November 2023 might signify a period of moderate activity in terms of monetary policy, alongside increased global tensions. Fiscal policy, on the other hand, could be more dynamic, as Japan considers a supplementary budget, China plans additional measures, and Europe deliberates on reinstating the Stability and Growth Agreement. In the United States, the recent House of Representatives’ events may lead to potential challenges regarding the federal government’s spending capabilities.
Given recent geopolitical shifts, Ray Dalio of Bridgewater was cited suggesting that the likelihood of a global conflict was approximately 50%. Others acknowledge that these risks are the most significant seen in decades. Despite this, the financial markets have remained remarkably stable. Notably, there were notable price fluctuations, such as the approximately $64 (around 3.4%) surge in gold prices on October 13 and the 6.2% increase in oil prices in the week following Hamas’s attack. Additionally, the US 10-year yield witnessed a significant spike of almost 65 basis points since the September 19-20 Federal Reserve meeting.
The dollar had ceased its 11-week climb against the Swiss franc in the first week of October. Interestingly, the franc was the sole G10 currency to appreciate against the dollar in the week following the Hamas attack and throughout October, up until the last full week of the month.
The US September CPI, which was marginally higher than anticipated (with the year-over-year rate staying unchanged at 3.7% rather than declining as predicted), temporarily halted the dollar’s decline a few days into the conflict. Speculation arose on October 3 when the dollar briefly traded above JPY150, prompting theories of BOJ intervention, though this did not seem to be the case. Despite the market’s hesitance to retest the JPY150 level, the dollar managed to reach new highs for the year on October 26, nearing JPY150.80. This move drew little more than verbal warnings from officials. China, on its part, seems to be utilizing both formal and informal means to manage the yuan’s exchange rate. The dollar’s strength is motivating other nations to bolster their own currencies.
The United States continued to display notable economic outperformance in the third quarter. The initial official report suggests that the largest economy in the world grew at an annualized rate of 4.9% in Q3, surpassing China’s reported growth of 0.9% quarter-over-quarter. Beijing has indicated its intention to provide further economic assistance, while economists had anticipated a significant deceleration in the US economy. Japan is also in the process of developing another economic plan, expected to involve tax rebates and an extension of subsidies for household utilities such as electricity, cooking gas, and gasoline.
Despite criticism directed at the Federal Reserve for not terminating its exceptional monetary stimulus sooner than it did, there were multiple instances during the cycle when the market anticipated the central bank to shift its approach, but this did not materialize. In September, the projected median reduced the expected number of cuts from four to two, while the derivatives market (comprising swaps and futures) favored three cuts. However, once again, the market aligned with the Federal Reserve’s stance rather than the other way around. The Federal Reserve’s decision seemed to be influenced by robust September CPI and retail sales data. The prevailing consensus now appears to favor a soft-landing scenario (avoiding a recession) and an extended period of higher interest rates.
Nevertheless, it is fair to acknowledge that soft-landing scenarios could be intrinsic to the cycle itself. Historically, optimism tends to diminish later in the cycle, considering the number of business cycles that have concluded without a recession and a significant increase in unemployment. There are noticeable emerging headwinds, such as the tightening of credit, the cumulative impact of rising interest rates, the resumption of student loan debt servicing, and increasing levels of debt stress. Consumer spending has outpaced income growth for four consecutive months until September. However, if there is no substantial evidence that these well-known headwinds are taking root, there remains a possibility of a Federal Reserve hike in December, even though the market perceives this as less than a 25% probability. This is particularly true if US long-term rates retract.
It is challenging to determine the appropriate level of analysis in light of recent geopolitical developments. Some perceive the supposed reconciliation between Israel and Saudi Arabia, facilitated by a pipeline with US support but paradoxically relying on ports controlled or managed by China, as having been deliberately undermined. Others suggest that Russia is subtly and indirectly manipulating the situation. Additionally, some individuals contextualize recent events within the long and violent history between these two nations.
Several protracted conflicts remain unresolved, resembling stalemates in various ways. The Israel-Palestine conflict is arguably the most volatile. Prior to October 6, signs indicated the potential resurgence of the earlier Armenia and Azerbaijan dispute. This conflict partly arises from Russia’s vulnerabilities rather than its strengths. Reports indicate increasing tensions between Kosovo and Serbia. The United States has escalated its military presence off the coast of Korea to deter any potential escalation there. The occurrence of various conflicts is often attributed to the weaknesses or distractions of the principal influencer, the United States. Nonetheless, such claims have persisted for years, and even during the height of the unipolar world, numerous conflicts persisted. In the words of political scientist and author Paul Poast, “war is persistent but not prevalent.”
The threat of a broader conflict in the Middle East or Central Europe is among the “unknown knowns,” but a more immediate risk looms in the form of the approaching November 17 deadline. The current spending authorization requires an extension; otherwise, a partial shutdown of the US federal government will occur. This would result in the suspension of numerous services, impacting over 2 million workers directly, and disrupting the pay of 1.3 million active-duty troops. While a partial government shutdown would not affect Washington’s ability to service its debt, Moody’s, the last of the major three rating agencies to uphold a AAA rating for the US, has cautioned that a shutdown would have a negative credit impact. The ongoing struggle to select a new speaker for the House of Representatives highlights a significant division within the Republican Party, potentially complicating the negotiation of a budget agreement. It is also plausible that another short-term resolution will be reached.
Moody’s has assigned Italy its lowest investment-grade rating. The outlook is pessimistic, and the results of its evaluation will be disclosed on November 17. Despite S&P affirming its rating for the country slightly higher than Moody’s a few weeks ago, it seems to be a close call. Italy’s 2024 budget has increased the deficit target to 4.3% from 3.7% six months earlier. Furthermore, the Meloni government assumes 1.2% growth for the next year. However, the Bank of Italy forecasts 0.8%, and the IMF projects 0.7%. Slower growth than the government anticipates would amplify the size of the deficit. The government does not anticipate meeting the 3% threshold until 2026.
Fitch, the third major rating agency, is set to conduct an assessment of Italy a week earlier, with its current rating aligning with S&P. The likelihood of a loss of investment-grade status is deemed highly improbable. Fitch acknowledges the Italian government’s budget as a significant relaxation of fiscal policy, potentially prompting a shift in the outlook from stable to negative. However, the immediate importance lies with Moody’s decision. If Italy’s investment-grade rating is revoked, the market impact might be minimal for two reasons. First, Italian bond yields have experienced a significant surge in recent weeks, both in absolute terms and relative to Germany. Second, the use of Italian bonds as collateral in ECB operations will not be affected.
Amidst the sharp increase in US interest rates and ongoing geopolitical developments, risk appetites have been dampened, resulting in a substantial cost for emerging markets. The MSCI index of emerging market equities witnessed a third consecutive monthly decline (approximately -4.5% in October) and is slightly lower for the year. The losses have been primarily concentrated in the Asia Pacific region, where China’s CSI 300 has declined by nearly 8% for the year, and Hong Kong’s Hang Seng has seen a drop of about 12%. Central European and Latin American equities have performed relatively better this year but encountered challenges in October. The premium over the US, measured by the JP Morgan Emerging Market Bond Index, widened marginally for the third successive month. Most emerging market currencies experienced depreciation, with Latin American currencies, which previously exhibited strong performance, generally underperforming in October. The Chilean and Mexican pesos were among the weakest, depreciating by approximately 4.4% and 3.6%, respectively, against the dollar last month. Apart from the Russian ruble, the Polish zloty emerged as the strongest performer, recording a 3.5% gain, bolstered by the national election outcome and the anticipated release of EU funds that had previously been blocked.
Bannockburn’s World Currency Index, a GDP-weighted basket consisting of the currencies of the twelve largest economies, experienced a brief dip to fresh multi-year lows in early October, marginally slipping below the low established in November 2022. It has remained in a trough, indicating the likelihood of further declines, suggesting that the US dollar has not yet reached its peak in the spot market. Initially, it was believed to have done so, but the sustained outperformance of the US economy, coupled with the continuous flow of unfavorable news from Europe and Asia, alongside heightened geopolitical tensions, might prolong the dollar’s upward trend.
The Mexican peso (with a 1.8% weighting in the BWCI) emerged as the poorest performer, recording a decline of approximately 3.7%. The Canadian dollar experienced the most significant loss among currencies from high-income countries in the index, with a 2% decrease. With the exception of the Russian ruble (2.8%), which is considered a special case, only the Brazilian real (2.4%) gained ground against the dollar in October, appreciating by around 1.7%.
The BWCI relies on one-month forward currency rates. By converting these forwards to interest rates, it becomes possible to establish a funding index. The implied rate reached its lowest point in April 2022 at approximately -1.7%, before surging to around 3.4% in November 2022. Subsequently, it decreased to approximately 1.7% by the end of February 2023. However, the implied funding cost of the BWCI has significantly surged to around 6.30% as of October. Among the BWCI members, China might still be considering rate cuts, while Brazil has concluded its tightening cycle and has begun implementing rate cuts. Russia is expected to increase rates once again, and Japan, as mentioned earlier, has expanded the upper limit for the 10-year JGB but has not raised overnight rates, with its balance sheet continuing to expand. Although the market anticipates the US and ECB to lower rates in late Q2 or early Q3, the central banks have not ruled out the possibility of an additional hike. Of the high-income countries in the index, Australia is perceived as the most likely candidate to raise rates again.
The US dollar continues to showcase significant economic outperformance, which has been instrumental in driving up US rates and the dollar’s value. A portion of this can be attributed to its fiscal policy. For the fiscal year ending in September, the US budget deficit amounted to 6.3% of GDP, following a 5.4% deficit in the previous year. While revenues experienced a decline, expenditures, such as those related to defense, healthcare, Social Security, and debt servicing costs, saw an increase. The deficit is expected to dip below 6% in 2024. In contrast, the eurozone’s aggregate deficit is around 3.5% this year (versus 3.6% in 2022) and is projected to decrease toward 3% next year. Japan’s budget deficit hovers around 5.3%-5.5% after a 6.7% deficit in 2022, with estimates suggesting a decline to approximately 4% next year. The Office for Budget Responsibility forecasts a UK budget deficit of 5.1% for the current fiscal year (up from 4.3% in 2022), expected to narrow to 3.2% in the next fiscal year.
Another crucial pillar supporting the US economy is consumption. In Q3 GDP, consumption surged by 4.0% after a modest 0.8% growth in Q2. However, with monthly consumption growth surpassing income growth in three out of the four months through September, this trajectory appears unsustainable. The resumption of student debt servicing, which had been deferred for three years, is viewed as a hindrance to consumption. Rising debt stress levels and tightening credit conditions also present challenges for the pivotal engine of US growth. Market expectations point to a substantial slowdown in the economy in Q4. According to the median forecast in Bloomberg’s survey, the economy is anticipated to decelerate to below 1% annualized, with a return to growth above 1% not anticipated until Q3 2024.
The Federal Reserve seems to have signaled no change in rates at the upcoming meeting concluding on November 1, marking the second consecutive month of unchanged rates. The surge in US interest rates (50-60 basis points on the 10-year yield since the last FOMC meeting on September 20), which Fed officials attribute to the rise in the term premium, is tightening financial conditions for the central bank. The December 2024 Fed funds futures contract implies an effective Fed funds rate of about 4.70% by the end of next year, while it currently stands at 5.33%. This suggests that the market expects the two cuts anticipated in the September Summary of Economic Projections (median) and approximately a 50% chance of a third cut. The Dollar Index hit its high for the year on October 3, reaching close to 107.35. After an 11-week rally through the end of Q3, it consolidated predominantly above 105.50 in October. Although the early October high was initially deemed significant, the current risk appears to be the possibility of a new high being established.
The economic conditions within the eurozone have shown minimal change over the past month. The economy appears to have either stagnated or even contracted slightly in Q3, with a similar outlook expected for Q4. Germany, as the largest economy within the bloc, is anticipated to experience a slight contraction. While Berlin and Paris have reached an agreement allowing for government support for French nuclear plants, a comprehensive consensus on the new fiscal regulations remains elusive. If an agreement is not reached by the end of the year, the previous regulations, which are perceived to be somewhat more stringent and less flexible than certain proposed new rules, will be reinstated. The European Central Bank does not have a scheduled meeting in November, but the market appears to believe its policy adjustments have concluded. Last October, a 1.5% surge in eurozone CPI will be excluded from the 12-month comparison, leading to a deceleration in the year-over-year pace to approximately 3%. However, this may signify the lowest point until late Q1 2024. Looking further ahead, the swaps market has fully factored in a rate cut by the end of H1 2024. Geopolitical and economic risks within the eurozone seem to be tilted to the downside. Following a decline of almost 7.5% from mid-July to early October, the euro experienced a corrective rebound last month. However, this upward correction slowed down in late October around $1.07, near the upper boundary of the $1.0660-$1.0700 range highlighted the previous month. There is a possibility that the euro might revisit the year’s low near $1.0450.
In October, the US dollar surpassed the JPY150 threshold on three separate occasions. The first instance, which occurred on October 3, triggered a rapid price movement that led many observers to speculate about the possibility of an official intervention. Within a span of less than fifteen minutes, the dollar dropped from around JPY150.15 to nearly JPY147.40, before subsequently recovering and stabilizing just above JPY149.00. While skepticism remains regarding the intervention, the impending release of a Ministry of Finance report is expected to provide authoritative insights. The second breach of the JPY150 level took place on October 23, with the dollar reaching approximately JPY150.10 before retracting in an orderly and calm manner. The third breach occurred on October 25, as the dollar surged through JPY150, eventually peaking at JPY150.80 on October 26. Alongside concerns about potential intervention, this level also represents a common option strike, prompting participants to exercise caution, particularly ahead of the Bank of Japan’s meeting scheduled for October 30-31.
Several news reports have suggested that the 10-year bond’s 1.0% cap might be lifted once more. Notably, the yield has climbed from around 0.50% at the end of July to 0.86% in late October. To stabilize the bond market, the BOJ has conducted unscheduled purchases and provided five-year loans to banks, ostensibly offering low-yielding money to encourage bond purchases. This move is perceived as complementary to the Yield Curve Control policy and marks the sixth such operation this year. In its upcoming update, the BOJ is expected to revise its economic projections, with inflation for the next fiscal year likely to be raised to 2.0% or slightly higher. Although the BOJ is anticipated to maintain its current stance, the possibility of an adjustment to the overnight rate, transitioning from -0.10% to zero, is speculated for the upcoming December meeting. The rate has been negative since January 2016 but effectively hovers near -0.02%.
Furthermore, in preparation for the anticipated supplemental budget, which is likely to include a modest tax rebate, Prime Minister Kishida has announced the extension of gasoline, electricity, and household gas subsidies until spring, after their initial extension to the end of the year.
In October, the Canadian dollar faced downward pressure due to the economic disparity with the US and a prevailing risk-off sentiment. The US dollar surged to a new seven-month high against the Canadian dollar following the Bank of Canada’s meeting, reaching CAD1.3845 after the robust Q3 US GDP was announced the following day. Despite the decision to leave the overnight rate unchanged at 5.00%, the Bank of Canada officials emphasized their readiness to implement further rate hikes, if deemed necessary. However, the market remains skeptical. For instance, the swaps market now reflects slightly over a 25% probability of a rate cut by the end of H1 2024, compared to an approximately 85% chance of a cut at the end of September. Although the central bank raised its inflation projections, anticipating CPI to reach 3.0% next year instead of the previously estimated 2.5%, it also lowered its growth forecast from 1.2% to 0.9%. Economists surveyed by Bloomberg suggest that the Bank of Canada’s growth forecast of 0.8% in both Q3 and Q4 2023 is overly optimistic, projecting a median growth rate of 0.5% and 0.4%, respectively.
Notably, the US set its high for the year in March near CAD1.3860, and a breach above this level could potentially trigger a rally toward the two-year high established in October 2022, hovering around CAD1.40. It is presumed that a broader setback in the US dollar and/or a significant rebound in risk appetites would be necessary for the Canadian dollar to establish a solid support level.
In October, the dollar-bloc and Scandinavian currencies exhibited relative weakness among the G10 currencies, a trend commonly observed during risk-off market environments. The Australian dollar, in particular, hit new lows for the year, nearing $0.6285. Although it traded below $0.6300 on eight occasions, it only settled below this level once. While there are indications of a potential bottoming out, it is essential for the Australian dollar to regain ground above $0.6450 to instill confidence that a lasting low has been established. A breach of $0.6250 could prompt a return to last year’s low around $0.6170. Market expectations regarding central policy underwent a shift following a smaller-than-expected decline in Q3 CPI. The probability of a hike at the November 7 meeting is now estimated at 50/50, doubling compared to the situation prior to the CPI release. The likelihood of a hike before the end of the year currently stands at around 75%. However, the Australian economy appears to be losing strength. Full-time job losses were recorded in two of the past three months leading up to September, and the preliminary October PMI composite experienced a significant decline of 4.2 index points to 47.3, marking its lowest level since January 2022. Additionally, there has been a notable easing of price pressures, with the year-over-year rate dropping from 7.8% in Q4 2022 to 5.3% in Q3 2023, with projections suggesting a further decline to approximately 4.5% in Q4 2023.
China’s economic performance has shown some signs of improvement, yet the persistent weight of the property market continues to act as a drag. Notably, Country Garden’s default on a dollar bond has added to the existing concerns. To counter the challenges, further economic measures are anticipated, and the possibility of a rate cut or adjustments to reserve requirements remains on the table before the end of the year. Local governments are expected to access next year’s bond-issuance quota, while the central government’s deficit is set to increase to 3.8% from the previously announced target of 3% in March. However, the strong government intervention continues to create apprehension among foreign investors. Recent events, such as the Foxconn investigation, the detainment of three WPP employees, and the espionage charges filed against an executive from Astellas Pharma, have contributed to this sentiment. Moreover, the detention of an employee from a Japanese trading company in March without any public acknowledgment or specific charges has raised further concerns.
During October, the dollar’s trading range against the Chinese yuan was constrained between approximately CNY7.27 and CNY7.3185, well within the range observed in September (around CNY7.24-CNY7.35). The People’s Bank of China (PBOC) has continued to utilize the fixing mechanism to curb the dollar’s strength. The activities of the large state-owned banks, whether for their own accounts or on behalf of the central bank, have been difficult to ascertain. However, there have been reports in the press highlighting their dollar-selling endeavors. Although a meeting between President Biden and Xi on the sidelines of the APEC summit in mid-November remains a possibility, it has yet to be officially confirmed.