Dollar Index Gives Back Half of 21-Month Gains in 3 1/2 Months

by
Marc Chandler
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Overview: The continued easing of US price pressures has strengthened the market's conviction that the Federal Reserve will further slow the pace of rate hikes and that the terminal rate will be near 5.0%. The decline in US rates has removed a key support for the US dollar, which has fallen against all the G10 currencies this week. The Dollar Index has now retraced half of what it gained since bottoming on January 6, 2021. Meanwhile, there are positive developments elsewhere. The German economy appears to have stagnated in Q4 22 rather than contracted, and the UK economy grew in November when most economists expected it to have shrunk. 

The Japanese yen has led the move against the dollar, rising 2.8% this week amid heightened speculation that the Bank of Japan could take another step away from its easy monetary policy as soon as next week's meeting. Still, in the past two sessions, the BOJ has bought around $75 bln of government bonds, and still the 10-year yield traded through its 0.50% cap. Investors continue to look beyond the Covid surge in China, and the lack of transparency, and do not seem disturbed by "golden shares" the government will take in two leading companies. Foreign investors have poured back into Chinese equities, buying around $2 bln today alone. China's CSI 300 gained 2.3% this week and the index of mainland companies that trade in Hong Kong rose 3.5% this week. 

Asia Pacific

There is heightened speculation that the Bank of Japan could abandon its yield curve control--the 0.50% cap on the 10-year yield--entirely as early as next week. Many, if not most observers, saw the December surprise as a prelude to the BOJ exiting from the extraordinary policy and the last country with a negative policy rate (despite current inflation well above target). However, the more aggressive calls had been for another move in March, at Governor Kuroda's last meeting before his term ends in early April. The latest speculation seems a bit much. In addition to expanding the band for the 10-year JGB last month, the BOJ also announced it would increase the JGBs it was buying (QE) from JPY7.3 trillion a month to JPY9 trillion (~$68 bln). This was not even a month ago. Moreover, at the time Kuroda insisted that yield curve control was not being abandoned but its effectiveness enhanced. Still, having been taken by surprise in December, the market remains wary. After record purchases yesterday (JPY4.6 trillion, ~$36 bln, of which JPY2.8 trillion was of the 10-year bond), the BOJ stepped in again today, setting a new overall record (JPY5 trillion and JPY3.2 trillion of the 10-year bond) with the yield trading as much as five basis points through the cap.

There are two developments in China to note. First, offshore investors are returning to China in a big way. Today, alone, using the trading links with Hong Kong, they bought about $2 bln of Chinese equities, the most in around two months. Since the end of October, there has been around $23.7 bln of equity inflows. China's CSI 300 Index rose 1.4% today and is up 16% from October's three-year lows. News that arms of the Chinese government are taking "golden shares" in Alibaba and Tencent did not discourage foreign investors. Second, China imports and exports fell less than expected last month, generating a larger trade surplus. Exports, which fell 8.9% year-over-year in November, fell 9.9% in December. Still, better than the 11.1% decline in expected by Bloomberg's survey. Imports, fell 7.5% in December after a 10.6% decline in November. The median forecast in Bloomberg's survey was for a 10.0% decline. Note that the data in terms in the yuan look considerably different. Exports were off 0.5% in yuan terms and imports were up 2.2%.

The dramatic expansion of the BOJ's balance sheet has not deterred the yen buying. The yen is trading is trading at its best level since last June. The dollar fell to almost JPY128.10 in late Asian turnover, meeting the (61.8%) retracement of last year's rally. A break of JPY128 could see JPY127.50 next, but the next important chart area is near JPY125.00. Note that the lower Bollinger Band is around JPY128.80 today. The Australian dollar is holding slightly below $0.7000, where options for A$1.34 bln expire today. A convincing break of this area targets $0.7090 to $0.7140. It is also flirting with its upper Bollinger Band, which is found near $0.6985 today. It is the fourth consecutive weekly gain by the Australian dollar, which fallen in only two weeks since mid-October. The greenback's losses against the Chinese yuan have been extended to almost CNY6.7035.  Recall that a couple of days before Christmas, the dollar was near CNY7.0. It has not been this low since last July. The PBOC set the dollar's reference rate slightly firmer than expected at CNY6.7292 instead of CNY6.7285 (median projection in Bloomberg's survey). It can hardly be considered a protest of yuan's strength. Lastly, note that South Korea's central bank delivered the expected 25 bp hike, lifting the seven-day repo rate to 3.50%. Although the swaps market thinks this is the top, the central bank did not confirm that, keeping its options open. The US dollar slipped about 0.35% against the won to bring the weekly loss to about 2.15%.

Europe

The UK offered a pleasant surprise today. It reported its economy grew 0.1% in November in the face of expectations for a 0.2% contraction. Still, it contracted by 0.3%, as anticipated in the three months through November as the October contraction was deeper than initially reported. The modicum of strength was seen in services, which expanded by 0.2% and construction, which was flat. Industrial output contracted and the trade deficit widened. Next week, the UK reports December inflation and retail sales. The swaps market is pricing in a nearly 73% chance that the BOE hikes by 50 bp when it meets on February 2.  

Germany reported that its economy grew by 1.9% last year (2.6% in 2021), which is slightly better than economists projected in Bloomberg's survey. This would translate into stagnation in Q4 rather than a contraction. Supply chains have opened, and companies are reportedly working through the backlog, while energy prices have eased, and the mild winter so far has helped. While most economists are project a contraction this year, one of Germany's leading think-tanks revised its forecast last month to a 0.3% expansion. Separately, the eurozone reported a 1.0% increase in November's industrial output rather than the 0.5% decline of the median forecast in Bloomberg's survey. And the November trade deficit was smaller than expected at 15.2 bln euros instead of 21.0 bln. The October trade deficit was 28.1 bln euros.

The euro made a marginal new high today, a little closer to $1.0870 but is consolidating yesterday's gains with a slightly heavier bias in the European morning. That said, it remains above its upper Bollinger Band, which is found near $1.0830. Initial support is seen around $1.0820. The euro has a five-day rally in tow. It fell almost 0.6% last week but is up 1.8% this week, its seventh weekly gain in the past eight weeks. The next important upside target is $1.0940, the (50%) retracement of its losses since the $1.2350 area was approached in early 2021. Sterling is firm and in a narrow range near yesterday's high, just shy of $1.2250, which is where its upper Bollinger Band comes in today. Recall that it reached a high last month near $1.2450. This is the third consecutive weekly advance for sterling, which follows a three-week downdraft. 

America

US headline CPI rose at an annualized rate of about 1.6% in Q4, down from 2% in Q3 23, and more than a 10% run-rate in Q1 and Q2 year. The core rate annualized pace has slowed from slightly more than 6% in Q3 to around 3.2% in Q4. That probably overstates the case, as it seems clear that shelter costs will fall later in a few months. Core services, excluding shelter cost fell at an annualized rate of 1.0% in Q422. Core goods prices fell by a 4.8% annualized rate. The data reinforced the consensus view, and as did the recent Fed comment (Harker, Collins) of a quarter-point hike at the conclusion of the FOMC meeting on February 1. The probability in the Fed funds futures market of a 50 bp more has fallen below 10%.

Perhaps, just as significantly, the market is even more confident of a rate cut before the end of the year. The implied yield of the December Fed funds futures contract has fallen to a new low below the September contract of 34 bp. The Fed seemed to go out of its way to include in the December minutes the observation that no official expected it to be appropriate to cut rates this year. And yet, the market has said not only will you cut a quarter-point, but after the CPI, report, there is better than a one-in-three chance that rates are cut by 50 bp instead before the end of the year. There is also, the Fed funds market implies, about 30% chance that a cut take place in Q3. According to the Bloomberg's index, financial conditions in the US yesterday were the easiest since last April. This seems a bit exaggerated, intuitively, given where rates, stocks, funding spreads, and the dollar are trading compared to last April. Still, a few weeks ago the Fed was concerned about the premature easing of financial conditions. Today, the Us reports December import/export prices and the preliminary January University of Michigan's consumer survey, where inflation expectations are the focus. The Fed's Kashkari and Harker are scheduled to speak today. Harker's views are known, and Kashkari is seen to be among the hawks now, but we suggest it has better considered him an activist, i.e., advocating strong action in whatever direction the Fed is moving.

Canada and Mexico's economic calendars are light. The US dollar is trading heavily against the Canadian dollar. It traded near CAD1.3320, the lowest level since late November and below the lower Bollinger Band (~CAD1.3335). The greenback posted a bearish outside down day yesterday by trading on both sides of Wednesday's range and settling below Wednesday's low. Nearby support is seen around CAD1.3300 and then the mid-November low closer to CAD1.3225. The Mexican peso remains firm. It continues to trade at its best level since March 2020. The greenback has nicked the MXN18.82 area. The lower Bollinger Band is around MXN18.8120 today. That said, the dollar's downside momentum appears to be stalling ahead of the weekend.  Lastly, note that Peru, as expected hiked its reference rate late yesterday by 25 bp to 7.75%.