary policy among major
economies. Nevertheless, the US pays a premium over the UK to borrow for two
years, and cable turned more sensitive to the spread in Q4 22. Some
Covid-related spending increases announced at the end of the year will blunt
the Office for Budget Responsibility's projections that anticipated the fiscal
deficit to be more than halved in 2022 to 3.3% (from 7.9% in 2021). The UK
government was battered in 2021, with "sleaze scandals," which
ultimately led to an embarrassing defeat in a special election toward the end
of the year, the resignation of the chief negotiator of Brexit, and the
Northern Ireland protocol. The re-imposition of some Covid-related social
restrictions was also unpopular. Moreover, an Opinium poll at the end of 2021
found that more than 60% of voters believe a year into Brexit, and it has gone
badly or worse than they expected. More than 40% who voted to Leave in the 2016
referendum had a negative view of the exit. With Labour ahead in the polls and
Starmer personally with a several percentage-point lead on the Prime
Minister, it is difficult to see how Johnson recovers. Even without an election
in 2022, high drama may return to UK politics.
Spot: $1.3530 ($1.3300)
Median Bloomberg One-month Forecast
$1.3495 ($1.3375)
One-month forward $1.3535 ($1.3315) One-month implied
vol 5.9% (7.5%)
Canadian Dollar: The Canadian dollar's nearly 1.1% gain in
December was enough to push the currency higher for the year (0.65). It was the
only major currency against to rise against the greenback in 2021. We often
find that the near-to-medium term, the exchange rate is driven by three
factors: the general risk appetite, for which we use the S&P 500 as a
proxy, commodity prices (with an emphasis on oil), and monetary policy
convergence/divergence, where the two-year differential serves as a guide.
Monetary policy considerations appeared to dominate in Q4 21. Initially, the
Canadian premium rose from around 20 bp to 60 bp, and the US dollar fell from
around CAD1.28 to CAD1.23. However, the more aggressive turn by the Fed saw the
Canadian premium fall back toward 20 bp, the greenback rebounded to over
CAD1.2950. Although the premium closed the year near a three-month low, the
Canadian dollar continued to strengthen. How this divergence is resolved will
be important. The swaps market has the Bank of Canada raising rates at 125 bp
next year, and the first move is anticipated at the March 2 meeting. The OECD's
estimate of Purchasing Power Parity puts fair value for the exchange rate
around CAD1.26, suggesting the Canadian dollar finished the year about 1%
cheap. US-Canadian trade relations remain strained a year into the Biden
administration. Disputes range from potatoes and oil pipelines to lumber and the
interpretation of domestic content for autos under USMCA. Canada, like Mexico,
was also rattled by the "Buy American" provisions in the Build Back
Better initiative, especially for electric vehicles.
Spot: CAD1.2635 (CAD 1.2775)
Median Bloomberg One-month
Forecast CAD1.2625 (CAD1.2685)
One-month forward CAD1.2640 (CAD1.2770) One-month
implied vol 6.4% (7.2%)
Australian Dollar: Lockdowns that covered half of
Australia's population led to a contraction of the economy in Q3 21, but it
appears to have snapped back strongly in Q4. The Reserve Bank of Australia is
one of the few central banks anticipating more robust growth in 2022 (5% vs.
~4.0% in 2021). The IMF and OECD also expect more robust growth in the New Year
but less than the central bank (4.1%). Despite projections of faster growth,
the RBA forecasts CPI to fall from around 2.5% to 1.8%. The OECD sees steady
prices, while the IMF projects a slight easing. The RBA has pushed hard against
market expectations for rate hikes in 2022. The swaps market has about 80 bp of
tightening discounted with the first hike in Q3 22. According to the IMF's
Purchasing Parity model, the Australian dollar's little more than 6% decline in
2021 helped make it more competitive, which puts fair value near $0.7100. We
note that Aussie's recovery in December (~2.0%) came despite a further widening
of the two-year interest rate differential in favor of the US, while
Australia's premium on 10-year bonds narrowed. We suspect this
leaves the currency vulnerable as the New Year gets underway. The national
election, likely around the middle of Q2 22, will be fought over economic and
environmental issues. The country is in a scissors that is likely to get worse.
Its most significant trade partner is China, and it has provoked it, leading to
trade sanctions, which appear to have been offset by rising prices. At the same
time, it is in a strategic alliance with the US that strengthened in 2021 (see
AUKUS).
Spot: $0.7265 ($0.7125)
Median Bloomberg One-Month Forecast
$0.7245 ($0.7195)
One-month forward $0.7270 ($0.7135) One-month
implied vol 8.0% (9.7%)
Mexican Peso: The peso posted its biggest monthly
advance in December (~4.6%) since March 2020, cutting its annual loss to about
2.9%. The larger than expected rate hike (50 bp) by the Bank
of Mexico in December helped solidify the peso's recovery. It was
the best performing currency in the region in 2021, and its loss was less than
half of the Brazilian real ~-6.8%). The untested deputy Finance Minister takes
over the helm of the central bank, and with inflation above 7%, may seek to
establish her anti-inflation credentials early by delivering another 50 bp hike
at her first meeting (February 10). The market has aggressively priced 200 bp
of tightening for 2022. The pandemic disruption helped the trade balance
improve and record worker remittances. However, the widening trade deficit
warns that the best may be behind it. As part of the nationalistic thrust of
the Mexican government, it will halve oil exports in 2022 and stop them
completely in 2023. The OECD projects the economy will slow to around 3.3% in
2022 from almost 6% in 2021. Economists (Bloomberg survey median) forecast
growth to slow below 3%. The OECD and the market anticipate Mexico's inflation
will moderate to around 4.4% from an average of a little more than 5.5% in
2021. The market is less constructive the peso going forward. The
median forecast (Bloomberg) has the dollar finishing 2022 near MXN21.20.
Spot: MXN20.53 (MXN21.46)
Median Bloomberg One-Month Forecast MXN20.66 (MXN21.23)
One-month forward MXN20.62 (MXN21.60) One-month
implied vol 11.0% (14.9%)
Chinese Yuan: Officials have made it clear in
word and deed that they prefer less upward pressure on the yuan. They have made
official comments, increased the reserve requirement for foreign currency
deposits, making them less attractive, and signaled displeasure in the setting
of the dollar's reference rate. The divergence of PBOC and Fed monetary policy
was driven home by the December decline (albeit a minor five-basis point move)
in the one-year prime loan rate, the first since March 2020. By shadowing the
dollar so tightly, the yuan rises against its other trading partners in a
robust dollar environment. The PBOC wants to loosen that link. However, its
large trade surplus and portfolio inflows are making it complicated. The
zero-tolerance of Covid and the quickly and enforced lockdowns will further
weigh on economic activity and will likely impact supply chains. Reforms in
China and more activist regulator officials in the US can be expected to extend
the financial decoupling that appears to already be underway. China fell short
of its commitments under the "Phase 1" agreement negotiated by the
Trump administration. The Biden administration does not appear ready to
negotiate another deal, but it also means that the tariffs will remain in
place. Since the middle of October, and with a few exceptions, the dollar has
been mostly confined to a CNY6.35-CNY6.40 range. Only a move out of it is
significant.
Spot: CNY6.3560 (CNY6.3645)
Median Bloomberg One-month Forecast CNY6.3680 (CNY6.38)
One-month forward CNY6.3830 (CNY6.3860) One-month
implied vol 3.3% (3.5%)
Disclaimer