The coming weeks will
likely continue the correction of the trends that began last month. The markets
recognize that tightening cycle is over. However, they swung hard, pricing in
aggressive easing by most of the G10 central banks, including the Federal
Reserve and the European Central Bank. Official comments and some
high-frequency economic data have encouraged participants to rein in their
expectations, reducing the odds of a rate cuts in Q1 and paring back the extent
of the cuts this year.
The pendulum of market expectations reached an extreme. In
the first part of January, pricing of the Fed funds futures strip implied a
rate cut at each of the remaining seven FOMC meetings. While this is possible,
it is not the most likely scenario, especially given what we know about the
national labor market and in the context of still elevated price pressures and
above trend growth in Q4 23.
Similarly, at the extreme in late December, the swaps
market had discounted 190 bp of ECB cuts this year. It had returned to around
140 bp (five quarter-point cuts and a 60% chance of a sixth) in late January,
which still seems aggressive compared with ECB signals. Comments from ECB
President Lagarde and the record from the December meeting suggest a timeframe
of the first rate cute toward the middle of the year. The market thinks April
is a reasonable timeframe and will coincide with a sharp drop in measured inflation.
With the eurozone continuing to struggle to sustain economic traction, the
disruption of Red Sea transit, which means greater costs and slower deliveries,
is the latest exogenous shock.
The earthquake in Japan at the start of the year and the
diminishing price pressures, framed by official comments, have strengthened the
emerging consensus for an April policy adjustment. This would allow for the
completion of the spring wage negotiations and corresponds to the end of the
government's gas and electric subsidies, which could boost measured inflation
by 0.4%-0.5%.
China's may have met last year's 5% growth target,
according to its own assessment but it is not satisfactory for Beijing. More
stimulus is expected in the form of government loans and lending by the PBOC.
Given weak prices pressures (deflation), there is still scope for ore targeted
measures after reserve requirements were cut in late January by 50 basis
points. New formal and informal efforts to stem the hemorrhaging of Chinese
stocks on the mainland, and especially in Hong Kong may be tested in the coming
weeks. The fact that officials needed to resort to such measures feeds the
sense that China is stumbling. Its enormous size means that the scale of
whatever it does is globally significant. Coupled powerful economic nationalism
and the lack of transparency contributes to economic anxiety in developed and
developing countries.
However, the economic rivalry, while intense, is
manageable. We often forget that the heated rivalry between the US, Europe, and
Japan previously, and the tactics included tariffs and restrictions on the
exports of some technology. Europe and Japan, no more than China, have chafed
under US leadership, but there the competition was limited to the economy and
trade. Not so with China, and Beijing's aggressive tactics, not only toward
Taiwan, but others Pacific nations, including the Philippines, and Nepal and
Bhutan, while aligning with Russia and Iran, remains particularly troubling.
Yet broadly, one cannot tell by looking at the capital or
commodity markets the geopolitical tensions are the highest in at least a
generation. Shipping costs between Europe and Asia reflect the disruption, but
crude oil prices are more than 10% below Q4 23's peak, and gold was a couple
percentage points lower through the first four weeks of January. The G10
currencies usually associated with risk-off, the Japanese yen and Swiss franc
have not been beneficiaries of the geopolitical tensions, falling about 4.8%
and 2.6%, respectively, against the dollar.
The reversal of the November and December trends in the
dollar and interest rates in January was seen in emerging markets too. We know
that Chinese equities fell sharply in January, but the MSCI emerging market
equity index, excluding China was off about 2.8% in the first four weeks of the
year. It had risen by a little more than 17% in the last two months of 2023. The
premium of emerging market bonds (JP Morgan Index) over Treasuries tightened by
about 50 bp last November-December. It widened a little in January but remains
near the lower end of where it has trading over the past two years. Emerging
market currencies generally weakened, as well. The JP Morgan and
the MSCI emerging market currencies indexes fell by about 1.7% and 1.1%,
respectively in the first four weeks of January.
Bannockburn's World Currency Index, a GDP-weighted basket
of the currencies of the 12 largest economies, fell by a little more than 1%. This
reflected that most of the components falling against the US dollar in January,
retracing some of the gains registered in late 2023. Among the G10 currencies
in the BWCI, the Japanese yen was the weakest, falling by a little more than
4.5%, dragged lower, arguably, by the more than 20 bp rise in the US 10-year
yield. Sterling was the strongest currency, and it rose by a modest 0.2%. All
the emerging market currencies in the BWCI fell, except the Indian rupee, which
eked out a minor (0.1%) gain. The South Korean won fell by about 3.6%, the most
of the emerging market constituents. The Chinese yuan fell about 1.1%, and among
the currencies that declined at the start of the year, only the Russian ruble
(-0.5%) and the Mexican peso (-1.05%) in the index fell by less.
The BWCI downtrend in January may not be complete, but we
suspect the lion's share of the adjustment is behind it. We think that markets
are still too ambitious in pricing the timing and extent of Fed rate cuts, and
until it adjusts more, there is still upside risk for the dollar, especially as
the economic impulses from Europe remain weak. If new initiatives from China
get traction, better cyclical news could be forthcoming, even without
structural reforms.
U.S. Dollar: There are
often many factors that drive exchange rates in $7.5-trillion average daily
turnover market, but most recently the dollar has broadly tracked interest rate
expectations. In Q4 23, the market recognized the Fed was pivoting, US interest
rates fell sharply and dragged the dollar lower. This year, official comments
and economic data persuaded the investors that it had been too aggressive and
as interest rates rose, the greenback was recovered. The Summary of Economic
Projections issued in December was a clear recognition by officials that the
next move will be a rate cut. However, officials do not have the same sense of
urgency that had been expressed in the market. The median Fed forecast
anticipated that three interest rate cuts would be appropriate this year. Ahead
of the January 30-31 FOMC meeting, the market is pricing five cuts and a 40%
chance of a sixth cut. We suspect there may be convergence toward four cuts.
During this election year, it seems in neither party's partisan interest to
force a government shutdown, but the path toward agreeing an appropriations
bills for a dozen departments four months after the start of the fiscal year
remains difficult. Spending authorization was extended into early March. We
expect solid, even if not spectacular job growth in January, but recognize that
the harsh winter conditions for much of the country in the middle of the month
likely dampened activity. Because we think the interest rate adjustment may not
have been completed, we suspect the dollar's correction from
the November-December slide can extend further. This could translate into the
104.00-50 area in the Dollar Index (settled January 26 ~103.40).
Euro: The
eurozone seems ill-prepared to address the economic and political challenges
that may lie ahead. The political leadership appears particularly weak. The
German coalition government is terribly unpopular. In France, President Macron
has begun the year by sacking his prime minister and appointing Attal, a young
popular French politician, in an apparent bid to revive his political fortunes.
Le Pen is running ahead of his party in the mid-year EU parliament election.
The economic performance remains moribund. The external balance has recovered
from the disruptions associated with Russia's invasion of Ukraine, but the
domestic growth remains poor, and the near-term prospects, through the first
half, is not much better. One of the bright spots is that the weak economy and
rate hikes have not spurred much of a rise in unemployment (so far). The ECB
has signaled that it is in no rush to cut rates, with a cut maybe near
mid-year. The euro traded between about $1.0815 and $1.10 in the first four
weeks of January. We suspect most of the correction from seven-cent Q4 23 rally
has been achieved, but it may not be over. The risk may extend by a little more
than a cent to the downside. The ECB has signaled a rate cut is likely near
midyear, yet the swaps market has almost an 88% chance of a hike in April.
(As of January 26, indicative closing prices, previous in
parentheses)
Spot: $1.0855 ($1.1040) Median
Bloomberg One-month forecast: $1.0875 ($1.0990) One-month
forward: $1.0865 ($1.1055) One-month implied vol:
6.2% (6.9%)
Japanese Yen: The
combination of the backing up of US rates and greater confidence that the Bank
of Japan will not hike rates until at least April dragged the yen lower in
January. It fell by about 4.6%. The dramatic slide in US rates November and
December 2023 saw the dollar drop from nearly JPY152 in mid-November to almost
JPY140 in late December. The greenback recovered to almost JPY149 in the first
four weeks of January before settling near JPY148. Despite fiscal efforts, an
extraordinary monetary policy, and an undervalued currency, the Japanese
economy struggled in H2 23. It contracted almost 3% at an annualized rate in Q3
23, with consumption and business investment falling in Q2 23 and Q3 23. Although
the economy is expected to have returned of growth in Q4 (GDP is due February
15), it may take the better part of three quarters to recoup the activity lost
in Q3 23. Public support for Prime Minister Kishida and the cabinet is weak.
The Liberal Democratic Party had not recovered from the negativity around its
ties with the Unification Church before a campaign financing scandal erupted,
hobbling some of the largest factions within the party. Still, one of Kishida's
achievements has been the stronger defense posture, which includes acquiring
offensive capabilities and reduced barriers to the export of armaments. Ironically,
core CPI is likely to fall below the central bank's target before it finally
exits its negative interest rate policy, seen most likely in April. The
dollar's rally in January stretched the momentum indicators suggesting that the
"correction" may be nearly complete. We suspect the JPY150 area may
hold as a consolidative phase in both US rates and the dollar seems likely
after the large adjustment in January.
Spot: JPY148.15 (JPY141.05) Median
Bloomberg One-month forecast: JPY145.65 (JPY142.05) One-month
forward: JPY147.45 (JPY140.35) One-month implied vol: 8.25% (10.7%)
British Pound: Since
the middle of December, sterling has been chopping in a two-cent range between
$1.2600 and $1.2800. Twice in December, the upper end was frayed, and once in
January, the lower end was violated, but not on a closing basis. The
consolidation is alleviating the overbought technical condition that resulted
from the roughly eight-cent rally in Q4 23. We are more inclined to see an
eventual downside break, which initially could be worth a cent. The swaps
market suggests the Bank of England easing cycle may begin after the Fed and
ECB and deliver fewer cuts this year. Specifically, the market does not have
the first cut fully discounted until June, and it has 105 bp of easing
discounted for this year. At the end of last year, the swaps market discounted
slightly more than 170 bp of cuts. The Bank of England meets on February 1,
with practically no chance of a change in policy. The economy has been
struggling since growing by 0.3% (quarter-over-quarter) in Q1 23. It was
stagnant in Q2 and contracted by 0.1% in Q3. GDP for Q4 23 is due February 15.
The risk is of another small contraction. The near stagnant conditions may
persist through the H1 24. At the same time, the base effect warns that
measured inflation will fall sharply in the coming months. In the February-May
2023 period, the UK's CPI rose at an annualized rate of almost 11.5%. As these
large monthly increases drop out of the 12-month comparison, with conservative
assumption, the year-over-year pace could be halved from the 4% pace seen at
the end of last year. The Sunak government is unpopular and support for the
Tory party is around 25% according to recent polls. Labour is holding on to
almost a 20-percentage point lead. Chancellor Hunt will deliver the Spring
budget (March 6), and it is expected to offer tax cuts ahead of the national
election expected later this year.
Spot: $1.2705 ($1.2730) Median Bloomberg One-month forecast: $1.2655 ($1.2650) One-month forward: $1.2735 ($1.2710) One-month implied vol: 6.6% (7.2%)
Canadian Dollar: The Bank of Canada left its policy rate steady at 5.0% last month. Citing the persistence of underlying inflation, officials expressed little sense of urgency to ease policy. While Governor Macklem refused to rule out an additional hike, he was clear that should economic activity evolve as officials expect, the question becomes when it should cut. The central bank chopped its forecast for Q4 23 GDP (due on February 29) to flat from 0.8% It projects 0.5% annualized growth in Q1 24. The Bank of Canada sees headline inflation remaining around 3% in H1 24 before slowing to 2.5% by the end of the year. The swaps market has the first cut fully discounted by mid-year and looks for almost 100 bp in cuts this year, back loaded. What seems to drive the exchange rate on most days are the broad direction of the US dollar (think Dollar Index) and the general risk-appetite. The Canadian dollar is often among the most sensitive dollar pairs to the movement of the S&P 500. Contrary to popular wisdom, the Canadian dollar's exchange rate does not appear tightly linked to oil prices. After falling by about 5.2% in November-December 2023, the US dollar rose by about 1.6% in the first four weeks of January. We suspect the move is not complete and look for the greenback to test the CAD1.3600-20 area, but a break of CAD1.3400 would bolster the chances that a high is in place.
Spot: CAD1.3455 (CAD
1.3245) Median Bloomberg One-month forecast: CAD1.3475 (CAD1.3300) One-month
forward: CAD1.3445 (CAD1.3235) One-month implied vol:
5.0% (5.7%)
Australian Dollar: In
the last two months of 2023, the Australian dollar appreciated by about 9.5%
against the US dollar. Momentum indicators were stretched, and combination of
soft inflation and a disastrous labor market report provided the precipitating
drivers that forced the Australian dollar to surrender more than half of its
gains in the first four weeks of the year. The loss of nearly 107k full-time
jobs in December is a record outside of a couple of months early in the
pandemic. This outsized loss was not confirmed in other high-frequency time
series, which appear to confirm the general slowing of economic activity, not a
collapse. The January job report is due February 15. However, even as inflation
falls and the economic pulse is faint, the market has pushed out the first cut
from May (at the end of 2023) to September now. It has also reduced the
amount of cuts this year from 68 bp at the end of December to about 40 bp in
late January. The Australian dollar's downside correction may not be complete,
and the initial risk could extend to $0.6450-$0.6500.
Spot: $0.6575 ($0.6810) Median Bloomberg
One-month forecast: $0.6635 ($0.6775) One-month forward:
$0.6585 ($0.6820) One-month implied vol:
9.0% (9.4%)
Mexican Peso: Mexico's
economy is slowing, and inflation is falling. This will set the stage for the
first rate cut in the cycle. A case can be made for a cut at the February 8
Banxico meeting, but on balance, a cut at the March 21 meeting, a day after the
FOMC meeting, may be more likely. The central bank forecasts growth to slow to
nearly 2% this year from about 3% in 2023. The IMF and the median forecast in
Bloomberg's survey concur with the central bank. Progress to restore price
stability has been extensive. The headline CPI peaked in July 2022 near 8.15%. It
reached about 4.25% in October 2023 and finished the year near 4.65%. The core
rate peaked in November 2022 around 8.50% and finished last year slightly below
5.30%. The headline rate accelerated to an almost 7% annualized rate in Q4 23
from about 4.4% in Q3. The core rate rose at annualized rate of around 4.35% in
Q4 23 after a 4.10% annualized pace in previous three months. The peso has been
a darling of the market for some time, and given market positioning
(over-weight asset managers, and speculators carry a large net long peso
position in the futures market), we think the risk is for some liquidation
ahead of the June election. It could be expressed as greater sensitivity to
risk-off developments. The high carry still makes it an expensive short. In the
middle of January and again in late January, the dollar jumped and tested the
200-day moving average (~MXN17.37-38) and the first retracement of the
November-December downtrend. It held. Support may be seen in the MXN17.00-05
area and a break could signal a retest on the January low near MXN16.7850.
Spot: MXN17.16 (MXN16.97) Median
Bloomberg One-Month forecast: MXN17.33 (MXN17.20) One-month
forward: MXN17.25 (MXN17.06) One-month implied vol:
10.3% (11.2%)
Chinese Yuan: Beijing
has managed to deliver a stable exchange rate. The US dollar has largely been
confined to a CNY7.10-CNY7.20 for more than two months. Although conventional
wisdom often attributes malevolent intentions to the PBOC efforts, it seems
that the exchange rate movement is understandable as a reactive function to the
dollar's broad movement, especially against the yen and euro. After leaving key
interest rates steady, the PBOC delivered a 50 bp cut in required reserves,
which frees up an estimated CNY1 trillion (~$140 bln). More stimulus is widely
expected, even if the timing is difficult to anticipate. While 10-year yields
US and European rose in January, they fell slightly in China. Short-term rates
are also low making the offshore yuan an attractive funding leg in structured
trades. After a sharp sell-off of Chinese shares on the mainland and in Hong
Kong, Beijing's pain threshold was discovered. Although Beijing eschews the
performance of the equities as a key metric, officials appear to be stepping up
their support using formal and informal channels. Of course, China and the
US have different institutional configuration and authority, but Beijing's
effort to stem the equity sell-off seems to have a similar goal in mind as the
so-called "Fed Put" that used monetary policy to stop a destabilizing
equity market decline. In this context, a broadly stable exchange rate may act
as a bit of a fire break to a potentially vicious cycle.
Reviewed by Marc Chandler
on
January 27, 2024
Rating:
