As the year of aggressive monetary tightening winds down, the Federal Reserve, the European Central Bank, and the Bank of England will likely slow the pace of rate hikes. All three delivered 75 bp hikes in November and will probably hike by 50 bp this month and moderate the pace again in the first part of next year.
Price pressures remain elevated even if near or slightly past the peaks. The G10 central banks are not finished tightening, though central banks from several emerging markets, including Brazil, Chile, and Czech, may be done. The fact that the UK and the eurozone have likely entered a recession will not prevent the Bank of England or the European Central Bank from tightening further. The US economy has proven quite resilient after contracting in the first half when companies found it difficult to manage inventories with the supply chain disruptions. However, the tightening of financial conditions, the inversion of the 3-month/18-month curve that Federal Reserve Chair Powell highlighted, and weakening global demand warn that the US economy may not be out of the woods.
The labor market's strength gave the Federal Reserve the encouragement to engage in the most aggressive tightening in its history. Counting the 50 bp move in December that has been signaled by Fed officials and fully anticipated by the market, it would bring the hikes to a cumulative 350 bp in the past seven months, and its balance sheet is unwinding faster than it did after the Great Financial Crisis. Last December, the Fed's Summary of Economic Projections had the median dot for the end of 2022, Fed funds at a little less than 1%. The two highest dots were at 1.125%. Instead, the year-end target range will most likely be 4.25%-4.50%. A year ago, the median projection was for Fed funds to be 1.6% at the end of 2023. In September, it was 4.6%, and the December iteration will likely be 5%, if not a little higher.
Still, despite the market expectation of the terminal rate to be closer to 5% than 4.5%, which it had discounted at the end of September, and the more hawkish Fed stance, the derivatives market continues to price a Fed rate cut in Q4 23. Fed rhetoric cautions against expectations of a cut but investors and businesses are concerned about the economic outlook. There are several yellow flags. First, there is that the long-end of the curve is now below the Fed funds target and the other inversions are associated with recession conditions. Second, there is a string of eight consecutive monthly declines in the Leading Economic Index and five months that the Composite PMI has been below the 50 boom/bust level. Third, the ISM services index has been trending lower since the end of Q1 and, in October, has fallen to its lowest level since May 2020.
Investors who are more pessimistic toward the United States seem unreasonably optimistic toward China. There was a narrative that with Xi having secured his position (as if the 20th Party Congress granted rather than acknowledged it), he was free to pivot from zero-Covid, aiding the property sector more and rebuilding ties with the US and Europe. Although several large banks upgraded their outlook for Chinese equities within a couple of weeks of the end of the Congress, we are more skeptical of each of the so-called pivots.
China's zero-Covid policy is not simply the result of overzealous officials. Still, it is also a reflection of its poor health infrastructure and its inability, according to domestic and international doctors, to cope with the like surge in cases that would likely accompany as significant relaxation. It deals with a weaker vaccine and reportedly low inoculation rates, especially among the elderly. Hong Kong, which was supposed to be the model, is experiencing a powerful surge, and its hospitals have had to turn around non-emergency procedures starting in late November. The rise in infections has laid to rest an idea of a meaningful shift from the zero-Covid stance. Still Beijing has pushed back against what it sees as overzealous local officials.
New measures were announced to support the property market. Yet not only is there a gap between declaratory and operational policy, but we are not convinced that excess capacity is addressed by the new measures, which seem aimed at reflating the property market from the supply side. For many years, the critical role it played in Chinese development, growth, and investment led to excesses that have not been absorbed. Investors also are optimistic that China's relative isolation on the world stage is ending. This seems to be the most ill-founded of the three hopes/wishes. China indeed signed on to the recent G20 statement condemning the war in Ukraine, and the US and China have renewed bilateral climate talks. US Secretary of State Blinken will visit Beijing, and there have been other high-level talks.
Yet, this barely returns the relationship to where it was before US House Speaker Pelosi visited Taiwan. That China is critical of the war in Ukraine should not be surprising. The consequence, which includes a larger NATO, is a closer examination of Chinese state-owned-enterprises purchases of European and Canadian companies, especially in the infrastructure, mining, and technology areas. The US is determined to block China from acquiring the latest semiconductor chip capability, and recent data suggests it is beginning to bite. Still, the US practice of announcing sanctions and then seeking to secure support from its allies (cart, horse issue) could undermine the strategy, creating the kind of arbitrage room, as it were, between Europe and the US that China looks to exploit. We see little to detract from Henry Kissinger's observation that we are in the "foothills" of a new Cold War.
In addition to the Fed's tightening and China's Covid and property sector challenges, Japan's extraordinary monetary policy is a third element of the investment climate. Japan's headline CPI rose to 3.7% in October, matching its highest in 30 years. The Bank of Japan targets the core rate, which excludes fresh food. At 3.5% year-over-year, it has not been this high in forty years. Yet, the BOJ insists the price pressures are not sustainable and do not warrant a change in its negative overnight rate or Yield Curve Control, which caps the 10-year yield at 0.25%. The BOJ forecasts core CPI to fall to 1.6% next year, and the market concurs (the median forecast in Bloomberg's survey is 1.7%). Moreover, the market is more aggressive than the BOJ for 2024, when it sees core inflation falling to 1.0%, while the BOJ sees it steady at 1.6%.
Although capping the 10-year yield has distorted the market, the BOJ appears under little pressure to abandon it. The economy unexpectedly contracted in Q3 and appears off to a weak start in Q4. The government has provided new fiscal support, which may help support growth and limit price pressures. The 20-year government bond yield has fallen from nearly 1.33% in late October to less than 1.15% at the end of November. The 30-year bond yield has fallen a little more after peaking near 1.72% in late October. The BOJ's balance sheet is still expanding, a metric that indicates monetary policy is still easing. There appears to be little chance that Japanese monetary policy will be altered soon.
Without an improvement in the outlook for world growth, emerging markets as an asset class performed well in November. This may be linked to the softer US rate profile and the pullback in the dollar. The MSCI Emerging Markets Index rose by 14.6% in November to pare the year's loss to 21%. The MSCI World Developed Market Index rose by about 6.8% in November and narrowed the year-to-date loss to 15.8%. The premium paid by emerging markets over Treasuries fell by over 30 bp last month, and to around 388 bp is the lowest since June (using the JP Morgan Emerging Market Bond Index). The JP Morgan Emerging Market Currency Index rose 2.9% in November, its largest gain since March, leaving it down about 4.4% for the year.
As we suggested last month, Bannockburn's World Currency Index (a GDP-weight basket of the 12 largest economies) looks to be carving out a bottom corresponding to a top for the US dollar. It gained a little more than 2% in November, matching its biggest gain since January 2018. The Brazilian real was the only currency in the index that fell in November. Its 0.2% loss was also mitigated by its small weighting in the index (2.1%). The 8% surge made the South Korean won the best performer in the index. It has a 2.4% weighting in the BWCI. The yen was the strongest G10 currency in the in basket last month, appreciating 7.7% against the US dollar, which is its best showing since October 2008. We suspect the more than 40 bp decline in the US 10-year yield was more important than the September-October intervention in lifting the yen. In addition, another three other G10 currencies in the index rose by 5% or more: the euro, sterling, Australian dollar. Together, they account for about a quarter of the index.
Dollar
The greenback stumbled in November. More banks and funds now think that its high is in place. The terminal Fed funds rate reflected in the futures market vacillated by a little more than 12 bp on either side of 5.0% since mid-October. The extent of various parts of the yield curve inverting, cumulative effects of Fed tightening and dollar appreciation, coupled with some indicators that the order pipeline is drying up, elevates fears of a bona fide recession next year. The global economy appears set to slow, and this is a source of additional headwinds to the US economy. The market continues to price in a rate cut in Q4 23. While we have been looking for the dollar's bull market would end when the market was confident that the Fed was nearing the end of its tightening cycle, we are concerned that technical indicators warn that it is oversold on a near-term basis. While delivering a 50 bp hike after four consecutive 75 bp moves, we expect Chair Powell to underscore that 50 bp is not "dovish" by any stretch of the imagination and may protest the "premature" easing of financial conditions seen in recent weeks.
Euro
The euro appreciated by around 5.25% in November. It was the best monthly performance in a dozen years and the first back-to-back monthly gain since April-May 2021. This primarily reflected the broad dollar setback rather than favorable developments in the euro area. In fact, the euro underperformed most G10 currencies last month. Still, the narrowing of Italy's premium over Germany (four-month lows for two-year tenors and seven-month lows of the 10-year differential) is a supportive development. The ECB meets on December 15, and the swaps market leans toward a half-point move after two 75 bp hikes. The smaller-than-expected early pre-payment of the long-term loans (TLTROs) may bring the beginning of QT proper to H1 23. The euro spent a bit of time in November above its 200-day moving average for the first time since June 2021. Our near-term concerns are that the euro's advance has stretched momentum indicators and has seen speculators in the futures market amass the largest net long euro position since mid-2021. Still, a move above $1.05 would target the $1.0600-$1.0650 area. A break of $1.0200 suggests a corrective phase is unfolding that could see losses toward parity.
(November 30 indicative closing prices, previous in parentheses)
Spot: $1..0405 ($0.9965)
Median Bloomberg One-month Forecast $1.0320 ($0.9350)
One-month forward $1.0445 ($0.9985) One-month implied vol 12.3 (11.1%)
Japanese Yen
The Bank of Japan spent more than $60 bln (~JPY9.18 trillion) intervening in the foreign exchange market in September and October. It did not need to intervene. The dollar fell by about 7.5% in the first half of November, helped by the nearly 40 bp decline in the US 10-year yield over the same period. Intervention bought time for US yields, arguably a key driver of the exchange rate, to price in both Fed hikes, the expected peak, and the coming slowdown. The dollar held above crucial support near JPY137.25. A break of this area could signal a move toward JPY130-JPY133. Meanwhile, Japan's inflation is accelerating even without crucial wage support, which the BOJ says is necessary to sustain the increase in price pressures. The Tokyo November figures (3.8% headline, 3.6% core rate, which excludes fresh goods, is targeted rate at 2%) warn that national figures have not peaked. The government's fiscal measures may help on the margins of both inflation and growth. However, the OCED's newest forecast of 1.8% growth next year seems somewhat optimistic.
Spot: JPY138.05 (JPY147.60)
Median Bloomberg One-month Forecast JPY138.95 (JPY146.30)
One-month forward JPY137.25 (JPY147.10) One-month implied vol 13.7% (12.9%)
British Pound
We felt confident that the capital strike against the Truss government's fiscal plans marked a significant low in sterling (~$1.0350 at the end of September) and suggested a $1.20 target for November. It surpassed this and rose slightly above $1.2150. Sterling's 5.1% surge in November was the largest monthly advance in July 2020. The good news is known. The capital strike was reversed, and the 30-year UK premium over Germany returned to status quo ante (less than 140 bp) before bouncing late in November amid supply concerns. The unfunded deficits to pursue debt-financed stimulus as the economy enters a protracted recession were rejected. Still, the new government's austere approach will also have a price. Backloading some of the pain until after the next election (no later than January 2025) will not help the Conservatives close the wide advantage that Labour enjoys in opinion polls for some time. The fissures within the Tory Party have seen to a short honeymoon for Prime Minister Sunak. The Bank of England will likely lift the base rate 50 bp when it meets on December 15, bringing the target to 3.5%. The swaps market sees another 125 bp increase before Q4 23. The BOE is also selling the bonds it bought for financial stability and reducing its holdings of bonds to ease policy during the Covid shutdown, actively and passively. Sterling looks overbought in the near term. The $1.1700-50 area offers support. On the upside, the next important area is around $1.2350-$1.2500.
Spot: $1.2060 ($1.1615)
Median Bloomberg One-month Forecast $1.1890 ($1.1240)
One-month forward $1.2085 ($1.1625) One-month implied vol 12.6% (13.0%)
Canadian Dollar
The outperformance of the Canadian economy has ended, and the Canadian has underperformed in Q4. After growing by a little more than 3% at an annualized pace in the first half, the Canadian economy slowed less than expect in Q3 to 2.9%. It is expected to slow to around 0.5% in Q4 before contracting in the first part of next year. The Canadian dollar performed best against the US dollar in H1 22, falling about 1%. The second-best currency was the Swiss franc, which depreciated by nearly 4.4%. The Canadian dollar was a middling performer in Q3, losing almost 7% against the US dollar. Its 3.0% gain so far in Q4 puts it at the bottom of the G10. That said, we think the US dollar peaked against the Canadian dollar in October, near CAD1.40. It found support ahead of CAD1.32. We continue to anticipate a test on the CAD1.30 area in the coming weeks. The Bank of Canada is slowing the pace of rate hikes. Following a 100 bp hike in July, it raised the overnight target rate by 75 bp in September and 50 bp in October. A 25 bp hike is most likely when it meets on December 7, though a half-point move cannot be entirely ruled out. A quarter-point move will rate the target rate to 4.0%. The swaps market is pricing in a peak of almost 4.5% by the middle of next year and leans toward a cut in Q4 23. The exchange rate is particularly sensitive to the risk appetite, for which we use the S&P 500 as a proxy. The rolling 60-day correlation reached almost 0.79 in late November, the highest in a decade. It has been relatively stable and has not been less than 0.70 for the past two months.
Spot: CAD1.3410 (CAD 1.3595)
Median Bloomberg One-month Forecast CAD1.3425 (CAD1.3650)
One-month forward CAD1.3415 (CAD1.3590) One-month implied vol 9.3% (8.9%)
Australian Dollar
The Australian dollar snapped a three-month decline and rose nearly slightly more than 6% against the US dollar in November, its best monthly performance since April 2020. Economists hold out the possibility that Australia can escape an economic contraction, and the central bank has dialed back its tightening. After four 50 bp hikes in June-September, it delivered quarter-point moves in October and November. The swaps market is not convinced that the Reserve Bank of Australia will hike in when it meets on December 6. The headline and the trimmed mean measure of consumer prices slowed in October, at 6.9% and 5.3%, respectively, but clearly are still elevated. We expect the RBA to lift the target rate from 25 bp to 3.10%. We envision another 50 bp in H1 23. The Australian dollar appears to have set a significant low in mid-October (~$0.6170). The recovery stalled in November near $0.6800. A convincing break of it signal a move into the $0.6920-$0.7000 area. Short-term momentum indicators are stretched and a setback signal $0.6600.
Spot: $0.6790 ($0.6410)
Median Bloomberg One-month Forecast $0.6720 ($0.6455)
One-month forward $0.6805 ($0.6420) One-month implied vol 14.3% (14.9%)
Mexican Peso
The peso broke out of a two-and-a-half-month trading range to rise to its best level since March 2020 in mid-November. The US dollar was flirting with the lower end of its MXN19.80-MXN20.20 spectrum at the end of October and broke down to almost MXN19.00. The dollar consolidated in the second half of November, and the peso seemed to weaken as cross positions, especially the carry trade against the Japanese yen, was unwound. However, the peso surged into the end of the month in a move that seem to exhaust the bulls. The greenback briefly traded below MXN19.05. The cumulative effect of higher interest rates and anticipated slowing of the US economy risk tipping Mexico into a downturn of its own but only beginning around mid-2023. Mexico's central bank will likely continue to match the Fed's moves, which means a half-point hike at the December 15 meeting and another 50 basis points in the first part of next year. That would bring the terminal policy rate to 11%. Dollar bounces run into resistance near MXN19.60 and MXN19.80. Before Covid, the dollar was trading below MXN18.80.
Spot: MXN19.27 (MXN20.7980)
Median Bloomberg One-Month Forecast MXN19.47 (MXN20.04)
One-month forward MXN19.3750 (MXN19.90) One-month implied vol 11.2% (10.3%)
Chinese Yuan
The Yuanis a closely managed currency. The central bank sets a daily reference rate, and the dollar can move no more than 2% away from it. Other major currencies have a wider band. Rarely is the full band explored. The large banks are state-owned, and their activity in the foreign exchange market is often seen as doing the work for officials, though how close and formal the link may be is subject to debate. Few would ascribe a tight connection, for example, if a Japanese bank reduced long dollar positions when the BOJ threatened intervention. Similarly, the US 2-year note yield rose by around 125 bp between September 2021, when the Federal Reserve first intimated it would begin normalizing policy, until the first rate hike in March 2022. No one argued this was a stealth intervention. Unable to decipher the machinations of Chinese officials, it seems notable that in recent weeks, the correlation (60-day rolling basis) of changes in the yuan, euro, and yen has increased to multi-year highs. This suggests that the broad dollar direction may be the most critical driver of the yuan's exchange rate. A move back below CNY7.0 seems likely.
Spot: CNY7.0925 (CNY7.2525)
Median Bloomberg One-month Forecast CNY7.1210 (CNY7.2095)
One-month forward CNY7.0150 (CNY7.2090) One-month implied vol 8.9% (8.6%)
