Monthly Overview: February 2024

Achieving an economic soft landing, wherein higher interest rates cool inflation without significantly increasing unemployment or causing economic contraction, is a rare feat for officials. Nevertheless, the FED’s optimism for realizing the outcome has grown, although it doesn’t signal an imminent rate cut. Understanding the current economic landscape requires a look back at the adjustments made in response to the final quarter of 2023.

Interest rate reductions late in 2023 spurred a notable rally in the stock market, with the S&P 500 experiencing its best quarterly performance in three years, surging 11.25% in Q4. This rally was let by a group of seven major tech companies, now dominating market influence, and complemented by a 13.5% gain in the Russell 2000 index. Concurrently, a softer dollar enhanced the value of major currencies and emerging market currencies alike, marking a period of correction and reaction to the preceding quarter’s events.

As 2024 began, expectations for interest rate cuts shifted, with the first FED rate cut now anticipated beyond March, aligning more closely with their December projections. This recalibration reflects a less aggressive approach to rate cuts across major economies, including ECB, BOE, and Bank of Canada, as market sentiments adjust to stronger economic indicators.

Despite these adjustments, stock markets, including S&P 500 and NASDAQ, continue to hit new highs, fueled by lower interest rate forecasts and signs of robust economic activity. Japan’s Nikkei and Europe’s Stoxx 600 also reached record levels, marked by optimistic economic data and and FED guidance.

The U.S. economy’s stronger-than-expected performance in late 2023, with a notable 3.2% GDP growth rate and moderating price pressures, has contributed to this optimism. The job market has seen significant growth, with wage increases supporting consumer demand and helping to stave of recession risks. Government spending, particularly in the U.S., remains a pivotal factor in economic stability, despite varying deficit levels among global economies.

Looking ahead, the outlook for the rate cuts and economic growth is mixed, with central banks in Europe and Japan navigating inflation and growth challenges. Geopolitical tensions and economic uncertainties continue to influence global markets, with effects on commodity prices and trade dynamics.

In summary, the early months of 2024 reflect a cautious optimism in financial markets, balancing the potential for economic stability with the ongoing adjustments in monetary policy and the broader geopolitical landscape.

United States

The financial markets have once again moved ahead of the FED’s guidance, mirroring a pattern observed last year, only to realign with the FED’s projections later on. This cycle of anticipation and adjustment seems to have reached its conclusion. Recent statements from officials haven’t indicated a significant shift from the December’s Summary of Economic Projections, which predicted a cut of 75 bps in interest rate for this year. THe FED is set to update its forecast at the meeting on March 20, which will also include insights into the unwinding of its balance sheet. Despite minimal changes in bank reserves, the brunt of the adjustment has been shouldered by money market funds and similar entities. A gradual tapering of the balance sheet is expected, possibly starting in the second quarter.

In the meantime, even job with job growth in January exceeding expectations, signs of a slowdown in economic activity are emerging. This slowdown could contribute to keeping both bond yields and the dollar’s value in check in the near future. The FED’s Bank Term Funding Program, initiated last year to provide one-year loans, will cease to issue new loans on March 11. The regulatory focus in shifting towards regional banks, particularly due to their considerable exposure to commercial real estate, contrasting with the performance of large U.S. bank shares, which have seen a marginal increase, against a 10% decline in regional bank shares this year.

After a rise from around 100.60 at the end of December to 105.00 by mid-February, the Dollar Index’s recovery seems to have plateaued. With a pullback expected in March, the index could potentially decrease towards 102.00. This adjustment period reflects the ongoing recalibration within the financial markets, aligning closer with the Federal Reserve’s projections and the broader economic landscape.

Eurozone

Economic activity in Europe has plateaued since the latter part of 2022, with growth impulses remaining weak, though unemployment has impressively stayed near historical lows despite monetary policy tightening and stagnant growth. This resilience in the job market seems to strengthen the European Central Bank’s (ECB) resolve to delay easing monetary policy until inflation aligns closer with its target. There’s an anticipation of a significant reduction in inflationary pressures in the upcoming months, potentially bringing the inflation rate below 2% in the second quarter. The preliminary inflation rate for February was reported at 2.6%, a decrease from 2.8% at the end of the previous year and a significant drop from 8.5% in February 2023. The ECB is expected to revise its forecasts in March, having previously predicted a 0.8% growth and 2.7% inflation rate for this year, figures that now seem likely to be adjusted downward.

The looming European Parliament elections in June are set to capture increasing attention from officials, with immigration and agricultural pricing emerging as pivotal issues. Meanwhile, the euro has seen fluctuations, dropping from around $1.1140 late last year to approximately $1.07 by mid-February. Although a recovery seems to be underway, potentially reaching the $1.0950-$1.1000 range, a sustained uptrend appears less likely than the establishment of a new, higher trading range. This economic landscape underscores the challenges facing the ECB as it navigates through stabilizing growth and inflation within a politically dynamic environment.

United Kingdom

In the UK, recent US jobs data and CPI reports caused the British pound to drop out of its February trading range of $1.26-$1.28. The pound hit a low near $1.2520 following the employment report but recovered to finish the month within its previous range. The British economy contracted for a second consecutive quarter in Q4 2024, which meets the Bank of England’s definition of a recession. Nevertheless, the market shrugged off this news, and the pound ended higher on the day the GDP report was released (February 15). The Chancellor of the Exchequer, Hunt, is scheduled to present the Spring Budget on March 6, with expectations of tax cuts ahead of the anticipated election later this year. These cuts could significantly impact the national health system or income taxes, potentially totaling GBP15-GBP20 billion. With inflation expected to decrease sharply in the coming months, the market might anticipate an earlier rate cut, previously not fully discounted until August. Despite these shifts in expectations, as observed in Q4 2023, the pound’s value may not suffer and could test the upper end of its previous range, with a late-year high nearly reaching $1.2830.

China

Authorities managed to stabilize the yuan’s value against the dollar, halting the CSI 300 index’s six-month decline. While there wasn’t a strong push to significantly strengthen the Chinese currency, efforts were made to maintain it within a tight range (approximately CNH7.1765 to CNH7.1995), marking the narrowest monthly fluctuation since July 2015. Despite the People’s Bank of China setting a daily reference rate that permits the dollar to trade slightly above CNY7.24, the CNY7.20 level has effectively acted as a strong resistance. This approach appears to be more of a short-term tactic rather than a long-term strategy. Thus, if the dollar gains strength against other major currencies, particularly the Japanese yen, there’s an increased chance it could also ascend past the yuan. Deciphering the intentions of Chinese officials is challenging, but a move above CNY7.20 might indicate a shift back to the previous range of approximately CNY7.25 to CNY7.30.

Encouragingly, reports of China’s sovereign wealth funds and large asset managers investing in equities prompted others to follow suit. As a result, the CSI 300 index witnessed a 7% surge in the holiday-shortened month, its most significant rally since January 2023, completely reversing the losses from January. Starting March 5, two major conferences are set to commence: the National People’s Congress, China’s legislative body consisting of 3,000 members, and the Chinese People’s Political Consultative Conference, an advisory group. It is anticipated that these meetings will announce this year’s growth target, possibly around 5%, alongside personnel changes and new economic policies. It is expected that additional stimulus measures and “reforms” will be introduced.

Meanwhile, economic tensions between China and the Western nations, including the US and Europe, remain elevated. Additionally, Chinese military activities have continued to be assertive towards Taiwan, the Philippines, and the disputed territories of the Senkaku Islands/Diaoyutai Qundao (claimed by both China and Taiwan), as well as Nepal and Bhutan.

Japan

Japan maintains a negative policy rate and has a debt-to-GDP ratio exceeding 250%, with the central bank’s balance sheet surpassing 125% of GDP. Despite an undervalued exchange rate, core inflation has decreased to 2%. The economy saw contractions in both Q3 and Q4 of 2023, and 2024 began on a weak note, evidenced by a 7.5% drop in industrial output in January. However, it’s anticipated that the Bank of Japan (BOJ) will increase its target rate from -0.10% likely in April. This expectation follows the spring wage negotiations concluding on March 15 and the cessation of government subsidies for household electricity and gas, just before an income tax reduction. BOJ Governor Ueda has highlighted the rise in services prices but is believed to view the negative interest rate as a constraint on monetary policy effectiveness. He seems determined to raise rates unless unforeseen events occur. Authorities aim to reassure businesses and investors that ending negative interest rates does not signify the start of a tightening cycle. Current monetary policy remains highly supportive, with the effective overnight rate lingering near -0.05%, less negative than the target. The BOJ holds nearly two-thirds of equity ETFs, comprising about a quarter of its assets. The Nikkei experienced a surge of over 28% in 2023 and has increased by approximately 19.25% in 2024, offering substantial returns even for unhedged, dollar-based investors compared to the S&P 500’s performance in the first two months of the year. The exchange rate continues to be influenced by U.S. interest rates. Should U.S. 10-year yields rise further, the JPY152 level, which previously limited the dollar’s strength, might be tested once more. Recent verbal interventions by Japanese officials have brought a cautious tone to the market, balancing the dollar’s initial rise in the year’s first eight weeks with a slight decline (~0.25%) by the end of the week leading to March 1, indicating a more orderly market despite its one-way trend.

Canada

In contrast to Japan and the UK, Canada successfully avoided a second consecutive quarter of economic contraction in Q4 2023, posting an annualized growth rate of approximately 1.1%. This growth fully offset the revised 0.5% contraction in Q3 2023, initially reported as -1.1%. Despite expectations for modest economic momentum through the middle of the year, the absence of contraction means the central bank is not pressured to reduce rates immediately. However, similar to the eurozone and UK, Canada experienced a sharp inflation increase in the early part of last year, with a 6% annualized rate in the first five months of 2023. Remarkably, in the five months leading up to January, Canada’s Consumer Price Index (CPI) slightly decreased, a deviation from the anticipated slowdown in inflation. Assuming inflation increases by an average of 0.2% per month from February through May, it could fall below 2%. The underlying inflation rates softened in January, following a period of stagnation in Q4 2023. The swaps market has not fully priced in the first rate cut until July, with a bit more than three cuts expected throughout the year. Initially, the first cut was expected in June with a total of 100 basis points of cuts anticipated for 2024. The Bank of Canada’s next meeting is on March 6, and a rate cut is highly unlikely at this juncture. The Canadian dollar has experienced weekly declines this year except for one week, where it marginally appreciated by about 0.02%. January accounted for two-thirds of the Canadian dollar’s 2.1% depreciation this year. The US dollar reached its highest level since mid-December in late February, slightly above CAD1.3600. A move above CAD1.3625 could indicate another upward trend, but without it, a consolidation phase is more likely, possibly retesting the CAD1.3450 area seen in late January and early February. The benchmark three-month implied volatility is around 5%, the lowest in four years, almost reaching 4% before the pandemic.

Australia

The Australian dollar hit its lowest point of the year following the release of the US CPI data on February 13, dropping to just below $0.6450. This downturn seems to mark the end of the retreat from a six-cent rally observed in the last two months of 2023. If the currency manages to maintain above the $0.6490 threshold, it could potentially rebound to the $0.6600-$0.6625 range. Since the beginning of the year, the Australian dollar’s exchange rate movements have closely mirrored those of gold, with a correlation near 0.80—a high figure relative to the past five years’ data.

Reserve Bank of Australia (RBA) Governor Bullock has left the door open for higher interest rates, yet the derivatives market is leaning towards an expectation of a rate cut as the next move. Currently, there’s nearly a 75% chance of a rate reduction in June, according to market predictions, with a quarter-point decrease not fully anticipated until September. This outlook has shifted slightly from the end of January when there was nearly a 70% likelihood of a cut in May and a 95% chance of one in June.

The slight increase in the January CPI to 3.6% from December’s two-year low of 3.4% suggests the RBA may adopt a more cautious stance at its next meeting on March 19. The employment report for February, due the following day, will also be closely watched. Economic growth in Australia is expected to remain modest, within the 0.2%-0.3% range per quarter, during the first half of 2024.

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