by Marc Chandler
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The pendulum of market sentiment swung from fear of a synchronized recession in the US and Europe to optimism that a recession can be avoid. The perceived reduction of downside risks had driven the upside performance of equities and bonds. Just as the data seems to confirm it, the rally in in stocks and bonds faltered. The MSCI Emerging Markets equity index gained 7.8% last month but is off almost 3.8% this month, and has fallen for three consecutive weeks. The performance of the developed markets has held up better. The MSCI World Index (developed economies) rose 7.0% in January and is up slightly so far here in February. A reassessment of the trajectory of Fed policy, which has seen the markets converge with the Fed's message, has helped the dollar correct higher after falling for the better part of the past four months. It is up against all the G10 currencies here in February, but the Swedish krona, which has eked out a small gain. The New Zealand dollar and Japanese yen have fallen by more than 3%. The Australian dollar, the Norwegian krone, and sterling are off 2.25%-2.75%. The rest are down more than 1.2%, except the Swiss franc, which has fallen by almost 0.9%.
Nevertheless, the inversion of yield curves and dramatic slowdown of money supply growth means that recessionary fears will not be entirely shaken off. Fed Chair Powell has pointed to the spread between the three-month bill and its 18 month forward as more telling part of the curve for the economic outlook. It has been inverted for nearly three months. In the US, the index of leading economic indicators has not risen since February 2022. While US financial conditions eased in Q4 22, the full effect of their tightening in the first three quarters of last year take time to cycle through. Financial conditions in the euro area have remained near the 11-year peak tightness recorded at the end of last year. On a trade-weighted basis, the euro has is off about 1.25% from the 16-month high set earlier this month.
The week ahead features the preliminary February PMI. The composite in the US, UK, and Australia (where flash estimate is provided) remained below the 50 boom/bust in January. The eurozone and Japan's composite PMI recovered above 50 in January. Japan's had been below it in the last two months of 2022. The eurozone's composite was consistently below 50 throughout the second half of last year. The Reserve Bank of New Zealand is the only G10 central bank to meet (February 22). It was expected to hike 50 bp, lifting the cash target rate to 4.75%. Another half-point hike is anticipated for the following meeting as well (April 5). However, in the wake of the devastating cyclone, this appears too aggressive. The risk is of a smaller move, or even a pause. This could add to the weight on the New Zealand dollar. In light of the firmer US dollar, the Kiwi briefly explored sub-$0.6200 ahead of the weekend, nearly matching last month's low to approach the 200-day moving average (slightly below $0.6190).
Among emerging markets, the disastrous earthquake in Turkey may give the central bank the opportunity to cut the repo rate, which the central bank hinted at by dropping the reference of standing pat. South Korea's key seven-day repo rate stands at 3.50%. It hiked by 25 bp in January but the central bank is signaling a pause. Its year end rate forecast is at 3.50%. The won was the strongest currency in Asia from late October 22 through early February appreciating by almost 18%. However, since the US employment data and service ISM, which has sparked the shift in Fed expectations, the won has been the weakest in the region, falling about 5.4%.
United States: As inflation rose, the Fed paid more attention to the CPI, but we suspect as the year progresses, and price pressures ease, officials will revert to the PCE deflator, which it targets. But not quite yet. The headline deflator stood at 5.0% at the end of last year, and the core measure, was at 4.4%. In the December Summary of Economic Projection, the median view was for the headline rate to fall to 3.1% this year and the core falling to 3.5%. It saw both at 2.5% at the end of 2024. More importantly, we may learn with the January report that personal consumption expenditures, which fell in November and December, like bounced back, helped by a rise income that may be larger the November and December combined.
At the same time, a decline in mortgage rates and anecdotal talk of more traffic, last month's existing home sales may have risen for the first time since January 2022. And we learned last week that although housing starts continued to contract, permits rose for the first time since last September. Also of note, the minutes of the February 1 FOMC meeting will be published. Recall that once again the market had one reaction to the statement and then another to Chair Powell's statement and press conference. The Fed had a nuanced message to deliver, and the market was not persuaded until a couple of days later with the monster jobs report and the unexpectedly strong services ISM.
Still we are concerned that sentiment is over-correcting. The string of stronger than expected January data is unlikely to be repeated. There were some statistical anomalies, unusually warm weather, methodological and seasonal adjustments following a very weak November and December. The Dollar Index surpassed our 103.80-104.00 objective to reach 104.65 ahead of the weekend. However, it pulled back and settled below 103.90. On the upside the next resistance area is 105.30, though we suspect the market has gotten ahead of itself.
Eurozone: We suspect the optimism about the eurozone's outlook is fragile. An outright energy crisis was avoided this year, but as the one-year anniversary of Russia's invasion passes, the new offensives begin. Even with some relief from high energy prices, retail sales (volume) fell by a dramatic 2.7% in December. It was the largest slump since April 2021. German exports plummeted by 5.9% in December, the most since the early days of the pandemic. Weak domestic and foreign demand remains a challenge. And as ECB President Lagarde has noted, the subsidies and/or tax breaks to cushion higher energy costs are limited and when they expire, price pressures and the squeeze on the cost-of-living may re-emerge.
Separately, the final read on January eurozone CPI is more important than usual. Most of the time the preliminary estimate is close enough to the final that the markets typically do not pay much attention (like the flash PMI and final reading). However, because of technical issues (one-off gas subsidy was removed in January, and base year was adjusted to 2020 from 2015), Germany delayed its estimate, which accounts for about a quarter of the EMU aggregate figures, Eurostat estimated it at 8.7%. Instead, Germany reported a 9.2% pace. The aggregate rate was initially estimated at 8.5% (down from 9.2% in December).
After breaking $1.07, the euro headed for our next target near $1.06 and slipped briefly below $1.0615 before the weekend. A break of $1.06, around where the lower Bollinger Band is found could target the $1.0460-$1.0500 area. The momentum indicators are stretched but have not turned up. A move above the $1.0710-20 area would help stabilize the tone.
Japan: With the new leadership of the Bank of Japan nominated, there will be hearings in both chambers of the Diet in the week ahead. While there is a sense of pragmatism, there also seems to be a recognition of the need for continued monetary support for the Japanese economy. With all the monetary and fiscal stimulus, the Japanese economy expanded by 1.1% last year. The economy contracted by 0.4% in Q1 22 and this year, it appears to be off to a better start. Consider that the composite PMI averaged 48.7 in Q1 22 and will likely average a little better than 50 in Q1 23. Tokyo's January CPI was higher than expected at 4.4% (from 3.9%) and warns of upward pressure on the national measure due February 24. The national rate stood at 4.0% in December, and the core, which excludes fresh food, also rose by 4.0%. Excluding fresh food and energy, Japanese inflation rose by 3.0%. The BOJ's forecasts anticipate that core inflation will fall to 1.6% this year. The median forecast in Bloomberg's survey is less sanguine and has it at 2%, the target.
Japanese investors were persistent sellers of foreign bonds last year. With thoughts of a rolling exit from Japan's extraordinary monetary policy, many observers fear more sales in the year ahead. Our concern is that these fears may confuse cyclical and structural developments. So far this year, Japanese investors have been net buyers of foreign bonds. In the first six weeks of the year, Japanese investors bought about JPY2.6 trillion (~$19.5 bln) of foreign bonds, the most in a six-week period since last November 2021. They have also been net buyers of foreign equities as well (~JPY366 bln).
The link between the exchange rate and US Treasuries is strengthening and the dollar rose above JPY135 at the end of last week for the first time since the BOJ's surprise last December but pulled back to settle near JPY134.20. A sustained move above JPY135 would target is JPY136.65-JPY137.00. Here. too, the momentum indicators are getting stretched, as one would expect given the five-week dollar rally. It frayed the upper Bollinger Band that begins the new week near JPY134.65.
UK: The British economy stagnated in Q4 22 after contracting by 0.2% in Q3. Although the labor market remains resilient, the economy is off to weak start of the year. The median forecast in Bloomberg's survey expects the economy to contract by 0.3% in Q1 23 and Q2 23. The data highlight in the week ahead is the preliminary PMI. The composite was last above 50 in July 2022. Despite stronger than expected January retail sales (0.5% rather than -0.3% median forecast in Bloomberg's survey), sterling fell through support we identified near $1.1950 and did not find bids until closer to $1.1915. Key support is the January low around $1.1840. A break of it would be an ominous technical development and warn of a potential double top with a measuring objective near $1.1250. That said, sterling bounced smartly in North America ahead of the weekend to close near $1.2040.
Canada: Canada reports December retail sales and January CPI on February 21. Canadian shoppers went all out in H1 22. Retail sales rose by at a monthly average of 1.3% in the first half of last year. The second half is a different story, and through November retail sales fell by an average of 0.3%. Consumer prices fell by 0.6% in January, the most since April 2020. The risk is on the upside, but the base effect suggests the year-over-year rate is set to fall. In Q1 22, Canada's CPI rose by 0.9%, 1.0% and 1.4%. With some conservative assumptions, like an average gain of 0.5% a month in Q1, the year-over-year rate can fall from 6.3% in December to 4.5% in March. The core trimmed mean measure is considerably more stable, as one would expect. It has been in a 5.3% to 5.5% range for the last eight months of 2022.
The incredibly strong Canadian January employment data coupled with the surge in US rates helped push Canada's two-year yield sharply higher. It rose about 25 bp since before the jobs report and more than 50 bp since the US employment report, a week earlier before consolidating at the end of last week. The swaps market implies that the central bank's pause may last into Q2 and the market has another 25 bp hike is mostly discounted in Q3. In the context of the broader US dollar strength and weakness in the S&P 500, the Canadian dollar fell by about 1% last week. The US dollar held above our CAD1.3260 target last week and saw almost CAD1.3440 ahead of the weekend. It took out the upper Bollinger Band (~CAD1.3490 on an intraday basis, but settled back below it. The greenback met the (38.2%) retracement of the decline from the mid-October high near CAD1.3975. The next retracement (50%) is around CAD1.3600.
Australia: A poor jobs report adds to the difficult outlook. House prices are trending lower and retail sales are softening. The central bank hiked the cash target and signaled more action is necessary on February 6, but this sowed confusion after Governor Lowe had previously indicated a pause was discussed. And, with the optimism over China's re-opening fading, another leg for the Australian dollar has weakened. We had anticipated a move to $0.6850 and the Aussie fell to almost $0.6810 ahead of the weekend. A break now of the the $0.6780-$0.6800 area that houses the (38.2%) retracement of the rally from last October's low (~$0.6170) and the 200-day moving average could signal would inflict significant technical damage. Still, it set new session highs in North American a little above $0.6880, putting in a potentially bullish hammer candlestick pattern. A move above $0.6920 could signal another test on $0.7000.
Mexico: The bullish case for Mexico, based on portfolio and direct investment inflows, coupled with an aggressive central bank does not make the peso immune to the broader dollar strength but helps minimize it. After recording a nearly 4.5-year low, a little below MXN18.50, the greenback recovered on the back of shifting interest-rate expectations. It reached about MXN18.75, shy of the 20-day moving average (~MXN18.79) where it met a wall of sellers that drove it to new lows near MXN18.33 before the weekend. The peso is the strongest currency in the world this month, up about 2.6%. There is little meaningful support ahead of our medium-term target of MXN18.00. However, it is getting stretched technically and the lower Bollinger Band begins the new week near MXN18.40 and below there may be some support around MXN18.25.The peso often does not appear to respond to the Mexico's macroeconomic and that includes the upcoming bi-weekly CPI and December retail sales. Instead, the more interesting report will be the minutes from the central bank's meeting when it delivered a 50 bp hike, outpacing the Fed.
China: The bloom is off the Chinese rose. The near euphoria about the re-opening has faded. The CSI 300 has fallen around 5.5% since peaking in late January. The Hang Seng Chinese Enterprise Index, which tracks mainland shares that trade in HK is now down 10% from the six-month high set last month. The US 10-year premium increased by 10 bp last week to approach 100 bp for the first time this year. The dollar has risen steadily against the yuan since the CNY6.70 level (seen in January) was retested in early February. We had seen near-term potential into the CNY6.88-CNY6.90 area. It reached almost CNY6.8850 at the end of last week. Still, the dollar's setback ahead of the weekend suggest the yuan trade higher at the start of the new week. Outside of the loan prime rates, China as a light economic calendar in the coming days. The next data points to note will be the February PMI on March 1.
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