Monthly Overview: February 2024

In the upcoming weeks, it is expected that the current market trends, which started last month, will persist in adjusting. The markets have acknowledged the end of the tightening phase. Nevertheless, there has been a significant shift, with expectations set for substantial monetary easing by several G10 central banks, such as the Federal Reserve and the European Central Bank. Recent official statements and certain key economic indicators have led market participants to moderate their expectations, consequently decreasing the likelihood of interest rate reductions in the first quarter and diminishing the projected scale of rate cuts for this year.

Market expectations recently swung to an extreme. In early January, the Fed funds futures market indicated a rate cut at each of the seven remaining FOMC meetings this year. While feasible, this seems less likely, especially considering the current state of the national labor market, persistent high inflation, and above-average economic growth in Q4 2023.

Similarly, in late December, the swaps market anticipated 190 basis points of ECB rate cuts this year. By late January, this expectation adjusted to about 140 basis points, suggesting five quarter-point cuts and a 60% probability of a sixth, which still appears ambitious compared to ECB communications. ECB President Lagarde’s remarks and December meeting minutes indicate the first rate cut might occur mid-year, with the market leaning towards April, coinciding with an expected significant drop in inflation. The eurozone’s ongoing economic challenges, compounded by disruptions like the Red Sea transit issues, exacerbate this situation.

The early-year earthquake in Japan and decreasing price pressures, along with official statements, support a growing consensus for a policy shift in April. This aligns with the end of Japan’s spring wage negotiations and the expiration of gas and electric subsidies, potentially raising inflation by 0.4%-0.5%.

China may have achieved its 5% growth target last year, but this falls short of Beijing’s expectations. Additional stimulus through government loans and PBOC lending is anticipated. Despite deflationary pressures, there’s room for more targeted actions following a 50 basis point reserve requirement cut in late January. Efforts to stabilize Chinese stocks, particularly in Hong Kong, highlight China’s economic struggles, with global implications due to its size, economic nationalism, and lack of transparency.

While the economic rivalry between major powers is intense, it is not unprecedented. Historical economic tensions between the US, Europe, and Japan involved tariffs and technology export restrictions. Unlike with China, past competitions were confined to economy and trade, not extending to geopolitical realms as seen with China’s approach to Taiwan, other Pacific nations, Russia, and Iran.

Despite high geopolitical tensions, capital and commodity markets don’t fully reflect this. Shipping costs between Europe and Asia are up, yet crude oil and gold prices have decreased since Q4 2023. The G10 currencies typically favored in risk-off scenarios, like the Japanese yen and Swiss franc, have depreciated against the dollar.

Emerging markets have also mirrored these trends. Chinese equities dropped sharply in January, and the MSCI Emerging Market Index, excluding China, fell about 2.8% in the first month of the year, following a 17% rise in the last two months of 2023. The spread of emerging market bonds over Treasuries has fluctuated but remains near the lower end of its two-year range. Similarly, emerging market currencies weakened, with the JP Morgan and MSCI indexes declining in January.

United States

In the vast $7.5-trillion daily turnover currency market, exchange rates are influenced by numerous factors, but recently, the dollar’s movements have been closely tied to shifts in interest rate expectations. In the fourth quarter of 2023, as the market perceived the Federal Reserve’s policy shift, U.S. interest rates dropped significantly, pulling the dollar down with them. This year, however, a combination of official statements and economic data has led investors to reassess, believing their initial expectations were too aggressive. As interest rates began to rise again, the dollar regained its strength.

The Federal Reserve’s Summary of Economic Projections released in December clearly indicated that the next policy move would likely be a rate cut. Yet, Fed officials don’t seem to share the market’s sense of urgency. The median forecast from the Fed suggested three rate cuts would be appropriate this year, but as of the January 30-31 FOMC meeting, the market is pricing in five cuts, with a 40% probability of a sixth. It appears there might be a shift towards expecting four cuts.

In this election year, it seems unlikely that either political party would benefit from a government shutdown, though the process of agreeing on appropriations bills for a dozen departments, four months into the fiscal year, remains challenging. The deadline for spending authorization has been extended into early March. January’s job growth is expected to be solid, albeit not exceptional, with the severe winter conditions in the middle of the month likely having an impact on economic activities.

Given the ongoing adjustments in interest rates, the dollar’s rebound from its November-December decline may continue. This could see the Dollar Index moving towards the 104.00-50 range.

Eurozone

The eurozone appears underprepared for the impending economic and political challenges. Political leadership across the region is facing difficulties. In Germany, the coalition government is grappling with a lack of popularity. France’s President Macron has taken a bold step by replacing his prime minister with Attal, a younger and more popular figure, in a move seemingly aimed at rejuvenating his political standing. This comes as Le Pen gains traction ahead of the mid-year EU parliament elections.

Economically, the eurozone continues to struggle. Although it has somewhat recovered from the impacts of Russia’s invasion of Ukraine on its external balance, domestic growth remains weak. The outlook for the first half of the year doesn’t show much promise for improvement. A silver lining, however, has been the ability of the weak economy and rate hikes to avoid significantly spiking unemployment rates, at least for now.

The European Central Bank (ECB) is taking a cautious approach, indicating no immediate plans for rate cuts, with a potential cut considered around mid-year. During the first four weeks of January, the euro fluctuated between approximately $1.0815 and $1.10. It seems that most of the correction from the seven-cent rally in Q4 2023 has occurred, but it might not be complete. There’s a possibility of a slight further decline, perhaps just over a cent.

Interestingly, while the ECB hints at a mid-year rate cut, the swaps market is pricing in an 88% chance of a rate hike in April. This divergence in expectations underscores the ongoing uncertainty and challenging economic landscape in the eurozone.

United Kingdom

Since mid-December, the British pound sterling has been fluctuating within a narrow range of two cents, oscillating between $1.2600 and $1.2800. There were instances in December where the upper limit was slightly exceeded and in January the lower boundary was briefly breached, though not on a closing basis. This period of consolidation has helped alleviate the overbought condition resulting from the approximately eight-cent rally seen in Q4 2023. The current market trends suggest a potential downward break, which might result in a decline of about a cent.

The swaps market is indicating that the Bank of England’s (BoE) cycle of monetary easing may commence later than the Federal Reserve and the European Central Bank, with fewer rate cuts expected this year. The first rate cut is not fully anticipated until June, with a total of 105 basis points in cuts projected for the year, down from over 170 basis points anticipated at the end of last year.

The BoE is scheduled to meet on February 1, with little expectation of a policy change. The UK economy has been underperforming since a modest growth of 0.3% quarter-over-quarter in Q1 2023, followed by stagnation in Q2 and a slight contraction of 0.1% in Q3. The Q4 2023 GDP data, due on February 15, may reveal another minor contraction, suggesting the stagnant economic conditions could persist into the first half of 2024.

Inflation in the UK is expected to decrease significantly in the coming months due to base effects. Between February and May 2023, the annualized CPI growth rate was nearly 11.5%. As these high monthly increases fall out of the year-over-year comparison, even with conservative estimates, the inflation rate could drop to half of the 4% rate recorded at the end of last year.

Politically, Prime Minister Rishi Sunak’s government is facing low popularity, with support for the Conservative Party at around 25% in recent polls, while the Labour Party maintains a lead of nearly 20 percentage points. Chancellor Hunt is set to present the Spring budget on March 6, which is expected to include tax cuts in anticipation of the national election later this year.

China

Beijing has successfully maintained a stable exchange rate, with the US dollar fluctuating within a narrow range of CNY7.10 to CNY7.20 for over two months. While there’s a common perception that the People’s Bank of China (PBOC) manipulates its currency for unfair advantages, the current exchange rate stability seems more like a response to the dollar’s overall movements, particularly against major currencies like the yen and euro.

Recently, the PBOC kept its key interest rates unchanged but implemented a significant monetary policy move by cutting the required reserve ratio by 50 basis points. This action is estimated to release around CNY1 trillion (approximately $140 billion) into the economy. Further stimulus measures are widely expected, although their exact timing remains uncertain.

Contrasting with the rise in 10-year yields in the US and Europe during January, China experienced a slight decline in its own yields. Additionally, China’s low short-term rates make the offshore yuan an appealing option for funding in structured trades. Following a sharp downturn in Chinese stocks both on the mainland and in Hong Kong, it became evident that Beijing has a threshold for market pain. Despite traditionally downplaying the significance of stock market performance as a key economic indicator, Chinese officials seem to be increasing their support through both formal and informal means.

In a manner somewhat reminiscent of the “Fed Put” in the United States – where monetary policy has been used to prevent destabilizing equity market declines – Beijing’s efforts to stabilize the equity market appear to aim for a similar objective. In this scenario, maintaining a broadly stable exchange rate could serve as a safeguard, preventing a potentially harmful economic cycle.

Japan

The combination of rising US interest rates and increased confidence that the Bank of Japan (BoJ) won’t hike rates until at least April contributed to the yen’s depreciation in January, where it fell by approximately 4.6%. This follows a significant decline in US rates in November and December 2023, during which the dollar plunged from nearly JPY152 in mid-November to about JPY140 by late December. The dollar then rebounded, reaching nearly JPY149 in the first four weeks of January, before settling around JPY148.

Despite various fiscal efforts, extraordinary monetary policy measures, and an undervalued currency, the Japanese economy faced challenges in the second half of 2023. It contracted by nearly 3% on an annualized basis in Q3 2023, with both consumer spending and business investment declining in Q2 and Q3. While the economy is anticipated to have returned to growth in Q4 2023 (with GDP data due on February 15), it might take up to three quarters to recover the losses experienced in Q3.

Prime Minister Kishida’s administration is currently facing low public support. The Liberal Democratic Party has not yet recovered from controversies related to its connections with the Unification Church, compounded by a campaign financing scandal that impacted major factions within the party. However, Kishida has made notable progress in adopting a stronger defense posture, including acquiring offensive capabilities and easing restrictions on arms exports.

Ironically, the core CPI in Japan is expected to drop below the central bank’s target before the BoJ exits its negative interest rate policy, which is most likely to occur in April. The dollar’s rally in January has pushed momentum indicators to their limits, suggesting that the correction might be nearing completion. The JPY150 level is expected to be a threshold, with a phase of consolidation likely for both US rates and the dollar following the significant adjustments made in January.

Canada

Last month, the Bank of Canada maintained its policy rate at 5.0%, highlighting the ongoing presence of underlying inflation and indicating a lack of urgency to shift towards easing policy. While Governor Macklem didn’t completely dismiss the possibility of a further rate hike, he emphasized that the primary question hinges on the timing of a potential rate cut, assuming economic activities align with the bank’s expectations. The central bank has revised its GDP forecast for Q4 2023 to flat, a significant adjustment from the previously anticipated 0.8% growth, and now projects a modest 0.5% annualized growth for Q1 2024.

The Bank of Canada anticipates that headline inflation will hover around 3% in the first half of 2024, with a gradual decrease to 2.5% by year’s end. The swaps market is already pricing in the first rate cut around mid-year, expecting almost 100 basis points in reductions, with the bulk of these cuts occurring later in the year.

On most days, the Canadian dollar’s exchange rate seems primarily influenced by the overall direction of the US dollar (as reflected in the Dollar Index) and the general appetite for risk in the market. The Canadian dollar is particularly reactive to movements in the S&P 500, often more so than other dollar pairs. Contrary to common belief, its correlation with oil prices is not as strong as frequently assumed.

After a decline of about 5.2% in November-December 2023, the US dollar gained roughly 1.6% against the Canadian dollar in the first four weeks of January. This upward movement may not be fully complete. The expectation is for the US dollar to potentially test the CAD1.3600-20 range. However, a break below CAD1.3400 would significantly increase the likelihood that a peak has been reached in the USD/CAD exchange rate.

Australia

During the final two months of 2023, the Australian dollar experienced a significant appreciation, rising about 9.5% against the US dollar. This upward trend was met with overly extended momentum indicators. A combination of softer inflation data and a particularly troubling labor market report acted as key catalysts, leading the Australian dollar to relinquish over half of its gains in the first four weeks of the new year. The loss of nearly 107,000 full-time jobs in December marked a record high, excluding the initial months of the pandemic, and indicated a significant downturn in the labor market.

Interestingly, this substantial job loss wasn’t echoed in other high-frequency economic indicators, which suggested a general slowdown in economic activity rather than an outright collapse. The upcoming January job report, due on February 15, is anticipated to provide further insights into the labor market’s condition.

Despite declining inflation and a weak economic outlook, market expectations for monetary policy adjustments have shifted. The timeline for the first interest rate cut, which was initially expected in May 2023, has been pushed back to September 2024. Additionally, the projected extent of rate cuts for the year has been reduced from 68 basis points at the end of December to about 40 basis points by late January.

Given these developments, the Australian dollar’s downward correction may not yet be fully realized. There’s an initial risk that the currency could further depreciate to levels around $0.6450 to $0.6500.

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