Looking for Clarity While Waiting for Godot

In the first few weeks of the year, there have been several breakouts in the foreign exchange market that have not been sustained.  The dollar broke higher to start the year against the Japanese yen, rising to five-year highs only to reverse and return to the JPY112.50-JPY115.50 range that confined it more or less since the middle of last October.  

The euro was bid to around $1.1485 in mid-January, its best level in two months.  It quickly reversed and fell to its lowest level since mid-2020 (~$1.1120).  It returned to the previous $1.12-$1.14 range, but jumped back above it with the help of the ECB's hawkish signals.  The January high proved a sufficient cap with the help of the unexpectedly strong US jobs report. With geopolitical tensions running high in Europe, the Swiss franc rose to seven-year highs against the euro but also bounced back to return to the status ante.  Indeed, in the second half of last week, the euro traded above CHF1.06, its highest level since last November. 

The dollar spiked higher against the Russian rouble, poking above RUB80 for the first time since late 2020.  It did not manage to close above this key area, and even without a resolution of the tensions, the dollar pulled back to test a trendline drawn off the October and December lows, coming in below RUB76.  Despite the divergence in policy and official cautionary remarks, the market sold the dollar to its lowest level against the Chinese yuan since April 2018 (~CNY6.32) before recovering back into the CNY6.35-CNY6.40 range that had dominated activity since the middle of last October before the Lunar New Year.  

The Australian dollar was sold below $0.7000 for the first time since July 2020.  At the end of January, it touched three standard deviations below the 20-day moving average.  The proverbial rubber band has not stretched that far since last August, when the Aussie launched a two-and-a-half-week rally that lifted it from around $0.7100 to about $0.7480.  This time too, the Australian dollar recovered to test the $0.7200 area.  In fact, it made new highs after the central bank continued to push back against market pressures for a hike, which remained fully priced in for July.   

The New Zealand dollar has been an exception to the false breakout pattern seen over the past few weeks.  The Kiwi had found support near $0.6700, but punched through it in late January, falling to $0.6530, its lowest level since September 2020.  It stabilized but did but was turned back after approaching the $0.6700 area ahead of the weekend.  The price action warns of a retrest on last month's low near $0.6530.    The swaps market has about 190 bp of tightening priced in for the Reserve Bank of New Zealand over the next 12 months.  This is more aggressive than any other high-income country.  Among the G7, the Bank of Canada is seen as the most hawkish and the market has nearly 165 bp of tightening over the next 12 months.  The swaps market sees about 125-135 bp of tightening from the Federal Reserve and the Bank of England. 

II 

There are two important US data points next week. For obvious reasons, the interest will be with the January CPI figures.  However, don't be caught unaware and ignore the trade balance.  The advanced goods deficit for December reached a record of nearly $101 bln.  Of course, goods for the holidays would have already been here.  The larger shortfall may have help helped rebuild wholesale and retail inventories.  The goods deficit last year was almost $1.1 trillion.  In 2020, it stood at nearly $911 bln and $851 bln in 2019.  

Some observers try turning the traditional argument on its head and claim that the US shortfall is because large surplus countries like China and German underpay their workers suppressing domestic demand, leading to greater exports. They argue that Germany and China need to make the adjustment, not the deficit country, and often advocate more public spending.  The German budget position swung from a surplus of 1.5% of GDP in 2019 to a 4.3% deficit in 2020 and 5.4% in 2021.  China's budget deficit rose to 6.2% of GDP in 2020 from 4.9% in 2019.  It appears to be the largest deficit since at least 1993.  It may have fallen to 5.4% last year, which would the second highest.  

Moreover, the larger American trade deficit will require foreign investors to buy more US assets at the same time that more buyers are needed to fund the US budget deficit as the Federal Reserve ends its net buying operations.  So called QT, when not all maturing issues ae recycled and the balance sheet shrinks, reserves will fall and this could impact offshore funding spreads, including fx swaps. Treasury auction results are often part of the "inside baseball" story, but going forward, they may offer insight into the funding of the "twin deficit".  In addition to the full contingent of bills, Treasury will auction three- and 10-year notes and 30-year bonds in the week ahead ($110 bln in coupons, a $10 bln reduction from the previous quarterly refunding last November)

The headline and core measures of CPI are expected to have risen by 0.5% in January.  This will lift the year-over-year rate to 7.3% and 5.9% respectively.  Average retail gasoline prices rose by almost 3% in January after surging more than 45% last year.  Used car prices appear sot have risen for the fifth month in a row after softening a bit in Q3 21.  The prices paid component of ISM manufacturing survey jumped to 76.1 from 68.2.  A modest decline had been expected.  It reflects the broader increase in commodity prices.    The CRB Index rose 9.8% in January, the most since November 2020 (CPI rose by 0.2% that month).  Both input and output price measures in the manufacturing PMI fell for the third consecutive month.

There are at least three reasons why the prices could begin moderating soon.  First is the base effect.  Last February and March headline CPI rose by 0.4% and 0.8% respectively.  These will drop out 12-month view. Second, supply chains remain a constraint on the manufacturing sector, but they appear to be gradually improving.  General Motors sees the chip shortage easing.  Delivery delays, measured by the ISM fell to their lowest level since November 2020.  Third, the economy is practically stagnating at the start of the year.  The Atlanta Fed GDPNow is at 0.1%.  It is still early in the quarter, but it illustrates what appears to be happening.  

III

The Caixin services and composite PMI will reported as China's mainland markets re-open from the week-long holiday.  It seems to already be appreciated that the world's second-largest economy is off to a soft start, even if Q4 21 GDP was stronger than expected (1.6% quarter-over-quarter vs. median expectation of 1.2% in Bloomberg's survey).  

The dollar rose against all the other reserve currencies (but the yuan) in January.  Bonds also sold off sharply.  The PBOC did not appear to intervene directly to support the dollar last month, but there were press accounts that reported Chinese banks (state-owned) buying the greenback.  The median forecast (Bloomberg survey) looks for a $10 bln increase in China's reserves.  The dollar valuation of China's reserves grew by about $33.6 bln in 2021 to stand at $3.25 trillion.  

China may also report its lending figures for January.  As new quotas open, there is often a surge in lending in January.  In January 2021, aggregate lending jump to CNY5.19 trillion (from CNY1.65 trillion in December 2020).  In January 2020, aggregate lending was CNY5.05 trillion (December 2019 it was CNY2.10 trillion).  Officials are encouraging lending and the median forecast (Bloomberg survey) looks for CNY5.46 trillion in aggregate lending.

The rise in bond yields in the US and Europe are exerting upward pressure on Japanese yields.  The key area to watch on the 10-year yield is 0.25%, the upper end of the yield-curve control target.  The issue is how does the BOJ respond.  Will it offer to buy government bonds beyond what is scheduled?  Could it take the IMF's advice and adjust the yield curve target to a shorter maturity?  

There are also two conflicting economic signals.  First, the market is looking through Q4 data.  Although many parts of northern Europe are easing Covid related restrictions, including the UK, Japan extends its quasi-emergency measures in late January and will carry over toward the middle of February.  This boosts the chances of contraction in Q1 22 GDP.  Second, the cut in mobile phone charges last April will drop out of the 12-month comparison leading to what will appear as measuring inflation. The BOJ's latest projections see inflation in the fiscal year starting in April of 1.1%, which would be the highest since 2014.   

Eurozone data is mostly from last quarter.  There may be some news for economists fine-tuning Q4 GDP, but as the middle of Q1 approaches, the data is too old to matter much.  After last week's CPI and ECB meeting, participants may look elsewhere for directional cues.  The UK provides its preliminary estimate of Q4 GDP.  It is expected to have ratcheted lower to 0.8% from 1.1% in Q3.  The British Office of Budget Responsibility forecast 6.5% growth in 2021 and 6.0% this year.  The IMF and the European Commission see growth this year slowing to 4.7%-4.8%.  The Bloomberg survey of private economists finds a median forecast of 4.5%.  

The BOE meets next on March 17.  The swaps market has about 125 bp of tightening priced this year.  While the market is pricing in 1-2 hikes by the Fed in 2023, the market suspects the BOE may frontload its hikes and not raise them in 2023.  The terminal rate for both the BOE and Fed is around 1.80%.   In 2018-2019, the base rate peaked at 0.75%, the highest since the Great Financial Crisis.  

That said, after Governor King cast the deciding vote for  quarter-point hike last week, the market has reassessed the risk of a larger move in March.  A rate hike is seen as a foregone conclusion, and the market is almost evenly split between a 25 bp and 50 bp hike. The BOE will begin allowing its balance sheet to unwind passively, by not recycling the full amount of maturing issues.  When the base rate reaches 1.00%, which is where a 50 bp move would take it, the BOE  would also be actively selling off its assets, not simply passively on maturaion.    

Sweden's Riksbank meets on February 10. It is expected wait until Q2 for lift-off and the market expects to see 50 bp in hikes this year.  The economy is strong (Q4 GDP 1.4%), and the January composite PMI was at a robust 66.0 (alternating monthly between gains and declines since last June).  The underlying measure of CPI that Sweden's Riksbank targets uses a fixed interest rate, and that rose to 4.1% in December year-over-year.  However, the challenge stems from energy prices.  If they were excluded from the underlying measures, the inflation eased in December to 1.7% from 1.9%.  The Riksbank forecast the underlying rate of inflation ease to 2.2% this year and 1.8% next.  Of course, the outcome is not independent of the central bank's actions.  

  

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