As the year draws to a close, it seems that the global economy is transitioning into a new stage. Despite assurances from North American and European central bankers about their readiness to address potential threats to price stability, the markets express skepticism.
The pricing signals in the derivatives markets suggest a prevailing belief that central banks have likely concluded the monetary tightening cycle initiated in the post-Covid era. Central bankers are resisting any premature relaxation of financial conditions.
The significant spikes observed in monthly Consumer Price Index (CPI) measures last year are no longer influencing the 12-month comparisons. However, inflation persists above targets, albeit at a notably slower pace. It’s worth noting that Japan stands out as a notable exception in this regard.
The Bank of Japan is gradually moving closer to exiting its extraordinary monetary policy. Initially, there were expectations that the BOJ might lift its overnight target rate from negative territory, where it has been since 2016, by the end of this year. However, current projections suggest a more likely scenario towards the end of the current fiscal year in March 2024 or possibly April. The BOJ has quietly halted its purchases of Real Estate Investment Trusts (REITs) and acquired the fewest equity Exchange-Traded Funds (ETFs) since 2010.
The stark divergence observed in the third quarter, where the US economy expanded by a robust 5.2% annually while the eurozone and Japanese economies contracted, has peaked. Presently, Europe and Japan’s economies continue to display lackluster performance at best. A new trend is emerging, primarily driven by a slowdown in American economic activity during the fourth quarter. This deceleration is expected to be widespread, affecting US consumption, government spending, and potentially causing stagnation in business investment. The eurozone and UK might consider themselves fortunate if they can avoid a contraction in the fourth quarter.
Each business cycle possesses unique features, and this is particularly evident in the current cycle. Initially, after the resolution of the Great Financial Crisis and the European sovereign debt crisis, the outlook favored a return to the “Great Moderation” characterized by slow growth, low inflation, and low interest rates. However, before the onset of the COVID-19 pandemic, Europe and Japan had not yet normalized their monetary policies. While the US made progress in normalizing monetary policy, fiscal policy presented a different narrative. In the two years before the pandemic, despite above-trend growth and historically low unemployment, the US experienced significant budget deficits.
The unprecedented pandemic triggered substantial policy responses, unevenly implemented and subsequently unwound. The response to Russia’s invasion of Ukraine marked a substantial shift, leading to changes in the competitive landscape. Presently, the cost of liquefied natural gas is approximately 3.5 times higher in Europe than in the US.
A key element shaping the economic landscape is the heightened tension in China. The consistent US stance toward China, characterized by tariffs and export controls, remains a point of general agreement amid political partisanship. Europe has also intensified efforts to scrutinize Chinese imports, with additional measures anticipated. Simultaneously, China has imposed new requirements on the export of materials crucial for semiconductor chip fabrication.
China’s trade surplus, while slightly below last year’s levels in dollar terms through October, has expanded in yuan terms. Exports have seen a modest year-over-year increase in yuan terms, while imports have experienced a marginal decrease.
The US economic expansion has proven more resilient than initially anticipated. Despite a December forecast by Fed officials predicting a 0.5% growth rate for the year, the median forecast in September reached 2.1%, allowing for potentially weak growth in Q4. Various economic indicators, such as the decline in the six-month average of the leading economic indicators index, M2 contraction, and the rate of business failures, have historically been associated with past US recessions. Although there was criticism in the market for the Fed’s delayed asset purchase tapering and rate hikes, the growing belief that US rates have peaked has alleviated pressure on risk assets.
Recent market movements reflect this sentiment, with indices like MSCI Asia Pacific, Europe’s Stoxx 600, and the US S&P 500 and Nasdaq rebounding from three-month declines. The S&P 500, in particular, saw a robust 9% rally in November, its second-best performance since 1980. The MSCI Emerging Market equity index also surged almost 8%, fully recovering losses from the previous two months. Additionally, the JP Morgan Emerging Bond Index spread over US Treasuries narrowed, approaching the low for the year. Emerging market currency indices appreciated by around 2.0%-2.8%.
In November, Bannockburn’s World Currency Index, a GDP-weighted basket encompassing the 12 largest economies, experienced a noteworthy 1.5% increase. This marks the first upturn since July and stands as its most robust performance since January. The surge is indicative of a generally weaker dollar, driven by a growing consensus that both policy rates and long-term yields have reached their peaks amid a deceleration in economic activity and inflationary pressures.
Notably, India was the sole currency within the index that did not appreciate against the US dollar, exhibiting virtually no change. The Mexican peso emerged as the standout performer in the basket, boasting a 4.9% gain. This strength can be attributed to the country’s resilient economy, a robust external sector, and the central bank’s decision to refrain from rate cuts despite declines in inflation and rate reductions among several neighboring economies. The Australian dollar closely followed, registering a 4.6% increase, supported by a rate hike, hawkish rhetoric, and a prevailing risk-on sentiment.
Two pivotal questions loom for businesses and investors: the extent of the slowdown in the US economy and the timing of the Federal Reserve’s response. Despite a robust 5.2% growth in Q3, indications point to a significant deceleration in Q4. Economists anticipate a halving of activity in Q4, with further slowing to 0.4% in Q1 2024. Growth may not return to 1.5% until Q4 2024, as per the median forecast in Bloomberg’s monthly survey.
The Federal Open Market Committee’s (FOMC) year-end meeting on December 13 is expected to maintain the upper band of its target at 5.50%, unchanged since July. However, the futures market has fully priced in two cuts by the end of H1 2024, with expectations of approximately 3.5 cuts by the end of Q3 2024. In its Summary of Economic Projections update, the Federal Reserve projected two rate cuts in 2024 in September, despite forecasting the Personal Consumption Expenditures (PCE) deflator to exceed the target at 2.5%. The median forecast also anticipated a growth slowdown to 1.5% in 2024.
The upcoming presidential election in 2024 introduces an 800 lb. gorilla into the equation, with Trump polling slightly ahead of Biden. The uncertain policy outlook may constrain the potential for new international agreements and could dampen investment.
The Dollar Index, which rallied from mid-July to early October, reached a crucial technical retracement objective post its mid-July surge. While the belief is that the cyclical high was recorded in September 2023 (~114.75), November’s 3% decline might be deemed excessive. A potential rebound could propel it back to the 104.70-105.00 range before facing renewed headwinds.
The eurozone grapples with ongoing challenges as its economy experiences virtual stagnation this year, with limited growth impulses as the year concludes. Policymakers find themselves with maneuvering space due to a sharp decline in price pressures. The preliminary Consumer Price Index (CPI) in November dropped to 2.4%, a significant decrease from the 10% figure observed last November and the lowest since July 2021. The swaps market indicates an 80% likelihood of the first interest rate cut occurring in Q1 2024, although central bank officials suggest a more suitable timeline around mid-year. By the end of H1 2024, the market has priced in two-and-a-half cuts. Fiscal policy outlook adds further uncertainty, requiring an agreement on modifications to the Stability and Growth Pact; otherwise, old rules will come into effect next year.
In a complicating development, Germany’s high court ruled the attempt to shift off-budget Covid spending to climate change as unconstitutional, creating an immediate budgetary gap of around 37 billion euros for this year. This ruling raises questions about other off-budget programs and intensifies strains within the coalition government. Suspending the debt-brake for another year seems like an inevitable choice. The euro hit its yearly high in mid-July around $1.1275 and reached the low in early October near $1.0450. Although it surpassed $1.0965 last month, meeting a crucial technical retracement, the soft CPI report has prompted a pullback. It is anticipated to retrace towards $1.0725-50.
The UK economy defied expectations by avoiding contraction in Q3, but beneath the surface, there was a concerning 0.4% decline in consumption, the most substantial since Q3 2022, and a significant 2.0% drop in business investment, marking the largest contraction since Q1 2021. According to economists in Bloomberg’s survey, the British economy is not anticipated to see growth until Q2 2024. The Bank of England’s latest forecast is notably pessimistic, projecting economic stagnation next year, in contrast to more optimistic predictions from the European Commission (0.5%), the IMF (0.6%), and the median forecast in Bloomberg’s survey (0.4%). However, a modest upgrade is plausible after the government’s Autumn statement, which eased fiscal policy by approximately GBP18 billion. This included a two-percentage-point cut in the national insurance rate and the permanent extension of full expensing for capital investment. The reduction in the national insurance tax translates to about GBP450 annually for the average wage earner. Conversely, personal allowances will remain frozen for the next five years, potentially leading to bracket creep, where inflation pushes wage earners into higher tax brackets.
Consumer price inflation in the UK has decelerated from 10.5% at the end of 2023 to 4.6% in October. If prices continue rising at the same pace for the next six months as they have for the past six months, headline inflation could be below 3% by early spring 2024. The swaps market indicates a slightly over 80% chance of the first rate cut by the end of H1 2024. In November, the British pound extended its recovery, coming within about seven cents of the October 4 low near $1.2035. It reached a significant technical retracement objective at $1.2720, with the $1.2800 area serving as the next chart resistance. November’s 3.8% rally, the most substantial since November 2022, has stretched momentum indicators, and downside risk may extend toward $1.2450-$1.2500.
Officials have recently introduced a series of measures aimed at supporting the Chinese economy and the property sector. Although interest rates have remained unchanged, the People’s Bank of China (PBOC) has implemented substantial liquidity injections. The central government is set to increase its deficit by CNY1 trillion and is contemplating the launch of another CNY1 trillion fund to bolster public housing and urban renewal. Additionally, the PBOC has initiated a facility to alleviate the debt stress faced by certain local governments.
Recent high-level meetings, including a notable one between President Biden and Xi Jinping last month, indicate a potential shift in China’s diplomatic approach. Xi Jinping has seemingly adopted a charm offensive, granting Mastercard permission to enter a local joint venture, expressing interest in purchasing Boeing’s Max 37 airplanes, placing new soy orders, and promising renewed efforts to address the fentanyl trade, despite prior denials. However, reports suggest that China’s provocative actions towards Taiwan persist, raising concerns of potential escalation ahead of Taipei’s election in mid-January.
China’s persistent low interest rates and the offshore yuan’s low volatility make the Chinese currency an attractive choice for funding purposes, allowing entities to borrow at a low cost and invest in higher-yielding or more volatile assets. This is evident in the notable increase in foreign entities issuing bonds on the mainland, known as “panda bonds.” Issuance this year has reached a record level through mid-October, with 73 issues totaling around CNY126.5 billion (approximately $17.7 billion), marking a substantial year-over-year increase. Beijing has also removed restrictions on outward fund transfers raised through such offerings, contributing to the internationalization of the yuan.
Amid heightened efforts by the PBOC to stabilize the yuan, and with the elevated risk of intervention by the Bank of Japan, the yuan initially decoupled from the yen in October, with the 30-day rolling correlation nearing zero. However, by late November, it had recovered to slightly above 0.60, compared to the year’s high of 0.70. The yuan’s correlation with the euro also increased from around 0.20 at the end of October to nearly 0.60 at the end of November.
Japan’s economy experienced a larger-than-expected contraction of 2.1% at an annualized pace in Q3, with both consumer spending and business investment declining for the second consecutive quarter. To counter this, an additional budget of JPY13.2 trillion (~$87 billion) has been proposed, including income tax rebates and funds for lower-income households, aiming to propel the economy back to modest growth in Q4 2023. The Bank of Japan (BOJ) meeting scheduled to conclude on December 19 initially raised speculation about an exit from the negative policy rate, but this has been deferred to March or April. Despite this, the BOJ is gradually normalizing policy, evidenced by the absence of Japanese real estate investment trust (J-REIT) purchases this year and the lowest acquisition of equity ETFs since 2010.
While major central banks have seen their balance sheets shrink, the BOJ’s balance sheet has expanded to approximately 132% of GDP from around 126.5% at the end of 2022. Headline Consumer Price Index (CPI) peaked in January at 4.3% and has since stabilized around 3.2%-3.3%. The core rate, excluding fresh food, was at 2.9% in October, down from 4.2% at the beginning of the year. The BOJ forecasts it to be at 2.8% in the next fiscal year before declining to 1.7% in FY25. However, the latest Bloomberg monthly survey indicates a median forecast for core CPI in FY24 at 2.2% and 1.6% in FY25.
The US dollar reached its peak near JPY151.90 in mid-October, approaching but not surpassing the high from October 2022. Factors such as valuation, with the OECD’s model of purchasing power parity estimating the yen to be more than 50% undervalued against the US dollar, coupled with expectations of the BOJ exiting its extraordinary monetary policy, may support the yen as US rates ease. Reports suggest that some investors and asset managers have already started buying the yen and/or Japanese assets. However, as of late November, speculators in the futures market had their largest net short yen position since late 2017, increasing by almost 30% in November. This signals potential vulnerability to a short squeeze, and while the process may have begun, an overestimation of US rate expectations could allow the dollar to rebound toward JPY150 before the downtrend resumes.
The Reserve Bank of Australia implemented a quarter-point interest rate hike last month, raising the target rate to 4.35%. Governor Bullock issued a warning that further rate increases might be necessary. Initially, the market responded in line with the interest rate adjustment, impacting the Australian dollar. However, subsequent data releases painted a less optimistic picture. The labor market displayed signs of cooling, with Australia generating an average of 16,000 full-time jobs per month this year, significantly lower than the threefold higher average observed a year ago. Retail sales unexpectedly declined in October (-0.2%), marking the first contraction since June. Inflation also slowed more than anticipated in October, settling at 4.9% (down from 5.6%) and matching the low for the year set in July.
Despite the November rate hike, the likelihood of a subsequent increase this month was never high. Moreover, the market currently perceives little chance of another hike in the cycle. The probability of a rate increase in H1 2024 has dropped to around 20%, a significant decrease from the approximately 75% probability following Governor Bullock’s comments in late November.
The Australian dollar, which had formed a double top around $0.6900 in June/July, projecting to $0.6300, surpassed this target and recorded a low in late October near $0.6270. A recovery followed, reaching $0.6675 in late November, meeting a crucial technical retracement level from the July high. While there may be room for a marginal new high, expectations suggest a subsequent pullback toward $0.6500.
The Canadian economy faced a contraction of 1.1% at an annualized rate in Q3, marking the weakest performance among the G7 countries. This is notably at odds with the robust 5.2% pace reported by the United States. The decline in inventories and exports acted as drags, while consumption remained flat during Q3. Despite this, suspicions arise that the reported weakness may overstate the true condition of the Canadian economy. The significant increase of nearly 60,000 full-time jobs in November, surpassing the total of the previous four months, lends credence to these suspicions. Previously concerned about excess demand, the central bank now appears to witness a satiation of this demand, which may contribute to maintaining a downward trajectory for inflation. Having been among the first high-income countries to raise rates in March 2022, the Bank of Canada is now anticipated to be among the first to cut rates. The swaps market reflects an almost 70% probability of the first rate cut occurring in late Q1 2024, with three cuts and a bit more fully priced in by the end of Q3 2024.
The Bank of Canada’s last meeting for the year is scheduled for December 6, and while no immediate action is expected, there could be modifications to forward guidance. However, the resilience of the labor market argues against validating the current interest rate expectations. The US dollar reached its yearly high against the Canadian dollar on November 1, nearing CAD1.3900, and subsequently trended lower throughout the month. The Canadian dollar experienced a 2.25% gain, breaking a three-month downward trend. On December 1, the US dollar slipped below CAD1.35 amid a widespread sell-off and following strong reported jobs growth. The next technical target is the CAD1.3380-CAD1.3400 area. Nevertheless, with momentum indicators appearing stretched, there is a risk of an extension back to the CAD1.3600 area.