Dollar Regains Some Traction as Markets Search for Direction

House Democrats will move ahead with impeachment proceedings today. A vote is expected by late afternoon. An important twist here is that more Republican lawmakers have said they will vote to impeach President Trump, including number three House Republican Liz Cheney. Elsewhere, reports suggest Republican Senate Majority Leader McConnell is happy with these developments, as they will help purge Trump from the Republican party. That said, it’s not clear when or if a Senate trial will be held before Biden’s inauguration January 20, as the Senate is on recess until the day before. As we have said before, impeachment is a largely symbolic gesture at this point.

December CPI data will be the US highlight.  Headline inflation expected to pick up a tick to 1.3% y/y and core inflation expected to remain steady at 1.6% y/y.  PPI will be reported Thursday, with headline inflation expected to fall a tick to 0.7% y/y and core inflation expected to fall a tick to 1.3% y/y.  The inflation debate has picked up with the unexpected return of the Blue Wave and so this data has taken on more significance. The US curve steepening is taking a breather today but at 105 bp, the 3-month to 10-year curve is still quite near the year’s high from March 18 near 120 bp.

US Nominal Interest Rates, 2020

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This is  a lot of paper for the market to digest but so far, so good. In fact, the 10-year yield traded as high at 1.18% yesterday before reversing sharply, suggesting investors (for now) will snap up US debt when rates go higher. Looking ahead, the next round of stimulus will have to be funded by increased debt issuance.  While it’s not too surprising that curve steepening continues, we need to see whether it picks up and see how the Fed reacts.

Speaking of bond supply, the December monthly budget statement will be of interest. A deficit of -$143.5 bln is expected. If so, the 12-month total would rise to a record high -$3.35 trln. As the economy continues to suffer, receipts are falling y/y while upward pressure remains on outlays. With another slug of fiscal stimulus likely in the early days of the Biden administration, these deficit numbers will only get worse this year. For now, the market has been able to absorb the supply without much dislocation, but this will surely be tested in the coming months. If the market cannot absorb this increased issuance, the Fed will have to start thinking about increasing its asset purchases, not tapering them.

The Fed releases its Beige Book report.  It is being prepared for the upcoming January 26-27 FOMC meeting.  Since the last meeting December 15-16, the US outlook has clearly darkened and so the Beige Book should reflect this.  The labor market has clearly softened as the economy lost momentum amidst rising virus numbers.  While we expect some divergence between the manufacturing and service sectors may be highlighted, the overall tone of the report is likely to be fairly cautious and perhaps even downbeat.

UK Covid-19 Hospital Admissions, 2020

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EUROPE/MIDDLE EAST/AFRICA

Italian political noise continues. Former Prime Minister and current Italia Viva leader Renzi will hold a press conference today regarding a possible decision to pull his ministers from the ruling coalition. We believe this is largely posturing on the part of Renzi. His party has only 3% support in recent opinion polls and so we suspect Renzi will try to avoid triggering fresh elections. Also, no one wants to be known as the one that forced the populace to vote during a pandemic. Italian yields have been climbing recently, but this has been in large part due to the global bond sell-off as the reflation trade gets more traction.

The UK and German governments warned of more restrictive measures. Chancellor Merkel said the lockdowns may have to be prolonged given the new virus strain. In the UK, PM Johnson is threatening harsher measures for those not respecting the rules. Hospital data show there are now more patients in ventilators in the UK than during the April peak. Elsewhere, eurozone reported firm November IP. It jumped 2.5% m/m vs. 0.2% expected, while the October gains was revised up to 2.3% from 2.1% previously. Of note, Italian IP surprised to the downside, falling -1.4% m/m vs. -0.4% expected.

Russia will restart its reserve accumulation policy. This will keep the nascent ruble appreciation pressures under check and start raising FX reserves as oil prices continue to climb. The Finance Ministry will start buying the equivalent of $1.4 bln between January 15 and February 4. Russia has been a net reserve seller from its sovereign wealth fund since March. The ruble remains one of the weakest EM currencies since the pandemic, with the euro-dollar basket down some 25%. Despite the undeniable positive fundamental story for Russia and our positive outlook on commodities, we still think the risk-reward is better for other commodity plays (such as Brazil) in the near term, or at least until we get a more visibility on Biden approach towards Putin.

EM FX 12-Month Performance

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ASIA

Japan’s government extended a state of emergency to seven more prefectures. This brings the total number up to eleven, which means that prefectures that account for nearly 60% of the nation’s GDP are now under lockdown. Plans to end the state of emergency in a month have been roundly criticized as too optimistic, leading many to forecast potential economic contraction in Q1. Elsewhere, Japan reported December machine tool orders. Order rose 8.7% y/y vs. 8.6% in November, with base effects flattering the readings .

The Bank of Japan meets January 20-21. While no change in policy is expected, reports suggest the BOJ may downgrade its economic assessment then. It may also mark down its GDP forecast for FY20 ending in March because of the emergency from the current -5.5%. With Suga’s popularity likely to continue falling as the economy weakens, we expect another fiscal stimulus package by mid-year to try and help shore up his support ahead of fall elections.

PBOC may be getting uncomfortable with yuan strength. The central bank set its daily fix at its weakest level relative to market modeling since mid-2018. This follows several minor measures in recent weeks that were designed to encourage capital outflows and limit capital inflows. That said, the yuan is simply reflecting the weak dollar trend that has seen many EM currencies trade at multi-year highs. Similar to other EM central banks, the best that the PBOC can hope for is to slow the move, not reverse it.