December 2023 Monthly

by
Marc Chandler
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As the year winds down, the global economy appears to be entering a new phase. While North American and European central bankers swear that they are prepared to respond to new threats to price stability, the markets demur. 

Indicative pricing in the derivatives markets reflects the general conclusion that the central banks have most likely completed the post-Covid monetary tightening cycle. Central bankers are pushing against a premature easing of financial conditions. 

Last year's sporadically large jumps in monthly CPI measures have dropped out of the 12-month comparisons. Still, inflation remains above targets but has slowed considerably. Japan remains the notable exception. 

The Bank of Japan continues to inch its way toward the exit of its extraordinary monetary policy. Previously, many expected that the BOJ could lift its overnight target rate out of negative territory where it has been since 2016 by the end of this year, but now it is seen to be more likely toward the end of the current fiscal year in March 2024, or maybe April. The BOJ has quietly stopped buying REITs and bought the least equity ETFs since 2010.

The dramatic divergence that saw the US economy expand by a sizzling 5.2% at an annualized pace and the eurozone and Japanese economies contract in Q3, has peaked. The Europe and Japan's economies remain lackluster at best. A new convergence is emerging, driven from the US side of the equation. American economic activity appears to be slowing sharply in Q4. It should be a broad slowdown, including a US consumption and government spending. Business investment may stagnate. The eurozone and UK may be considered fortunate if they can avoid a contraction in Q4.

Every business cycle has unique features, this is especially true of the current cycle. After the Great Financial Crisis and the European sovereign debt crisis subsided, the most likely scenario seemed like a return to the Great Moderation of slow growth, low inflation, and low interest rates. Before Covid struck, Europe and Japan had yet to normalize monetary policy. While the US had more success in normalizing monetary policy, fiscal policy was a different story. In the two years before the pandemic, despite above-trend growth (an average of about 4.5% per year) and the lowest unemployment in a generation, the US recorded large budget deficits (3.8% of GDP in 2018 and 4.6% in 2019). 

The once-in-a-generation (hopefully) pandemic was met with dramatic policy responses, unevenly applied, and then unevenly unwound. The reaction to Russia's invasion of Ukraine was on a completely different order of magnitude from the response to Moscow's 2008 invasion of Georgia, its 2014 invasion of Ukraine, and the later annexation of Crimea. The resulting shock altered the competitive landscape, and even now the cost of liquified natural gas is around 3.5x higher in Europe than in the US. 

An integral part of the economic landscape is the elevated tension in China. The fact that the US stance toward China, including the persistence and extension of tariffs, and export controls, reflects at least one general agreement amid great partisanship. Europe has also escalated its efforts to check Chinese imports, and new measures may be taken shortly. For its part, China has imposed new requirements on exporting several materials used to fabricate semiconductor chips.

Meanwhile, China's trade surplus is running slightly below last year's levels through October ($680.4 bln vs. $703.1 bln in the year ago period) but in yuan terms it is a little larger (CNY4.79 trillion vs. CNY 4.64 trillion). While exports have averaged a 5% drop year-over-year this year in dollar terms, exports have edged higher (average of almost 1.2% year-over-year) in yuan terms. Imports have fallen by an average of 6.1% from year ago levels in dollar terms but in yuan terms have eased by only an average of 0.12% from a year ago.

The US expansion has proven more resilient than imagined. Last December, the median forecast among Fed officials was that the economy would grow by 0.5% this year. The median forecast has steadily increased and stood at 2.1% in September, which would still allow for very weak Q4 growth. There are several economic indicators, including the pace of decline of the six-month average of the index of leading economic indicators, the contraction of M2, and rate of business failures that have been associated with past US recessions. Although the market was critical that the Fed did not stop its asset purchases earlier and was slower than several other high-income central bank to lift rates, on several occasions it has looked for rate cuts to be delivered sooner and more aggressively than the Fed has signaled. 

The growing conviction that US rates peaked seemed to help take pressure off risk assets. The MSCI Asia Pacific Index, Europe's Stoxx 600, and the US S&P 500 and Nasdaq snapped three-month declines last month. The S&P 500 rallied nearly 9%, its second-best November since 1980. The MSCI Emerging Market equity index rose almost 8% and recouped the losses of the past two months in full plus some. The JP Morgan Emerging Bond Index spread over US Treasuries narrowed to approach the low for the year set in July near 335 bp (the five- and 10-year averages are around 370 bp). Indices of emerging market currencies appreciated by about 2.0%-2.8%

U.S. Dollar: There are two key questions for businesses and investors: What is the magnitude and extent of the slowdown in the US economy and when will the Federal Reserve respond? The US economy grew by 5.2% in Q3 but appears to be slowing markedly in Q4. Economists look activity to be at least halved in Q4 and slow further in Q1 24 to 0.4%. In fact, the median forecast in Bloomberg's monthly survey does not see growth returning to 1.5% until Q4 24. The FOMC's last meeting of the year concludes on December 13. It is widely expected to standpat with the upper band of its target at 5.50%, where it has been since July. The futures market has fully discounted two cuts by the end of H1 24. for the early May meeting and about 3.5 cuts by the end Q3 24. The Federal Reserve will update its Summary of Economic Projections. In September, the median projection anticipated two rate cuts in 2024, even though its PCE deflator forecast is for above target 2.5%. The median forecast also saw growth slowing to 1.5% in 2024. Meanwhile, the 800 lb. gorilla in the room, whose presence is going to be increasing felt in the 2024, is the presidential election, where Trump is polling a few percentage points ahead of Biden. The uncertain policy outlook will likely limit scope for new international agreements and may dampen investment. The Dollar Index's rally from mid-July through early October ended and meeting an important technical retracement objective of its rally since mid-July. While we think the cyclical high was recorded in September 2023 (~114.75), we suspect November's 3% decline was a bit too much. A bounce could lift it back to the 104.70-105.00 before it falls out of a favor again.

Euro:  The eurozone continues to struggle. The economy has practically stagnated this year and growth impulses seem poor as the year winds down. The sharp decline in price pressures gives policymakers room to maneuver. The preliminary CPI in November stood at 2.4%, down from 10% last November, and lowest since July 2021. The swaps market has around an 80% chance that the first cut is delivered in Q1 24, though bank officials seem to suggest mid-year may be more appropriate. By the end of H1 24, the market has two-and-a-half cuts discounted. There is even greater uncertainty about the outlook for fiscal policy. An agreement is needed about modifications in the Stability and Growth Pact, or the old rules will come into force at starting next year. At the same time, Germany's high court ruled that efforts to shift off-budget Covid spending to climate change was unconstitutional, which blew an immediate hole (~37 bln euros) into this year's budget, raised questions about other off-budget programs, and is spurring increased strains in the coalition government. There seems to be little choice but to suspend the debt-brake for another year. The euro recorded the year's high in mid-July near $1.1275 and recorded the year's low in early October around $1.0450. Last month, it surpassed $1.0965 to meet a key technical retracement of its losses and traded above $1.10, but the pullback, encouraged by the soft CPI report, has already begun. We suspect it retrace toward $1.0725-50.

(As of December 1, indicative closing prices, previous in parentheses)

Spot: $1.0885 ($1.0565) Median Bloomberg One-month forecast: $1.0860 ($1.0650) One-month forward: $1.0900 ($1.0585)   One-month implied vol: 6.5% (6.7%) 

Japanese Yen: Japan's economy contracted by a larger-than-expected 2.1% at an annualized pace in Q3. Consumer spending and business investment declined for the second consecutive quarter. Arguably, with the help of a JPY13.2 trillion (~$87 bln) extra budget, which includes income tax rebates and funds for lower income households, the economy will likely return to modest growth in Q4 23. The Bank of Japan meeting concludes on December 19. Earlier speculation of an exit from the negative policy rate has been pushed out to March or April. Still, the BOJ is gradually normalizing policy. It has not purchased any Japanese real estate investment trusts (J-REITs) this year and has bought the least amount of equity ETFs since 2010. Yet, while the other major central banks have seen their balance sheets shrink, the BOJ's balance sheet rose to about 132% of GDP from around 126.5% at the end of 2022. Headline CPI peaked in January at 4.3% and has steadied around 3.2%-3.3% in recent months. The core rate, which excludes fresh food was at 2.9% in October, down from 4.2% at the start of the year. The Bank of Japan's forecasts it to be at 2.8% in the next fiscal year before falling to 1.7% in FY25. Of course, embedded in the forecast is BOJ's policy. The latest Bloomberg monthly survey found a median forecast of core CPI for FY24 at 2.2% and 1.6% in FY25. The dollar peaked near JPY151.90 in mid-October to approach but not take out the high from October 2022. A combination of valuation, which OECD's model of purchasing power parity, estimates is more than 50% under-valued against the US dollar, and ideas that the BOJ will exit is extraordinary monetary policy may help underpin the yen as US rates ease. Anecdotal reports already suggest some investors and asset managers have already begun buying the yen and/or Japanese assets. Still, in late November, speculators in the futures market had their largest net short yen position since late 2017. It increased by almost 30% in November, warning that they may be in weak hands, and vulnerable to short squeeze. The move appears to have already begun, but if the market has gotten ahead of itself on US rate expectations, there may be scope for the dollar to return toward JPY150 before the downtrend resumes. 

Spot: JPY146.80 (JPY149.65) Median Bloomberg One-month forecast: JPY146.30 (JPY147.20) One-month forward: JPY146.15 (JPY148.90) One-month implied vol: 8.8% (8.1%) 

British Pound: The UK economy did not contract as economists expected in Q3, but the stagnation masked a 0.4% decline in consumption, the most since Q3 22 and a whopping 2.0% decline in business investment, the most since Q1 21. Economists in Bloomberg's survey expect the British economy not to grow until Q2 24. The Bank of England's latest forecast see the economy stagnant next year, which is more pessimistic than the European Commission (0.5%), the IMF (0.6%), and the median forecast in Bloomberg's survey (0.4%). However, a small upgrade is possible after the government's Autumn statement, which eased fiscal policy by about GBP18 bln. It included a cut in the rate of national insurance by two percentage points and made permanent the full expensing of capital investment. The reduction of the national insurance tax is worth about GBP450 a year to the average wage earner. On the other hand, personal allowances will remain frozen for the next five years, which will lead to bracket creep (inflation pushing wage earners into higher tax brackets. Consumer price inflation has slowed from 10.5% at the end of 2023 to 4.6% in October. If UK consumer prices rise at the same pace for the next six months as they have for the past six months, headline inflation can be below 3% early spring 2024. The swaps market has a little more than an 80% chance that the first rate cut is delivered by the end of H1 24. In November, sterling extended its recovery to about seven cents off the October 4 low near $1.2035. It met an important technical retracement objective at $1.2720. The $1.2800 area offers the next chart resistance. Sterling's 3.8% rally in November, the largest since November 2022, has stretched momentum indicators. Downside risk may extend toward $1.2450-$1.2500. 

Spot: $1.2710 ($1.2120) Median Bloomberg One-month forecast: $1.2600 ($1.2215) One-month forward:  $1.2715 ($1.2125) One-month implied vol: 7.1% (7.5%) 

Canadian Dollar:  The Canadian economy contracted by 1.1% at an annualized rate in Q3, the worst performance among the G7 and is in stark contrast with the heady 5.2% pace the US reported. Inventories and exports were drags, while consumption was flat in Q3. We suspect this overstates the weakness of the Canadian economy. The nearly 60k increase in full-time jobs in November, more than the total of the prior four months lends credence to our suspicions. Previously, the central bank was concerned about excess demand, but this seems to have been satiated. This may also help ensure that inflation remains on a downward trajectory. Just as the Bank of Canada was among the first of the high-income countries to raise rates (March 2022), it is seen to be among the first to cut rates. The swaps market is pricing in almost a 70% chance that the first cut is delivered in late Q1 24 and has three cuts and a little more fully discounted by the end of Q3 24. The Bank of Canada's last meeting of this year is on December 6, and while it will not do anything, it could modify its forward guidance. But the resilience of the labor market argues against expecting a validation of interest rate expectations. The US dollar recorded the year's high against the Canadian dollar on November 1 near CAD1.3900 and then trended lower for the rest of the month. The Canadian dollar's 2.25% gain snapped a three-month drop.  The US dollar slipped through CAD1.35 on December 1 amid a broad sell-off and after strong jobs growth reported. The next technical target is the CAD1.3380-CAD!.3400 area.  However, the momentum indicators are stretched, and risk extends back to the CAD1.3600 area.

Spot: CAD1.3500 (CAD 1.3870) Median Bloomberg One-month forecast: CAD1.3500 (CAD1.3675) One-month forward: CAD1.3490 (CAD1.3865) One-month implied vol: 5.6% (5.7%) 

Australian Dollar:  The Reserve Bank of Australia delivered a quarter-point hike last month, lifting the target rate to 4.35%. Governor Bullock warned that higher rates may be needed. The market initially seemed to react according on interest rates and the Australian dollar. However, data disappointed. The labor market is cooling. Australia created an average of 16k full-time jobs a month this year. The average was three-times higher a year ago. Retail sales unexpectedly fell in October (-0.2%) for the first time since June. Inflation slowed more than expected in October and at 4.9% (from 5.6%), it matches the low for the year set in July. After the November hike, there was never really a strong chance of a follow-up hike this month, but the market now sees little chance of another hike in the cycle. The probability of a hike in H1 24 has fallen to around 20% from closer to 75% after Bullock's comments in late November. The Australian dollar had carved a double top around $0.6900 in June/July, which projected to $0.6300. The Aussie overshot it and recorded a low in late October near $0.6270. It recovered to reached $0.6675 in late November-meeting an important technical retracement of the sell-off from the July high. While there may be scope for a new high, we expect it to be marginal before a setback toward $0.6500.

Spot: $0.6675 ($0.6335) Median Bloomberg One-month forecast: $0.6655 ($0.6420) One-month forward $0.6685 ($0.6340)    One-month implied vol 9.0% (9.9%) 

Mexican Peso:  The Mexican economy is slowing, but it remains more resilient than several of its neighbors who have already begun cutting rates. The strong worker remittances more than cover the trade deficit, which is on pace to fall to about a third of last year's shortfall. The carry remains attractive, but it is an old story, and encouraged by some official comments, the market bringing forward Banxico’ s first rate cut into Q1 24 from Q2 24. Indeed, over the next 12 months, the swaps market is pricing in about 180 bp of cuts in Mexico and 115 bp in the US. The dollar approached MXN17.00 (~MXN17.0350) in late November, essentially meeting the objective of a double top formed in October. The market seems reluctant to push it further. It has come down from almost MXN18.50 in October, and the funding leg of the carry trades, besides dollars, like yen, or Swiss franc, or the offshore yuan, strengthened. This generated some positioning pressure on the peso. The dollar recovered to MXN17.50 at the end of November. That may not have exhausted the corrective potential, and the risk may extend toward MXN17.70-80.

Spot: MXN17.1950 (MXN18.11) Median Bloomberg One-Month forecast MXN17.3875 (MXN17.95) One-month forward MXN17.28 (MXN18.22) One-month implied vol 11.9% (13.9%)

Chinese Yuan: Officials have announced a series of measures to support the economy and the property sector. While interest rates have been left unchanged, the PBOC has made sizeable injections of liquidity. The central government will boost its deficit by CNY1 trillion and is considering launching another CNY1 trillion fund to support public housing and urban renewal. The PBOC launched a facility to help relieve the debt stress of some local governments. There have been several high-level meetings in recent weeks, culminating a meeting between President Biden and Xi last month. Xi seemed to have gone on a charm offensive with Mastercard getting its long-awaited permission to enter a local JV, possible orders for Boeing's Max 37 airplanes, new soy purchase orders, and after repeated denials it can do anything about the fentanyl trade, more efforts were promised. That said, reports suggest that China's aerial harassment of Taiwan continued, and the risk is that it may intensify ahead of Taipei's election in mid-January. Meanwhile, China's low interest rates and the low volatility of the offshore yuan makes the Chinese currency a candidate for funding (borrowed cheaply and sold for the purchase of a higher yielding or more volatile asset). Another way this is expressed is the marked increase in foreign entities issuing bonds on the mainland ("panda bonds"). The issuance this year is a record through mid-October (73 issues for ~CNY126.5 bln, or ~$17.7 bln, a 60%+ increase year-over-year). Beijing has also lifted the restrictions on the outward transfer for funds raised in such offerings. This is also another, though less appreciated, dimension of the internationalization of the yuan. With the long Chinese holiday in October, heighted efforts by the PBOC to stabilize the yuan, and the elevated threat of BOJ intervention, the yuan decoupled from the yen, and the 30-day rolling correlation was near zero at the end of October, it has recovered to slightly above 0.60 by late November. The year's high was 0.70. The yuan's correlation with the euro rose from around 0.20 at the end of October to almost 0.60 at the end of November.