Weekly Overview: Has the Interest Rate Adjustment Period Come to an End?

The US dollar and interest rates seem to be at a turning point, after recent corrections from an overestimation in 2023 Q4. This overestimation involved derivatives markets anticipating nearly seven quarter-point FED rate cuts this year. Last week, US 2 and 10 year interest rates reached new three-months highs, influenced by economic data and FED officials’ remarks.

The market, repeating its pattern from last year, has aligned with the FED’s stance, and this realignment appears complete. I anticipate weaker US economic data in the upcoming weeks, potentially stabilizing US rates. Concurrently, the technical outlook for several G10 currencies is improving, with the momentum indicators showing positive signs. While growth signals are still weak in other high-income countries, developments in the US remain crucial, as demonstrated in 2023 Q4.

In China, both official and unofficial measures have been taken to bolster the stock market. The CSI 300 index rose consistently ast week as mainland markets reopened post-holiday, marking its first five days winning strike since November 2020. This rise follows a pattern observed during the Great Financial Crisis and the Covid pandemic, where high-income nations supported their stock markets and restricted short sales. The stability of financial markets, often underpinned by the so-called “FED Put”, is deemed critical, especially in China. This due to the property market’s downturn impacting a major savings avenue and the low yields on central government bonds. The downturn in stocks has led Chinese investors to save overseas and buy gold, with foreign investors via the Hong Kong Connect also showing increased activity, possibly driven by the fear of missing out.

Another notable trend is the significant slowdown in inflation, highlighted by Canada’s January CPI last week and expected in the Eurozone’s preliminary February CPI this week. The Eurozone, United Kingdom and Canada experienced sharp increases in consumer prices from February 2023 to May 2023.

United States

The January CPI and PPI reports have once again brought market expectations in line with the Federal Reserve’s December projection, suggesting three rate cuts this year might be apt. Federal Reserve Chair Powell has cautioned that as the quarter unfolds, the projections (dot plot) could become outdated. However, to date, the majority of Fed officials speaking publicly seem to have maintained their original stance. By the end of last week, the Fed funds futures reflected the anticipation of three rate cuts, with the probability of a fourth cut standing at less than 30%—a significant reduction from the more aggressive easing expected late last year.

Market participants are primarily focused on two issues. The first concerns the economy’s strength at the outset of Q1 2024. Despite solid job growth in January, retail sales and industrial output fell short of expectations. This cycle has proven unique, with several traditional metrics failing to provide clear guidance, such as the yield-curve inversion, the contraction in M2, and the collapse of leading economic indicators. With current data, it seems the economy may be growing above the Fed’s long-term non-inflationary target of 1.8%, though signs of slowing are expected to become clearer with this month’s data. Notably, weak Boeing orders are likely to impact durable goods orders negatively, and the early prediction for March’s nonfarm payrolls suggests a significant decrease from January’s 353,000 increase.

The second issue at hand is inflation. The personal consumption expenditure (PCE) deflator, targeted by the Fed, employs a different methodology and weighting compared to the CPI. In the second half of 2023, the PCE deflator’s annualized increase was 2%, with the core measure rising by 1.8%. A 0.3% uptick in January would reduce the year-over-year rate to 2.3% from 2.6%, considering the 0.6% rise in January 2023. The core rate’s 0.4% increase could lower the year-over-year figure to 2.8% from 2.9%.

The Dollar Index saw its peak on February 13, coinciding with the January CPI release, reaching around 105.00 and surpassing the 61.8% retracement of its Q4 2023 losses. Since then, it has declined in seven of the eight sessions. A move below the 103.30 level could indicate a potential drop to 102.80 and possibly 102.30. For the first time since early January, the five-day moving average fell below the 20-day moving average last week, signaling a downturn in momentum indicators.

Eurozone

The recent reports on Consumer Price Index (CPI) and Producer Price Index (PPI) have nudged market expectations closer to the Federal Reserve’s December projections, suggesting three rate cuts this year could be appropriate. Despite Fed Chair Powell’s caution that the Summary of Economic Projections (dot plot) might become outdated as the quarter advances, most Fed officials have maintained their stance. Currently, futures for Fed funds are pricing in three rate cuts, with less than a 30% chance for a fourth, marking a significant reduction in easing expectations from late last year.

Market participants are primarily focused on two issues. The first is the state of the economy in early Q1 2024. January showed strong job growth, yet retail sales and industrial output were below expectations. Despite unique business cycle characteristics and some traditional indicators failing to provide clear signals, the available data suggest the economy is growing faster than the Fed’s long-term non-inflationary target of 1.8%. However, this growth is expected to slow, with indicators like weak Boeing orders and a projected decrease in nonfarm payrolls suggesting a downturn. The second issue is inflation, particularly the personal consumption expenditures (PCE) deflator, the Fed’s preferred inflation measure. Unlike the CPI, the PCE deflator uses different methodologies and weights, showing a rise of 2% in the second half of 2023 and a core measure increase of 1.8%. A 0.3% rise in January would lower the year-over-year rate to 2.3%, with the core rate potentially slipping to 2.8% from 2.9%.

The Dollar Index experienced a peak following the January CPI report but has since declined in most sessions. A drop below the 103.30 area could indicate further declines. Technical indicators, including moving averages and momentum indicators, suggest a weakening trend.

In the Eurozone, expectations for sharp declines in headline inflation from March could prompt speculation about an earlier European Central Bank (ECB) rate cut, especially amid reduced growth forecasts. With an assumed monthly inflation increase of 0.3% from February to April, the headline rate could drop below 2%, potentially aligning with the ECB’s April meeting. Despite a firmer core inflation rate, the market is less certain of a rate cut in April than it was at the beginning of the year. Interest rate differentials between the US and Germany have fluctuated but remain a focal point.

The euro’s recent spike and subsequent sell-off highlight ongoing market adjustments. Technical indicators are improving, suggesting a consolidation phase might be ending. However, surpassing the $1.0900-20 area could be necessary for a more significant upward movement, while a drop below $1.0790-$1.0800 indicates that establishing a new low might take additional time.

United Kingdom

The upcoming February Nationwide house price index and January consumer credit and mortgage lending reports are not typically influential factors for the British pound. Nonetheless, political events such as the third by-election of the month in Rochdale could have an undercurrent effect. This by-election, necessitated by the passing of a Labour MP, has garnered attention due to controversies surrounding the candidates from both the Labour and Green parties, related to their comments about the Middle East. Additionally, the election features a former Labour MP, suspended in 2017 for inappropriate communications, now running as the Reform Party candidate under Nigel Farage’s leadership. With local elections scheduled for May and a national election anticipated later in the year, these political dynamics could subtly influence market sentiment towards sterling.

Sterling’s performance last week marked its first gain since mid-January, showcasing the most significant increase since mid-December. Closing at its highest point since January 26, the momentum indicators for sterling have shifted positively. The currency’s recent recovery, moving from a low of around $1.2520 earlier in the month back into the mid-range of the $1.26-$1.28 trading bracket, highlights a return to its late 2023 to early 2024 stability. The $1.2750-$1.2800 range now poses a significant resistance level, signaling a critical juncture for future movements. This technical analysis, combined with the backdrop of UK political developments, suggests a complex landscape for sterling in the near term.

China

The upcoming release of China’s February PMI and the Caixin manufacturing PMI will be scrutinized for insights into the health of its economy amidst debates over the viability of China’s development model. Critics, including Nobel laureate Paul Krugman, have argued that China’s approach, characterized by aggressive diplomacy and a rollback of reforms initiated since Deng Xiaoping’s era, has reached a standstill. The shift away from Deng’s strategy of “peaceful rise” or “peaceful development,” which aimed to reduce friction with the United States, towards a more assertive stance under Xi Jinping, underscores a significant departure from previous policies.

This tension is exacerbated by a mutual perception between Beijing and Washington of the other’s decline, potentially increasing the risk of miscalculation. In response to its dissatisfaction with current growth rates and structures, Beijing is anticipated to implement further stimulus measures, despite the outcome of the latest PMI reports. Recent actions to discourage institutional investors from selling at market open or close, along with discouraging short selling, reflect an interventionist approach to stabilize the stock market. This strategy, while aimed at supporting market confidence, has been criticized for its lack of transparency compared to measures taken by market economies during crises, such as the Great Financial Crisis and the COVID-19 pandemic, where short selling was banned in certain sectors.

The government’s efforts seem to have had an impact, with the CSI 300 experiencing consecutive weekly gains for the first time in three months, signaling a potential stabilization or improvement in market sentiment. This positive momentum in the stock market could alleviate some pressure on the yuan. However, the ongoing depreciation of the Japanese yen suggests that the dollar might still test the upper limits against the yuan, particularly around the CNY7.20 level, which has acted as a ceiling in recent months. Beijing’s management of its currency, alongside its broader economic strategies, remains a critical area of focus for observers and participants in global financial markets.

Japan

The January Consumer Price Index (CPI) in Tokyo, released several weeks ago, signaled disinflationary pressures, running slightly below the national figures due to differences in weights. The headline and core CPI in Tokyo dropped to 1.6% from 2.4% and 2.1%, respectively, suggesting a potential nationwide slip below 2% for January. This aligns with the unexpected contraction of the Japanese economy in Q4 2023, complicating the Bank of Japan’s (BOJ) anticipated move away from negative interest rates. The BOJ’s approach appears more technocratic, focusing on the challenges negative interest rates pose to monetary policy effectiveness, rather than purely economic indicators. The significant decline in January industrial production, influenced by an early January earthquake, is unlikely to deter the BOJ’s direction.

Japan’s retail sales data is forthcoming, with consumer spending contracting for three consecutive quarters through the end of last year. Despite a decrease in consumer spending and a significant monthly drop in retail sales, the strongest quarterly industrial output in two years was recorded in Q4 2023. January’s industrial production report and employment figures, with the unemployment rate hitting a three-year low at the end of last year, are also awaited.

In the US, yields reached new yearly highs last week, with the dollar continuing its upward trajectory. Despite the low implied three-month volatility, suggesting a stable market, Japan’s negative interest rate policy may limit sympathy from international counterparts for significant intervention in the currency market. However, caution may prevail as the yen approaches the JPY152 level, a previous resistance point. Anticipation of softer upcoming data, including the US February jobs report, could potentially ease pressure on US rates and the yen, reflecting a cautious outlook for both economies.

Canada

Canada is set to release its GDP figures for December and the fourth quarter of 2023 on February 29, being one of the last G10 nations to do so. Following a contraction of 1.1% in Q3 2023, the Canadian economy is anticipated to have returned to growth in the final quarter. Estimates suggest a growth rate of approximately 0.2% for December, building on a similar expansion in November, which marked the end of a three-month period of stagnation. Bloomberg’s survey points to a median forecast of 0.3% growth for each of the first two quarters of this year. The swaps market is pricing in a roughly 75% chance of a rate cut by June, a stark change from the beginning of the month when a cut was fully expected.

The US dollar has been trading within a specific range against the Canadian dollar since the release of the US January CPI report on February 13, oscillating between approximately CAD1.3440 and CAD1.3585. This range aligns closely with the 50- and 100-day moving averages (around CAD1.3410 to CAD1.3540), with the 200-day moving average sitting midway within this span. The Canadian dollar’s value remains closely tied to the broader risk environment, as evidenced by a rolling 30-day correlation with the S&P 500 at about 0.56, indicating a strong link to global market sentiments and positioning at the higher end of its typical range over the past year. This sensitivity highlights the influence of global risk trends on the Canadian currency, making it a key factor to watch in the context of financial markets.

Australia

The Antipodean currencies, particularly those of New Zealand and Australia, are positioned differently in the anticipated easing cycle, with Japan being the notable exception among major economies. The swaps market currently anticipates a possible rate hike by the Reserve Bank of New Zealand (RBNZ) by the end of May 2024, with about a 60% likelihood, reflecting expectations for the first half of the year. However, by the end of November, a rate cut is virtually fully priced in, demonstrating a significant shift in monetary policy expectations within the year.

Conversely, the Reserve Bank of Australia (RBA) is facing a clearer easing bias, though the market does not fully price in the initial cut until September 2024, despite there being an approximately 85% chance of a cut as early as August. This outlook is influenced by Australia’s monthly CPI data, which showed a significant drop from 8.4% at the end of 2022 to 3.4% by the year’s end, with the Q4 2023 CPI decreasing to 4.1% from 5.4% in the previous quarter. The RBA’s projection of CPI falling to 3.2% this year adds to the anticipation of potential rate cuts, although the market and policymakers seem to place greater emphasis on quarterly inflation data for their decisions. January’s retail sales in Australia, which declined by 2.7% month-over-month, may overstate the impact of recent rate hikes, including the last increase in November 2023, on consumer spending.

The Australian dollar’s performance reflects these economic undercurrents, with the currency achieving three consecutive weeks of gains after an initial five-week decline at the start of the year. Reaching its highest closing level since February 1 just before the weekend, the Australian dollar is on an eight-day rally, supported by bullish technical indicators, including a crossing of the five-day moving average above the 20-day moving average for the first time since early January. The immediate technical resistance lies in the $0.6600-$0.6625 range, while a fall below the $0.6520 area could signal a reversal of the recent upward momentum.

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