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Market Prices in a Fed Cut in Q4 Ahead of CPI, While ECB to may Deliver a 50 bp Hawkish Hike

Market Prices in a Fed Cut in Q4 Ahead of CPI, While ECB to may Deliver a 50 bp Hawkish Hike

Three macro events highlight the week ahead. The US February CPI will be reported on March 14. The UK's Chancellor of the Exchequer Hunt will deliver the spring budget on March 15. The ECB meets the following day. A 50 bp hike is discounted not only for this meeting, but that is the bias for the May meeting as well. It seems that US interest rate adjustment that began early February (jobs data and strong gains in the service ISM) and helped fuel the dollar's recovery seems complete.

Concerns about the implications and ramifications of the $620 bln (estimated by FDIC) of unrealized losses from banks' bond portfolios coupled with more evidence that January's "hot" data will not be repeated helped ease market anxiety about a more aggressive Federal Reserve. A 50 bp hike later this month never seemed particularly likely to us, but even less so now. The US two-year yield, which slipped below 4.05% in early February. peaked near 5.08% on Powell, but finished the week near a little below 4.60%, a drop about 50 bp in the last two sessions. To appreciate the swing in psychology, consider that after Powell's testimony ended the January 2024 Fed funds futures contract implied a yield of about 11 bp less than the implied yield of the September 2023 contract. That differential was near 40 bp before the January jobs report in early February. It reflected the unwinding of rate expectations in Q4 from high confidence to less than a 50/50 proposition. Amid the banking concerns and after the jobs report, the differential settled at 35 bp, as a rate cut gets priced back into the futures and swaps market.

United States:  Few doubt that US CPI has peaked. The issue at hand is the pace of decline. The year-over-year measure of CPI has slowed every month since last June when it peaked at 9.1%. It slowed by an average of 0.3% a month in Q3 22 and by 0.6% a month in Q4 22. The improvement slowed to 0.1% in January. For the next few months, with the exception of April, the slowdown looks set to accelerate. A 0.4% rise in CPI last month would see the year-over-year pace slow to about 6%. Recall that in March last year, the CPI jumped by 1%. Making a conservative assumption that it will be replaced by a 0.5% gain, it would bring the year-over-year pace to around 5.5%. In Q2 22, CPI rose by an annualized rate of slightly more than 10%. If the monthly average is around 0.5% through Q2, the CPI could be near 4.5% at mid-day, halved in 12-months. The median forecast in Bloomberg's survey sees CPI finishing the year at 2.5% (the median forecast for the PCE deflator is 2.3%, while the median Fed projection in December was 2.5%).

There are a few other reports that will also be tracked closely as investors and businesses try to decipher the underlying economic signal. The February jobs data supports ideas that the surge in activity in January was not sustainable, even if more than just a fluke created from benchmark and methodological changes, seasonal adjustment distortions since Covid, and unseasonably warm weather. Retail sales jumped by 3% in January, after falling by 1.1% in November and December. Economists look for a small gain, but there may be scope for disappointment. Indeed, the measure used in some GDP models, which excludes auto, gasoline, building material, and food services is expected to fall by 0.3%, which makes the heady gain of 1.7% in January look like the anomaly--the only gain in four months. After falling 1.8% in December, manufacturing output jumped 1% in January, the most since February 2022. We note that the manufacturing PMI and ISM are remain below the 50 boom/bust levels. Industrial output as a whole had been dragged down by a record slum in utility output (-9.9%, which is unlikely to have been repeated. Mining output rose by 2% in January despite the decline in oil and gas well drilling. The rig count fell by 8 in January and 18 in February, which was the most since June 2020. Lastly, the index of Leading Economic Indicators likely fell for the 11th straight month in February. The six-month annualized decline of 7% is consistent with recessions in the past half century and might not have changed much last month. 

Meanwhile concerns about the risks that may be associated with the large bond portfolios of US banks has emerged as a potent market force, unwinding the hawkish "read" of Fed Chair Powell's testimony. The FDIC reported recently that US banks have roughly $620 bln in unrealized losses on their securities portfolios. Higher rates drive the losses. At the same time, banks, reluctant to pass on higher rates to savers, are seeing deposits flee to money markets and US T-bills. The net effect of the drop in US rates helped cap the Dollar Index in front of 106.00, though it did make a new marginal high for the year (almost 105.90). Note that the (38.2%) retracement of the Dollar Index decline since last September's peak is around 106.15. A break now of support a little below 104.00, which held before the weekend, would strengthen the technical case for a top being in place. 

Eurozone:  The hawks are in control of the European Central Bank's monetary policy. The elevated inflation readings and the new cyclical high in the core rate while economic activity appears to be picking up, has quieted the resistance by those inclined for more accommodative policy. At the same time, fiscal policy is looking less strict. The Stability and Growth Pact thresholds were suspended due to the pandemic and then Russia's invasion of Ukraine. They are to enforce again starting next year, but now other social goals seem to encourage some flexibility. Formal EC proposals are at least a few weeks away, but talk suggests that provided a commitment to reforms, pursuing the EU's strategic goals (digital transition, environmental sustainability, and expanding defense capabilities) may be taken into account. This speaks to more customized budget plans and the creditor countries will resist "too much flexibility."

At the ECB meeting, the staff will update its economic forecasts. In December, the forecast had seen CPI falling from 8.4% last year to 6.3% this year, 3.4% in 2024 and 2.3% in 2025. The market is more optimistic. The median forecasts in Bloomberg survey see CPI at 5.6% this year, 2.4% next, and 2.1% in 2025. The ECB forecast the region's economy will grow by 0.5% this year and 1.9% next followed by 1.8% in 2025. Here the market is less confident. The median forecast is for the economy to expand by 0.4% this year and only 1.2% next year and 1.5% in 2025. After falling to two-month lows near $1.0525, the euro rebounded. The euro kissed $1.07 before the weekend but was unable to sustain it and settled a little below $1.0645. A convincing move above $1.07 would boost the likelihood that a low is in place. Last week's low could have been the new low we were looking for, but we saw risk toward $1.0460-$1.0500.

United Kingdom: The spring budget will be announced on March 15. The somewhat better growth puts Chancellor Hunt in a better position than a few months ago. However, room to maneuver is very limited, especially relative to demands. Prime Minister Sunak's two predecessors are pushing to drop the corporate plan increase (to 25% from 19% starting next month). These efforts are likely to prove ineffective. However, the compromise position in clear. Extend the break for capital investment and, possibly boost the threshold for the new levy to exempt more small and medium sized businesses. Meanwhile, public sector strikes continue and a pay package, perhaps with one-off payouts in excess of 3.5% the government has offered on average would require more funds. Defense will also be looking more funds, some of which is to help fund assist Ukraine. Lastly, the extension of household energy guarantee (at GBP2.5k for typical household instead of rising to GBP3 bln in April) will cost an estimated GBP3 bln. 

The budget is unlikely to have much impact on the outlook for the Bank of England, which meets on March 23, the day after the FOMC meeting concludes. A quarter-point move is largely discounted. Such a move would bring the base rate to 4.25%. The terminal rate in the swaps market is about 4.75%. There had been some market talk of a pause after this month's hike, but the swaps market has more than 3/4 chance of another 25 bp hike at the May 11 meeting discounted. The focus will be on the wage growth reported in the jobs report on March 14. Sterling fell to a four-month low just ahead of $1.1800. The technical damage was quickly reversed, and sterling rose to $1.2115 ahead of the weekend, encouraged by both the broader setback of the US dollar and better than expected January GDP (0.3% vs. expectations of 0.1% after a 0.5% contraction in December). Sterling settled higher for the second consecutive week and begins the new week with a three-day advance in tow. Despite the failure to close above $1.2100, it did manage to close above the 20-day moving average (~$1.2015) for the first time since February 1. A break above $1.2125 could spur a test on more formidable resistance around $1.2200.

China:  The National People's Congress appears to have doubled down on the trend toward more centralized control of the world's second-largest economy. While it has potential to strengthen the implementation of policy emanating from Beijing, it makes checks and balances more difficult and boosts the risk of group think. At the same time, having the National Public Complaints and Proposals Administration and the China National Intellectual Property Administration report directly to the State Council elevates those functions. The restructure of the Ministry of Science and Technology, which was listed as the top item in the new government plans, ahead of financial oversight, recognizes the significance of the US, Europe, and Japanese efforts to increasingly restrict technology sales to China.

However, in the week ahead, the rebound in the Chinese economy amid the re-opening will be the chief focus. Retail sales and industrial output should confirm the recovery seen in the PMI and anecdotal reports. The contraction in completed investment in real estate (property investment) may moderate for the first time since peaking two years ago. New home prices were unchanged in January, the first month that they have not declined since August 2021. A small gain would also help lift sentiment. Meanwhile, the central bank appears in no hurry to ease monetary policy directly and the one-year medium-term lending facility rate is expected to be held steady at 2.75% (where it has been since last August) and lending volumes may be reduced for the second consecutive month. The greenback rose by about 0.5% against the yuan last week, but the broader dollar pullback ahead of the weekend suggests that the CNY7.0 will hold. The greenback held a little above CNY6.90. The next area of support is around CNY6.86. A break would see another 1.0%-1.5% dollar decline.

Japan:  With Governor Kuroda's last policy making meeting behind it, the market's attention turns back to real sector data. Three reports stand out in the coming days: the February trade balance and the final read of January industrial output, and the tertiary industry index. There are often strong seasonal influences on Japanese trade. While the balance regularly deteriorates in January, it always (without fail since at least 1994) improves in February. Moreover, the January trade deficit (~JPY3.5 trillion or ~$26 bln) was a record shortfall. Contrary to references to Japan's "export prowess", it has been running a trade deficit on a 12-month rolling basis since November 2021. The shift to a deficit does not appear to have changed domestic class relations as some observers would have anticipated (See my review here). Japan initially reported industrial output fell by a dramatic 4.6% in January. Economists (median in Bloomberg's survey) had anticipated a 2.9% contraction. Real household spending continued to contract on a year-over-year basis. Recall that the January manufacturing PMI was unchanged at 48.9 (and fell to 47.7 in February). It was last above the 50 boom/bust level last October. On the other hand, the tertiary industries index fell by 0.4% in December (though the services PMI rose to 51.1 from 50.3 in November). In January, the services PMI rose to 52.3 and February's 54.0 reading matches the highest from last year.

The dollar peaked last week slightly above JPY137.90, to pierce the 200-day moving average for the first time since last December's surprise widening of the 10-year yield band. The intraday move was not sustained, and as US rates tumbled in the last two session, they took the dollar with it. The greenback was sold back to the lower end of the recent range near JPY134.00, but it held, and the dollar recovered to settle slightly above JPY135.00. The dollar closed below its 20-day moving average for the first time since February 1. A break of JPY134 points to a near-term top being in place well short of our JPY140 target. The momentum indicators have rolled over. It would target JPY132. 

Australia:   The central bank's forward guidance last week underscored the importance of the upcoming data to determine "whether and by how much" interest rates still need adjust. That puts a heavy emphasis on the February employment report due on March 16. The Australian labor market has been decelerating in recent months and posted a net loss of full-time position in January for the first time since last July. The February report will show whether it was a fluke. Recall that in February 2022, Australian full-time employment jumped by 120k. The unemployment rate rose to 3.7% in January, up from the record low of j3.4% last October. Still, in February 2022, it was at 4.0%. Meanwhile, expectations for the terminal policy rate peaked in late February near 4.35%. It is now near 4% (the new cash target rate is 3.60%). The Australian dollar made a new four-month low ahead of the weekend (~$0.6565), holding above the $0.6550 area that marks the (61.8%) retracement of the gains since the mid-October low near $0.6170. On the back of a weak US dollar, it recovered to $0.6640 before the weekend but settled poorly (~$0.6580). A break of the $0.6550 area could target the $0.6400 area. 

Canada:  The Bank of Canada made good in "conditional pause,” and this weighed on the Canadian dollar, which fell to new lows since last October. The sharp downside reversal of US rates amid the banking concerns did the Canadian dollar no favors as it apparently was overrun by the risk-off and sharp losses in the equity markets. The US dollar set a new five-month high before the employment reports near CAD1.3860. Although the US created more jobs than expected it was mired by a fall in the work week, slower earnings growth, and rising in the unemployment rate. Canada reported another solid rise in full-time employment and wage growth (permanent workers) accelerated to 5.4% from 4.5%. The US dollar fell to approach CAD1.3765, holding above important support near CAD1.3750 and recovered to settle near CAD1.3830, near the previous day's high. The momentum indicators are stretched but have not begun turning. There seems to be little on the charts to deter a run into the CAD1.39-CAD1.40 area.

Mexico:  We have been concerned that the high-flying peso was in need of consolidation/correction after rallying to five-year highs. Still, on March 9, the peso rose to a marginal new high (since 2017), with the dollar briefly falling through MXN17.90. However, the shunning of risk assets amid concerns about the unrealized losses at US banks, saw dramatic short squeeze that lifted the greenback to MXN18.44 to record a bullish key reversal. Follow-through buying ahead of the weekend saw the approach MXN18.60. While there may be some pent-up corporate demand for pesos, who did not want to chase it and could afford to wait. However, the jump in volatility and broader concerns may see carry-trade strategies be put on hold for the time being. The dollar's high met the (50%) retracement objective of the slide of the leg down since February 6 high (~MXN19.29). The next retracement (61.8%) is near MXN18.76. The momentum indicators have turned higher. The peso's nearly 3% loss made it the worst performing emerging market currency last week, leaving it up about 5.4% for the year, and slipping into second place behind the Chilean peso, which rose nearly 0.85% last week. It has appreciated by 6.8% year-to date. 

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Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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