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Originally posted on February 12, 2023
After selling off sharply in the past four months, the dollar rebounded. Since the FOMC meeting on February 1, it has enjoyed one of the strongest bounces since it topped out in late September/early October. The incredible US jobs data, sharp bounce in the January services ISM, speculation of BOJ Governor Kuroda’s successor, and some easing of the euphoria over China’s re-opening have been notable drivers. The dramatic rise in the US two-year note illustrates the adjustment. The yield rose from the lower end of its range that goes back to the middle of last September (~4.0%) to the upper end near 4.50%.
Market positioning was part of the pre-conditions that led to such an impulsive surge in the dollar. However, several of the currency pairs have met technical retracement targets, and the market has moved to catch up with the Federal Reserve in terms of the terminal rate being closer to 5.25%. The most market-sensitive data point is the US January CPI. Japan and the eurozone provide estimates of Q4 ’22 GDP along with December trade and industrial output figures. The UK and Australia report their latest readings on the labor market. The UK also reports January CPI and PPI. Ironically, good news on the economic performances may weigh on stocks and bonds and unwind the easing of financial conditions seen in recent weeks.
United States: The world’s largest economy seemed to have fallen off a cliff at the end of 2022. Manufacturing output and retail sales fell by more than 1% in November and December. However, the economy appears to have rebounded in January. Retail sales and manufacturing production are expected to have snapped back. We already know that auto sales rose more than expected to a 15.74 million unit pace (seasonally adjusted annual rate), the most since May 2021. Yet, even the control measure used in some GDP models (which excludes autos, gasoline, building materials, and food services) is expected to have risen last month for the first time since October, and the 0.7% median forecast in Bloomberg’s survey would be the most since last June. Even permits for new homes are expected to have ticked up last month for only the second time since the end of Q2 ’22. Mortgage applications are running about 18% above the late October lows, as the average 30-year mortgage rate has fallen by around 100 bp to about 6.2%.
If the real sector is recovering in early 2023, the year-over-year decline in consumer and producer prices looks set to continue. Recall that US CPI rose by 0.6.%, 0.8%, and 1.2% month-over-month in the January-March period last year. These will drop out of year-over-year comparisons. Nevertheless, we remain struck by the fact that CPI rose at an annualized rate in excess of 10% in both Q1 and Q2 ’22. In H2 ’22, it slowed to a 2% annualized pace. At issue, now, is how much of the price pressures were transitory. Of note, the reweighting of the CPI basket (annually now rather than every two years) gives owner-equivalent rents a slightly greater weight and used cars a little less. Still, even if CPI rose by 0.5% each month in Q1 ’23, which is not a forecast but a thought experiment, the year-over-year rate would fall near 5% in March. If repeated in Q2 ’23, headline CPI would be slightly above 4%. The median forecast in the Bloomberg survey has CPI at 3.8% at the end of the year. Incidentally, the median forecast sees the PCE deflator at 3.8% at year-end, while the median Fed dot plot puts it at 3.1%.
The Dollar Index met our 103.80-104.00 target. Then it held above 102.00-40 in the subsequent pullback, warning that the upside correction may not be over. A convincing break of the 104.00 area could see 104.50-105.00.
Eurozone: At the end of January, Eurostat estimated that the eurozone economy expanded by 0.1% in Q4 ’22 for a 1.9% year-over-year rate. Real sector data has been limited to industrial output and some trade figures. The weakness in German industrial production in December (-3.1% vs. -0.8% median forecast in Bloomberg’s survey was likely blunted by a small upward revision in the November series (0.4% vs. 0.2%), the better-than-expected French (1.1% vs. 0.3%) and Spanish (0.8% vs. 0.2%) reports. The German trade surplus fell less than anticipated, though it widened rather than contracted as expected. Hence, the risk seems asymmetrically to the downside for the new Q4 GDP estimate, even if minor. Still, the Q4 may be too old to elicit much of a market reaction. Nor will the apparent precision of the estimate obscure the fact that, for all practical purposes, the eurozone stagnated in Q4. A contraction in Q1 ’23 cannot be ruled out yet. At the same time, the shift in sentiment downgraded the risk of a recession.
The 3.5 cent pullback in the euro since the February 2 high of almost $1.1035 is the second largest since the euro bottomed at the end of last September near $0.9535. It has been driven by the strong US employment data and service ISM, which spurred a convergence of market expectations with the Fed’s dot plot. The two-year US premium over German jumped from about 146 bp on February 1, the least in a little more than a year, to almost 187 bp before consolidating. The surge in the US yield can account for the lion’s share of the increase. The euro surpassed our $1.0700-50 target, falling to about $1.0665 ahead of the weekend to record a marginal new low for the week. It may need to re-establish footing above $1.0800 to repair the technical damage, without which a move toward $1.06 and possibly $1.0550 cannot be ruled out, even though the momentum indicators are getting stretched to the downside.
Japan: Better consumption and net exports more than offset the contraction in business investment to help fuel a recovery after the Japanese economy contracted in Q3 (-0.2% quarter). The median forecast in Bloomberg’s survey projects a 0.5% expansion in Q4 ’22. The positive momentum is expected to carry into Q1 ’23. Two conflicting forces are pulling the exchange rate. First, and sparking the dollar’s gap higher opening to start the week, was the report suggesting that BOJ Governor Kuroda’s possible successor boosts the chances of policy continuity. A formal announcement is expected in the coming days. However, at the end of last week, Japanese press reported that Amamiya turned the offer. On February 14, Prime Minister Kishida is expected to nominate former BOJ board member Ueda as the next BOJ governor. Second is the economic data, including labor cash earnings and acceleration in Tokyo’s January CPI, which makes many participants convinced that Japan would have to adjust its monetary policy stance.
The gap created with the higher opening on February 6 is between JPY131.50 and JPY131.70. The greenback stalled near JPY133.00. It has not traded above JPY135 since the December surprise. The gap was what technicians call a “normal gap” and was filled the following day. News of Ueda’s likely appointment sent the greenback to JPY129.80, but it quickly rebounded. It returned to JPY131.50 in the North American session. Maybe our JPY135 target was aggressive, but a retest on the JPY133 area seems reasonable.
UK: The Bank of England plays down that it is on a pre-set course to hike rates again when it meets on March 23, but the swaps market sees it as about an 80% likelihood that the bank lifts the base rate 25 bp to 4.25%. If it is data-dependent, the jobs report (February 14), inflation (February 15), and retail sales (February 17) may be critical. However, their impact may be limited because each will be reported again before the BOE meets. Moreover, it is not clear that the data will reveal anything that policymakers do not already know. Despite the economic contraction in Q4, the labor market remains tight and wage pressure is strong. Inflation may have peaked, as the BOE judged earlier this month, but the easing of price pressures is likely to have been minor at best last month. A more substantial decline is expected with the March and April readings. At the same time, the cost-of-living squeeze and softening house prices sap consumers. Retail sales in volume terms rose only in one month last year (October). The British economy stagnated in Q4, despite very weak December figures, after contracting by 0.2% in Q3.
Sterling’s recovery from the record-low in late September (~$1.0350) peaked in mid-December, a little shy of $1.2450. It drew ever so slightly closer to $1.2450 last month without going above. The 5-day moving average fell below the 20-day moving average on February 3, and the momentum indicators turned lower. We had suggested potential toward the January low near $1.1840. Instead, it approached the 200-day moving average (~$1.1950 last week) and bounced back to almost $1.2200. A move above the $1.2230-65 area would bolster the technical tone, but without it, sterling seems likely to retest the lows.
Canada: The Bank of Canada’s announced pause takes away whatever (albeit limited) impact domestic data typically has on the exchange rate. That said, the reaction to a much stronger-than-expected jobs report is an exception that proves the rule. Part of the reason the BOC is going to stand pat is to evaluate the cumulative rate hikes. One area that has felt the higher interest rates is the housing market, and Canada reports January starts and existing home sales. However, the more important driver of the exchange rate continues to be the general risk appetite. The 30-day correlation eased from 0.88 in mid-December to about 0.65 in early February. The 60-day correlation is near 0.78. The 30-day correlation with WTI is less than 0.05, and the 60-day correlation is around 0.27, which is the least since last June. That is roughly the same as the correlation between changes in the exchange rate and the two-year interest rate differential. Still, the 121k increase in full-time jobs last month, the most since last May and about twice the monthly average in Q4 ’22, underscores our suspicion that the risk is that the Bank of Canada hikes rates again. The greenback posted a bearish outside down day before the weekend by trading on both sides of Thursday’s range and settling below its low. The next obvious target is the recent low near CAD1.3260 and then the low from the middle of last November around CAD1.3225. The 200-day moving average begins the new week by CAD1.3235, and the US dollar has not closed below in seven months.
Australia: Last week’s 25 bp rate hike and indication from officials that they see additional moves as necessary takes some thunder away from the January jobs report on February 16. Australia created more than three times the amount of full-time employment in Q4 ’22 (~107k) than in Q3 (~29k). The Australian dollar approached our $0.6850 target earlier than we had expected and recovered to the $0.7000 area, where it stalled. In its monetary policy statement, the RBA noted the tightness of the labor market and cautioned that price pressures remained broad-based and too high. It revised its underlying measure of inflation (trimmed mean) to 6.25% in the middle of the year from 5.5%. It signaled that the cash rate target may be lifted to 3.75% from 3.30%. The Australian dollar popped on the RBA statement, but without establishing a foothold above $0.7000, the risk is that it may have to retest the lows again. There is scope for a test on $0.6800 if the $0.6850 area gives way.
Mexico: The central bank’s more aggressive 50 bp rate hike last week surprised the markets and sent the peso sharply higher. Some economists had expected a quarter-point hike to have signaled the end of the tightening cycle. Moreover, Banxico made it clear that it was not done but suggested the next move could be smaller. The central bank meets next on March 30. It was the first time since last March that Banxico took a bigger step than the Federal Reserve. The overnight target rate is now at 11.0%, and the swaps market looks for a peak between 11.75%. Initial support is now seen in the MXN18.60-18.65 band, which was entered before the weekend, but the three-year low near MXN18.50 seen in January and again earlier this month offers more significant support. In the medium term, we see potential toward MXN18.00.
China: The markets seemed most euphoric over the re-opening of China when mainland markets were closed for the Lunar New Year. However, a nearly 5% pullback in the CSI 300 brought new foreign buying. Nevertheless, the CSI finished lower for the second consecutive week. Illustrating the broader dollar recovery after the incredible jobs report saw the greenback trade from around CNY6.70 to CNY6.8145 ahead of the weekend. On Monday, January 9, the dollar gapped lower against the yuan. The gap is found between CNY6.8150 and CNY6.8280. Assuming the gap is filled, we suspect there is potential toward CNY6.88-6.90. The yuan appears to be continuing to track the euro and yen. The 60-day correlations are around 0.50 and 0.42, respectively, little changed from the end of 2022.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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