Weekly Overview : Central Banks Hesitant to Act

This upcoming week is poised to be a significant one in the world of finance, starting with the initial estimate of the US’s GDP for the fourth quarter. This figure is subject to revisions over the next few years. Additionally, key policy meetings are on the schedule for several major central banks, including the Bank of Japan, the European Central Bank, the Bank of Canada, and Norges Bank in Norway.

Markets are currently expecting a shift towards more lenient monetary policies by these banks, along with a potential move away from the Bank of Japan’s negative interest rate policy. However, these changes are likely to commence later in the first half of the year. This period is marked by an atypical business cycle, where, despite a slowdown, the US’s economic growth is anticipated to exceed the Federal Reserve’s benchmark for long-term stability in terms of prices.

Adding to the economic narrative, the preliminary results from the University of Michigan’s January survey indicate an upswing in consumer confidence and a reduction in inflation expectations for the year ahead. Meanwhile, the preliminary PMIs for January are set to highlight the challenges faced by many major economies, particularly in the manufacturing sector. This week’s developments could provide valuable insights into the current economic climate and the direction central banks might take in response.

Since the beginning of the year, there’s been a notable shift in investor sentiment as reflected in the swap and futures markets. Investors are now expecting the first rate cuts to occur later than initially anticipated and are also moderating their expectations regarding the extent of these cuts. This adjustment in market outlook has coincided with a resurgence of the US dollar, which had been weakening in the final two months of the previous year.

Looking ahead, barring any unexpected developments from the upcoming central bank meetings, it seems that the Federal Open Market Committee (FOMC) meeting scheduled to conclude on January 31st and the nonfarm payroll report due two days later (with an early estimate of around 150,000 jobs added) are likely to be the next major catalysts for market movements.

In the stock markets, the US S&P 500 and Nasdaq 100 have recently achieved new record highs. However, it’s Japan’s stock market that has made a particularly dramatic entrance into the new year. The Nikkei has surged by nearly 7.5% in the first three weeks, reaching heights not seen since 1990. In stark contrast, the index of Chinese companies listed in Hong Kong has dropped by just over 11%, and South Korea’s Kospi has fallen by nearly 7%.

The oil market remains volatile with March West Texas Intermediate (WTI) crude oil prices oscillating between $70 and $75 a barrel. This fluctuation persists even as the conflict in the Middle East appears to be escalating.

Lastly, the so-called “fear gauge,” which is the volatility index of the S&P 500 (VIX), is hovering around 13.3%. This is on the lower end of its range from the previous year, suggesting a relative calmness in market sentiment despite the underlying dynamics.

United States

The upcoming US GDP report for Q2, set to be released on January 25, is generating significant interest among economists and market watchers. Recent forecasts have shown an upward trend, with the median estimate in Bloomberg’s survey rising to 2% from an earlier 1.5%. The Atlanta Fed’s GDPNow model is even more optimistic, suggesting a 2.4% growth rate. This contrasts with the Federal Reserve’s consistent assessment of a non-inflationary growth pace at 1.8%. The possibility that the economy might be growing above this trend fuels skepticism regarding the extent of rate cuts anticipated by the market.

Recent feedback from Federal Reserve officials and a series of data revisions have led to an upward adjustment in the forecasts for Q4 2023 GDP. Consequently, the likelihood of a rate hike in March has dipped below 50% for the first time since the release of November’s CPI data on December 12. Market expectations for rate cuts this year have also been moderated, now anticipating around 132 basis points of cuts, down from 167 basis points at the end of last year. This suggests the possibility of five rate cuts, with a nearly 30% chance of a sixth, in the seven meetings following this month’s.

The forthcoming GDP report is also notable as it will include an estimate for December’s trade balance, which could make the goods report released on the same day less impactful. Additionally, the report will take into account the personal income and consumption data scheduled for the following day. A key focus will be the PCE deflator, especially the core PCE deflator, which is often regarded as the Fed’s “preferred measure.” The core PCE deflator, excluding food and energy due to their volatility and supply-driven nature, is expected to provide a clearer signal of inflation trends. Economists predict that the core PCE deflator might fall below 3% for the first time since March 2021, with the core rate excluding shelter possibly slowing to an annual pace of 2.5%-2.6% in the second half of 2023.

In fiscal matters, a political agreement has extended the federal government’s spending authorization until early March. The US budget deficit, which was about 6.5% of GDP in the last fiscal year, is projected to be around 6% for the current fiscal year that began on October 1.

Turning to the currency markets, the Dollar Index recently experienced a surge, with a notable gap occurring between 102.67 and 102.75, and rallying to around 103.70. It approached but did not exceed the 50% retracement of losses since early November 2023. Despite ongoing consolidation, the Dollar Index has maintained levels above 103.00. While momentum indicators are stretched, they haven’t yet indicated a downturn, leading to caution against prematurely predicting a peak for the Dollar Index. The bottom of the recent gap might offer support. Additionally, there are expectations for the two-year yield, which recently bottomed near 4.11%, to return to the 4.50-4.55% range, following a climb to almost 4.32% before the weekend.

Eurozone

As we approach a crucial period in the European financial landscape, attention is shifting towards the European Central Bank (ECB), which is set to meet the day after the preliminary January PMI report is released on January 24th. While there is little expectation of a policy change at this meeting, ECB President Christine Lagarde’s press conference will be pivotal in shaping future expectations.

The swaps market currently indicates about a 15% likelihood of an ECB policy move in March, contingent upon the updated economic forecasts by the ECB staff. This represents a significant shift from the end of last year when the market was pricing in nearly a 65% chance of a rate cut in March. Now, a rate cut is fully anticipated in April. The current pricing in the swaps market suggests expectations for five rate cuts (or 125 basis points) this year, with a nearly 30% probability of a sixth cut.

In terms of inflation, the base effect presents a challenge for comparisons, as the Consumer Price Index (CPI) fell by 0.2% in January 2023. Despite this, both the ECB and market participants recognize that the annualized CPI increase of over 9% between February and April 2023 is likely to lead to a sharp decline in eurozone inflation as these figures drop out of the year-over-year calculation.

Looking at growth forecasts, the ECB’s projection in December was for 0.8% growth in the eurozone this year. However, market sentiment is more cautious, with the median forecast in Bloomberg’s survey at 0.5% growth. The World Bank predicts a 0.7% growth, whereas the International Monetary Fund’s (IMF) forecast appears somewhat outdated at 1.2%. For comparison, the median forecast from the Federal Reserve (Fed) is for 1.4% growth in the US this year, with the IMF and World Bank slightly more optimistic at 1.5% and 1.6%, respectively.

Turning to the currency markets, the euro recently tested the 200-day moving average, around $1.0865, and is also in a crucial zone due to the potential formation of a head and shoulders top pattern. The neckline of this pattern has a slight downward slope, easing to around $1.0855 by the end of the next week. On the upside, the euro’s initial rebound last week was halted just before $1.0910. A downtrend line, drawn from the late last year’s high (~$1.1140) and including the mid-January high (~$1.10), is expected to intersect near $1.0915 at the start of the next week, descending to around $1.0865 by the week’s end. While momentum indicators are stretched, they continue to fall. A move above the $1.0920-40 range could significantly improve the technical outlook for the euro.

United Kingdom

The UK economy, after experiencing a contraction of 0.3% in October, showed resilience with an expansion of 0.3% in November. As we look forward to the release of the December and Q4 GDP figures on February 15, the prevailing economic indicators paint a mixed picture of the UK’s economic trajectory.

The PMI data offers a glimmer of hope that the UK might avoid another quarterly contraction, following a decline of 0.1% in Q3. Notably, the composite PMI improved from 48.7 in October to 50.7 in November, eventually reaching 52.1 in December, marking a six-month high. However, this optimism is somewhat dampened by the unexpectedly poor performance in December’s retail sales, which fell by 3.2%, significantly more than the median forecast of -0.5% predicted in Bloomberg’s survey.

In the context of monetary policy, the Bank of England is scheduled to meet on February 1. The swaps market currently indicates a very low probability of a rate cut at this meeting, with even lesser chances in March (less than 15%). The likelihood of a rate cut in May, previously deemed certain, has now been adjusted to just below 60%. Moreover, the swaps curve has adjusted its expectations, now forecasting around 110 basis points in rate cuts for the year, a reduction from the 130 basis points anticipated at the end of the previous week and significantly lower than the nearly 175 basis points expected at the end of last year.

The British Pound Sterling (GBP) continues to exhibit volatility within a narrow trading range between $1.26 and $1.28, a pattern that has been consistent since mid-December. While there have been brief excursions beyond this range, both on the upper and lower ends, these deviations were not sustained on a closing basis. In such a sideways market movement, momentum indicators are less informative. Although there was an initial bias towards a potential downside break of this range, the persistence of the range coupled with the advanced stage of interest rate adjustments has lessened this conviction.

China

The recent monetary policy decisions by the People’s Bank of China (PBOC) have defied some expectations, including ours, particularly regarding the benchmark one-year Medium-Term Lending Facility (MLF) rate. Contrary to the anticipations of many, the PBOC refrained from reducing the MLF rate, a move that seemed to have been hinted at by the government’s decision to offer loans at 10 basis points lower last month.

This decision is particularly noteworthy given that when the PBOC last cut the MLF rate by 15 basis points in August, banks did not fully pass this reduction through to their loan prime rates. The one-year rate was trimmed by 10 basis points to 3.45%, while the five-year rate was held steady at 4.20%. Despite this, it appears unlikely that banks will announce a cut in the prime rate soon. However, many still anticipate a reduction in the reserve requirement ratios later this quarter, which could ease monetary conditions.

In terms of currency management, the PBOC’s approach in setting the daily reference rate for the yuan suggests a strategy of moderation rather than an attempt to reverse or halt the yuan’s depreciation. Contrary to the conventional wisdom that portrays the PBOC as aggressive in its foreign exchange policy, our view is that the PBOC’s actions are more reactionary. The central bank seems to manage the exchange rate primarily to minimize fluctuations.

This approach is evident when observing the correlations between the yuan and other major currencies. For instance, the 100-day rolling correlation between the changes in the Dollar Index and the dollar against the yuan is just below 0.65, the tightest it has been in six months. Similarly, the correlation between changes in the dollar-yuan and the yen over the past 100 days is around 0.55, which is at the higher end of the range since Q4 2022.

From a trading perspective, a near-term cap for the yuan appears to be around CNY7.20. In a broader context, this level might signify the midpoint of a new trading range, approximately between CNY7.15 and CNY7.25. This range suggests a level of stability in the yuan’s valuation, within which the PBOC seems comfortable operating.

Japan

As the financial world turns its attention to the Bank of Japan’s (BOJ) meeting concluding on January 23, there’s a shift in market expectations regarding its negative overnight rate target, currently at -0.10%. Earlier speculations about the BOJ ending its negative rate policy have been dampened by a mix of factors, including the recent earthquake, weaker economic data, and comments from officials. The emerging consensus among market participants now points towards a potential policy shift in April. This timing aligns with the outcomes of the spring wage negotiations and the expiration of government subsidies for gas and electricity, which are estimated to suppress the Consumer Price Index (CPI) by about 0.4%-0.5%.

The BOJ is also set to update its economic forecasts. The previous projections were for 1.0% growth this year and a 2.8% core CPI. While the GDP forecast might see a minor adjustment, the core CPI projection could undergo a more significant revision. The core CPI, excluding fresh food, ended 2023 at 2.3%, with the BOJ projecting it to decrease below the 2% target to 1.7% by 2025.

Just two days after the BOJ meeting, Tokyo will release its January CPI figures, which are viewed similarly to the eurozone’s preliminary CPI estimate – as a robust indicator of national or final figures. Tokyo’s headline CPI was 2.4% year-over-year in December, a decrease from 4.4% in January 2023. The core rate, which excludes fresh food, was at 2.1%, down from 4.3% at the start of 2023. However, the measure that excludes both fresh food and energy is more concerning, having been at 3.0% in January 2023, peaking at 4% around mid-year, and ending at 3.5%.

In the currency markets, the US dollar has continued to strengthen against the Japanese yen, marking its third consecutive week of gains and reaching JPY148.80 at the end of last week. The yen has been the weakest currency globally at the start of the year, depreciating about 4.8%. The dollar has now moved past the 61.8% retracement of its decline from the high in November, suggesting that this level (around JPY147.50) might now act as a support. While momentum indicators are stretched, they continue to rise. Interestingly, Japanese officials have not commented on this price action, even though the current pace is similar to that which elicited a response last year. This lack of official commentary is fueling discussions about a potential move back to JPY150.

Canada

The upcoming meeting of the Bank of Canada on January 24 will be closely watched, as it sets the tone for the central bank’s approach in the early part of the year. Similar to other G10 central banks, the Bank of Canada is not yet in a position to reduce interest rates, reflecting a cautious stance amidst mixed economic signals.

The Canadian economy experienced a contraction of 1.1% (annualized) in Q3 2023, but is projected to see a modest recovery with an estimated 0.4% growth in Q4. For the year ahead, the Bank of Canada forecasts a 0.9% growth, a figure more conservative than the International Monetary Fund’s (IMF) more optimistic projection of 1.6%. The median forecast from Bloomberg’s survey sits at 0.5% growth for the year.

One of the key reasons for the Bank of Canada’s hesitation to ease monetary policy is the persistence of strong price pressures and robust wage growth. Although the headline and underlying inflation rates are around 3.4%, the economy shows mixed signals with a negative three-month annualized inflation pace and a six-month annualized rate below 2%. Despite a 5.7% year-over-year increase in wage growth among permanent employees, the Bank of Canada recognizes that excessive demand has cooled, reducing the urgency for aggressive monetary tightening.

Market expectations regarding the Bank of Canada’s rate decisions have been adjusted recently. The swaps market has lowered the likelihood of a rate cut in March to just over 25%, down from almost 60% at the end of the previous week. Additionally, the probability of an April cut has been reduced to around 66% from a previously anticipated certainty. Earlier in January, the market was pricing in five quarter-point hikes for the year, with a 50% chance of a sixth. This expectation has now shifted to almost four cuts.

In currency markets, the US dollar recently reached its highest level against the Canadian dollar (CAD1.3540) since late November, before pulling back slightly. The US dollar tested the CAD1.3430 area and dipped below the 200-day moving average (around CAD1.3480), which it had previously exceeded. This pullback was aided by a strong rally in US equities, with both the S&P and NASDAQ 100 reaching new record highs.

While momentum indicators for the US dollar suggest a potential downward turn, the recent surge appears more like a consolidation phase rather than the start of a new downtrend. A decisive break below CAD1.3400, however, could signal a more significant shift in the currency’s trajectory.

Australia

The preliminary January Purchasing Managers’ Index (PMI) is a key data point for Australia this week, offering insights into the country’s economic momentum at the start of the year. The recent PMI surveys suggest a sluggish end to 2023 and a lack of strong momentum entering 2024.

In the manufacturing sector, the PMI has been on a declining trend over the last four months of 2023, reaching a cyclical low of 47.6 in December. Notably, it has remained below the 50-mark threshold, indicating contraction, since February of the previous year. The services PMI also displayed weakness, falling to 47.1 in December from 46.0 in November, marking its third consecutive month below 50. The composite PMI, which combines output measures from both sectors, showed a slight increase to 46.9 from 46.2, but still lingered below 50 throughout Q4 2023. To put this in perspective, the composite PMI stood at 48.5 in January of the previous year.

The Australian economy grew by 0.2% quarter-over-quarter in Q3 2023, and economists anticipate a similar performance for Q4. While an outright contraction might be avoided, the overall economic outlook doesn’t suggest significant improvement until the second half of 2024. Interestingly, the futures market isn’t fully pricing in the first rate cut until November, though there is a slightly over 80% chance of a hike in September. The market currently anticipates about 1.5 rate cuts for the year, translating to roughly 38 basis points. This is a scaled-back expectation from the end of last year, when two quarter-point cuts and a nearly 75% probability of a third cut were factored into the futures strip.

In the currency markets, the Australian dollar recently encountered resistance at the 38.2% retracement level of its decline from the high on January 12. It recorded its first consecutive gains this year, although it still registered a loss of about 1.3% last week. The currency found support near $0.6525, just ahead of the $0.6500 level we previously identified. Given the nearly 3.5-cent decline since late last year, the momentum indicators are understandably stretched. Looking ahead, the immediate resistance is in the $0.6625-50 range, and a breakthrough above this level could enhance the technical outlook for the Australian dollar.

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