by Marc Chandler
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With this month's hike, the Federal Reserve would have raised overnight rates by 300 bp while doubling the pace that its balance sheet is shrinking over the past 100 days. The US economy is the largest in the world, and US interest rates and the dollar are vital benchmarks. America's centrality remains in what has been dubbed a G-Zero world, even if its share of the world economy is a bit less than it used to be, or the dollar's share of global reserves has been eroded a bit more by the smaller currencies than the euro or yuan. So what happens in the US often has repercussions around the world.
It is striking that a little more than a year ago, US leadership was questioned over how it withdrew from Afghanistan, and parallels with Vietnam were drawn. Since then, US intelligence about Russia's intentions and plans proved spot-on, and the US has been instrumental in the Ukrainian-imposed humiliation of Moscow. Still, ironically, Putin has succeeded where American leaders have failed: Germany and others in Europe will boost defense spending. The Nord Stream 2 pipeline, which the US long objected to, may never operate. Going forward, Europe will rely more on the US for energy and military hardware. Sweden and Finland will join NATO.
China has been weakened by Russia's invasion of Ukraine. Europe's experience over the past year makes it more suspicious of the authoritarian government in Beijing. It does not want to make the same mistake it made with Russia by thinking commercial ties can overcome political differences. US allies in the Asia Pacific region, especially Japan and Australia, have stepped up their military preparedness amid heightened fears of similarities between Russia and Ukraine and China and Taiwan. Ukraine's successfully repulsing Russian forces also offer the Taiwanese people a powerful and positive message. And in a striking demonstration that Russia's actions are not distracting the US from the strategic challenge posed by Beijing, new sanctions by the Biden administration threaten to seriously disrupt China's semiconductor industry.
The geopolitical backdrop is challenging, but US adversaries are largely suffering from self-inflicted wounds. And as we spend more time thinking and planning for next year, having a sense of the trajectory of the US economy, Fed policy, and interest rate is critical for businesses, households, and consumers. Unfortunately, the domestic challenges may be greater than the international ones, and the worse has yet to come.
Around the time the US withdrew from Afghanistan, the Federal Reserve pivoted and committed itself to the process of normalizing monetary policy after the Covid crisis. Between the signal and the first rate hike (March 2022), the two-year yield rose more than 125 bp, underscoring the importance of the communication channel of policy. US businesses struggled to manage inventories as the economy re-opened unevenly amid supply-chain disruptions. Who can forget the pictures of the congestion at US West Coast ports? China's zero-Covid policy led to lockdowns of key manufacturing/export areas, compounding the difficulties. Using GDP math, the trade and inventory developments saw the US economy contracted in H1. While worrisome, most seemed to recognize the quirkiness and resisted drawing the conclusion that the US was in a recession.
The US economy bounced back in Q3, as the drag from trade in H1 22 was reversed. But surveys are picking up caution among businesses as concern about demand becomes more salient. The path to avoiding a bona fide recession looks exceptionally narrow. The federal government and the Federal Reserve are tightening policy aggressively. The fiscal headwinds are not fully appreciated, as monetary policy is often the focus. However, the US budget deficit is expected to fall from 10.8% of GDP in 2021 to 4.2% this year. After the Global Financial Crisis, achieving this magnitude of fiscal consolidation took several years.
The Federal Reserve is engaged in one of its most aggressive tightening operations, even if it was slow to begin. Moreover, the Fed continues to be surprised by the magnitude and persistence of inflation. In June, with monetary tightening well underway, the median Fed forecast was for the Fed funds to be 3.375% at the end of this year and 3.75% at the end of 2023. Three months later, the median jumped to 4.375% and 4.625%, respectively. Even this might not be enough. The futures market is closer to 4.5% at the end of this year. It sees a peak between 4.75% and 5.0% in late Q1 23 or early Q2 23. No Fed official in September anticipated a Fed funds target rate above this at the end of next year.
There are several dimensions of the labor market. Job growth remains strong, and job openings are plentiful. The unemployment rate stood at 3.5% in September, matching the lowest since 1969. Average hourly earnings are 5% above year-ago levels, which the Fed sees as another sign of the tightness of the labor market, even though wage growth has not kept pace with inflation. A negative nonfarm payroll report would be a wake-up call. Households coping with the cost-of-living squeeze by drawing down savings and heavily using credit cards. Many had taken equity out of their homes when they refinanced mortgages, but the higher rates dried up this source.
Financial instability can take many forms. What previously stopped the unwinding of the Fed's balance sheet was the strains in the banking system from extinguishing reserves. Around the October IMF/World Bank meetings, US Treasury Secretary Yellen expressed concern about the liquidity in the US Treasury market. To improve liquidity, the US Treasury is considering issuing extra notes and bonds and using the proceeds to buy back off-the-run issues. In late October, the German Finance Agency also addressed its liquidity challenge by increasing the amount of securities the Bundesbank can lend to traders in the repo market.
In addition, some observers put an emphasis on the blowback from trouble abroad, such as the Bank of England stepping back into the market recently to buy bonds, the Bank of Japan's intervention in the foreign exchange market for the first time since 1998 to stop the yen from falling, and the increasing difficulty in securing dollar funding. In planning for next year, we need to recognize that the headwinds are set to intensify next year. The cumulative effect of the tighter monetary and fiscal policies has not yet worked its way through the economy. Moreover, the Federal Reserve will likely continue to raise interest rates through at least the first quarter of next year. As a result, the recession that may have been avoided in 2022 looks bound to come to the US (and Europe).
The UK has its fifth prime minister in six years since the referendum to leave the European Union. Truss's fiscal gamble was rejected by the markets and then by parliament. The old orthodoxy was restored. The tax cuts and some spending initiatives were reversed. Still, all three major rating agencies have a negative outlook for UK creditworthiness. S&P has the UK as a AA credit, while Moody's and Fitch have it as an equivalent of AA-. Sterling did not trade below $1.0920 in October after reaching $1.0350, according to Bloomberg on September 26. The UK's 30-year bond surged from around 3.5% in mid-September to above 5% and returned to below 3.50% in late October. There is no "moron premium," as some observers have suggested. The US premium over the UK for this long maturity is back to the level seen in mid-September (~50 bp) as has the UK's 30-year premium over Germany returned to early September levels (~150 bp).
If the developments in the UK were the most dramatic last month, resulting in a new prime minister this month, then developments in China were mainly as advertised. Xi solidified his control of the Communist Party. This will translate into greater control of the state when appointments are announced in March. The iconic image of Xi's predecessor being unceremoniously escorted from the closing of the 20th Party Congress captures the moment better than the rhetoric. Xi's wing of the Communist Party appears to be fiercely nationalistically, less interested in market reforms, and undeterred in challenging the global order.
The JP Morgan Emerging Market Currency Index stabilized in October after falling by nearly 8.5% in the slide over the previous four months. While equity markets in the high-income countries rallied in October, emerging markets underperformed. The MSCI Emerging Market Index fell to new two-and-a-half years lows in late October. It fell by about 3% after dropping nearly 12% in September.
The Bannockburn World Currency Index (GDP-weighted of the dozen largest economies) snapped a four-month drop. Most currencies in the index appreciated in October. However, the muted gain was due to the losses suffered by four currencies that account for slightly more than a third of the index.
The Russian rouble fell by 2.3% and was the weakest currency but has a small weight in the index (~2.2%). The Chinese yuan's nearly 1.9% decline was more significant given its 21.8% weighting, the most after the dollar (~31.0%). The Indian rupee fell by 1.4% and has a nearly 4% weight in the index. The Japanese yen was the only major currency in the basket to decline. The yen has a weighting of about 7.5 and is the fourth most important currency in the index. Perhaps, surprisingly, its 4.0% gain makes sterling the best-performing currency in the index. The Brazilian real was the second strongest with a 2.3% appreciation. The euro and Canadian dollar were next. They both rose by a little more than 1.6%. Broadly speaking, we suspect that BWCI may be forging a low, which is consistent with our sense that the dollar may be carving out a top.
Dollar: The greenback was looking tired as October wound down. The key force lifting the dollar was the outlook for Fed policy. The market now sees a terminal rate of 4.75%-5.00% in H1 23. Moreover, after its fourth 75 bp increase, widely expected to be delivered on November 2, the market anticipates the Fed will slow the pace of increases. After a 50 bp increase in December, which brings the upper end of the Fed's target range to 4.50%, the market is pricing in 1-2 quarter-point moves to finish the cycle. The market continues to price the Fed's first cut late next year. At the end of Q3, the implied yield of the December 2023 Fed funds futures contract was about 12 bp below the September 2023 contract. By the end of October, the discount had doubled to 24 bp. We expect CPI to come off sharply over the next few quarters beginning with the October reading due November 10. We suspect the dollar is in the process of carving out top to this historic rally.
Euro: The eurozone economy is on the edge of a recession. The energy shock and broader cost-of-living squeeze are taking a toll, yet with inflation above 10%, the European Central Bank has little choice but to continue to tighten policy. After a 50 bp hike in July, the ECB hiked by 75 bp in September and again in October. The market is pricing in at least a half-point move in December, and after the preliminary national October readings, the market unwound the shift after the ECB meeting and has another 100 bp of hikes discounted through Q1 23. Many eurozone members are trying to protect households and small businesses from the surge in energy prices. The euro's decline exacerbates inflation, but the depreciation against the dollar overstates the case as the trade-weighted index has fallen by less than half as much. A break of the $0.9800 area negates some of the constructive technical developments seen in October. A trendline drawn off the September and October lows is around $0.9830 in mid-November and near $0.9940 at the end of the month. As widely expected, following the collapse of the Draghi government, Italy has elected among the most right-wing governments in modern times. The more conservative forces also won the Tory Party leadership contest and Sweden's general election. In anticipation of rising tensions with the EU, the premium demanded by investors for Italian debt had risen sharply, but fell to two-month lows in late October. ECB President Lagarde has been explicit that the new Transmission Protection Instrument will not be used to save countries from their policy mistakes. This will be a potential flash point in the period ahead.
(October 28 indicative closing prices, previous in parentheses)
Spot: $0.9965 ($0.9800)
Median Bloomberg One-month Forecast $0.9835 ($0.9800)
One-month forward $0.9985 ($0.9825) One-month implied vol 11.1 (13.3%)
Japanese Yen: While the Bank of Japan is expanding its balance sheet and capping the 10-year government bond yield at a lowly 0.25%, it has sought to support the yen by selling an estimated $30-40 bln in October. The greenback had risen for 12 consecutive sessions through October 20 and threatened to climb further. Looking at the historical charts, officials may have recognized the same thing the market did. There was little standing in the way of a move to JPY160. When the BOJ intervened in September, the dollar had approached JPY146. In October, the dollar neared JPY152.00. The intervention late last month was unable to drive the dollar below JPY145.00. Still, Japanese officials appear to be playing for time, buying some (expensive) stability with the hope of a peak in US rates soon and to the J-curve effect that is worsening the trade balance. Benchmark three-month implied volatility rose to almost 13.5% in September before the BOJ intervened and set a new two-and-a-half-year high near 15% last month.
Spot: JPY147.60 (JPY144.75)
Median Bloomberg One-month Forecast JPY146.30 (JPY143.10)
One-month forward JPY147.10 (JPY138.55) One-month implied vol 12.9% (12.1%)
British Pound: As it became clear that fiscal orthodoxy will retain its grip on the UK, sterling recovered in October. The new government will likely boost taxes and cut spending. Reports suggest as much as GBP50 bln in austerity. Even though the UK is either in a recession or about to enter one, sterling looks to have put in a significant low in late September at a record of around $1.0350. It pushed above $1.15 in late October and approached $1.1650. A move above $1.1750 could signal a test on $1.20 before year-end. Ideas that the Bank of England would hike as much as 150 bp at the November 3 meeting have been scaled back. The market seems split between 50 bp and 75 bp. A three-quarters-point hike would be the most in the cycle that began last December. In addition to the rate hikes, the BOE's balance sheet will resume its decline that was interrupted by the emergency actions it took. The balance sheet had fallen by around GBP17.2 bln from mid-August to the end of September. The emergency action boosted its balance sheet by nearly GBP20 bln. The fiscal statement was pushed out until November 17 to allow the Office for Budget Responsibility to take lower rates that are prevailing into account when they share their assessment. According to some estimates, the difference in rates could reduce the funding gap by around GBP15 bln.
Spot: $1.1615 ($1.1170)
Median Bloomberg One-month Forecast $1.1240 ($1.1250)
One-month forward $1.1625 ($1.1180) One-month implied vol 13.0% (18.5%)
Canadian Dollar: The US dollar rose to new 2.5-year highs near CAD1.40 as US equities fell to new lows in the middle of October. The rolling 60-day correlation of changes in the exchange rate and the S&P 500 reached new 10-year highs above 0.75 late last month. Other frequently cited drivers, like oil prices, commodities more broadly, and interest rate differentials, show a weaker correlation and appear less stable. The Bank of Canada surprised in July with a larger-than-expected 100 bp hike. Last month, it surprised with a 50 bp hike instead of 75 bp. The dour outlook offered by the central bank spurred the market to lower its expectations for the terminal rate to 4.25% at the end of Q1 23 rather than 4.50%. Canada's economic outperformance in H1 22 is over, and a dramatic slowdown has begun that could see the economy stagnate at best for the next few quarters. The Bank of Canada slashed next year's GDP forecast to 0.9% from 1.8%. It sees 2023 inflation at 4.1% rather than 4.6%. Still, we suspect the US dollar's high is in place, and a break of CAD1.35 would bolster our confidence.
Spot: CAD1.3595 (CAD 1.3830)
Median Bloomberg One-month Forecast CAD1.3650 (CAD1.3610)
One-month forward CAD1.3590 (CAD1.3835) One-month implied vol 8.9% (11.4%)
Australian Dollar: Unable to surpass the $0.6550 cap we highlighted last month, the Australian dollar probed our downside target near $0.6200 around the middle of October. before bouncing smartly. It is still not clear whether the low is in place. The risk could extend toward $0.6000. Australia typically offers a premium over the US, but this is not the case now. Its two-year discount is among the largest in at least 40 years (~100 bp). The premium Australia offered on 10-year rates disappeared in early October for the first time in over a year. The Reserve Bank of Australia hiked only 25 bp in October, and the market expects another move of the same magnitude when it meets on November 1. That hike would lift the target rate to 2.85%, and the swaps market looks for it to be near 4% by the end of Q2 23. If there is a surprise, it is that the RBA delivers a 50 bp hike. Headline inflation accelerated to 7% in Q3, and Australia will report a monthly estimate going forward. The underlying measures are still rising.
Spot: $0.6410 ($0.6400)
Median Bloomberg One-month Forecast $0.6455 ($0.6540)
One-month forward $0.6420 ($0.6405) One-month implied vol 14.9% (16.4%)
Mexican Peso: Since the middle of August, with a few exceptions, the dollar has been confined to an MXN19.80 to MXN20.20 range. That range remained intact last month without fail. This relatively low volatility (actual) in October (7.7%) was near the weakest since February. This is conducive for carry-trade strategies or holding extra peso balances. A one-month Mexican cetes pays slightly more than 9.5% (annualized) while a four-week US T-bill pays about 600 bp less. The central bank is committed to matching the Fed's hikes, and Banxico is expected to deliver a 75 bp hike when it meets on November 10. That move will lift the overnight target to 10%. The swaps market looks for a peak of around 10.75% in H1 23. Leaving aside the Russian rouble, the top three emerging market currencies this year are from Latam: Brazil (~5.2%), Mexico (~3.7%), and the Peruvian sol (~0.7%). The JP Morgan Emerging Market Currency Index was rose by about 0.75% in October, trimming the year-to-date loss to roughly 7.2%.
Spot: MXN19.7980 (MXN20.14)
Median Bloomberg One-Month Forecast MXN20.04 (MXN20.19)
One-month forward MXN19.90 (MXN20.25) One-month implied vol 10.3% (12.3%)
Chinese Yuan: China's economy expanded by 3.9% in Q3, the best in two years, but the underlying quality is poor. What it calls surveyed jobless was at 5.5% in September, matching its highest since May. The property market continues to contract, and the debt situation remains of concern. At the end of last year, China offered a 125 bp premium to the US to borrow for a decade. Now it is at a 135 bp discount. Mainland equities have underperformed. In October, the CSI 300 fell almost 7%. Hong Kong's Hang Seng fell by 13.7%. The other major equity markets advanced. The US has escalated its efforts to deny China supplies and capability to use or develop cutting-edge semiconductors. Meanwhile, Xi's consolidation of power has seen the economic reformers cast aside, which, like the zero-Covid policy, undermines investor confidence. Since the 20th Party Congress ended, officials have accepted a weaker yuan, allowing the daily reference rate to ratchet higher. The yuan fell by about 1.9% in October, bringing the year-to-date decline to slightly more than 12.3%. A turn in US interest rates and a broader setback for the dollar may provide a conducive environment for the yuan to steady. It has fallen against the greenback every month since February.
Spot: CNY7.2525 (CNY7.1160)
Median Bloomberg One-month Forecast CNY7.2095 (CNY7.0755)
One-month forward CNY7.2090 (CNY7.1025) One-month implied vol 8.6% (8.0%)
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