March 2023

by
Marc Chandler
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Price pressures remain elevated, and labor markets are strong, giving most policymakers in the G10 the incentive to continue raising interest interests. There are two exceptions: Japan, the only country still with a negative policy rate (-0.10%), and Canada, where the central bank has indicated it would pause. While half-point hikes or larger were common in the second half of last year, the major central banks have slowed or will slow the pace to quarter-point moves as the endgame is in sight in either late Q2 or early Q3. The European Central Bank stands out as the exception, which has pre-committed to a 50 bp at its March meeting, even before the staff provides new forecasts. It may also be early to rule out a 50 bp hike at the early May meeting.

Four developments in February helped shape the business and investment climate. First was the string of robust US economic data that saw market expectations converge with the Fed's more hawkish outlook. This was reflected in a sharp backing up of US interest rates, with spillover effects and recovery in the US dollar after falling for 3-4 months. Second, strong data and elevated prices spurred speculation that the terminal rate for European Central Bank is also higher than previously anticipated. The swaps market is pricing in the risk of a 4% terminal rate, up from 3.50% at the start of the year. Third, higher-than-expected Japanese inflation and a surprise choice for Bank of Japan Governor Kuroda's successor kept expectations running high for an exit from Japan's extraordinary monetary policy. However, these faded as the nominee endorsed the current policy settings. Fourth, the optimism over the re-opening of China post-Covid was tempered. Flows into Chinese stocks slowed, and the yuan unwound January's gains.

Until the extremely strong US jobs growth reported on February 3, the Fed funds futures market had priced in a terminal rate below 5%. In December, the median projection of Federal Reserve officials was for a peak closer to 5.25%. However, the employment report, robust service ISM survey, and economic data showing a solid rebound in consumption and output spurred the market to catch up with the Fed. After bottoming on the eve of the jobs report near 4.0%, the two-year yield traded above 4.80% amid talk of "no-landing" replaced speculation about a "soft" or "hard" landing of the world's largest economy. While the yield was rising, the US dollar appreciated by about 3.5% on a trade-weighted basis, which is the biggest increase since it peaked last October. As a result, the Fed funds futures market has second thoughts, as it were, about the prospects of a rate cut before the end of the year. The January 2024 Fed funds futures contract (the FOMC meeting concludes on January 31) yield was slightly more than 35 bp below the September contract at the end of January 2023. It finished February near 10 bp. 

A US rate cut has not been completely dismissed, but it is now seen as less than a 50/50 proposition than a high conviction view. Inversion of various measures of the yield curve and the contraction of M2 money supply, the limits of withdrawal from some significant property funds, the rise of business failures, and the increasing default rates on auto loans continue to warn of economic hardship and a downturn. Moreover, the index of Leading Economic Indicators has fallen for ten consecutive months through January, the longest since the Great Financial Crisis. The 7.0% decline at an annualized rate in the past six months has been a reliable signal of a recession for over half a century.

On the other hand, even if the January employment growth (517k) was a distorted exaggeration, most metrics of the US labor market illustrate its strength. This is true more broadly, too. It seems that post-Covid, labor markets throughout the G10 are particularly tight. Conventional wisdom deduces two things from the resilience of the labor markets. First, economic downturns, if they materialize, will be short and shallow. Second, upward pressure on prices may not be broken until labor market conditions ease. These views may be challenged in the coming months. The Bank of England anticipates a five-quarter recession despite the tight labor market. Japan has long experienced low unemployment with low wage pressure and low inflation (before Covid). The US economy contracted in Q1 and Q2 22 despite solid job growth and rising wages.

Governor Kuroda will chair his Bank of Japan policy meeting on March 10. The swaps market is pricing in a positive overnight target rate at the first of Kuroda's successor's (Ueda) meeting on April 28. This seems too aggressive given the official view, which Ueda shares, that Japanese inflation is about cost-push. A policy review and a broader plan of sequencing an exit, when appropriate, are the most reasonable first steps. Meanwhile, Japanese investors are re-investing substantially Japanese investors are re-investing substantially after being large sellers of foreign bonds, in 2022according to weekly Ministry of Finance data. In the first seven weeks of the year, Japanese investors have replaced about a fifth of the international bonds they liquidated in 2022.

China has stepped up its lending and support for the beleaguered property sector, but it is not clear that the measures are sufficient. Mortgage lending remains weak. President Xi's call for more robust consumption is a recognition of the validity of critics' complaints. From the end of last October through late January, the index of mainland shares that trade in Hong Kong rallied by 57%. The euphoria over activity during the Lunar New Year seemed to mark the peak. Since the six-month high in January, the index has fallen by more than 12%, and the yuan surrendered January's gains. Still, the February PMI shows a recovery is taking hold and led by services in the face of weak foreign demand that may be curtailing the recovery in the manufacturing sector. The strength of the construction sector reflects debt-financed local-government infrastructure spending. The National Party Congress, beginning in early March, will see personnel appointments in Xi's third presidential term, including a new central bank governor. 

Russia's invasion of Ukraine in February 2022 shows no sign of ending. However, the human tragedy and military confrontation have grown while the economic impact has arguably lessened. Conservation and a relatively mild winter have seen Europe escape a recession, and natural gas prices (Europe's Dutch benchmark) are cheaper now than when the war began. Brent crude oil was around $90 a barrel at the end of January 2021. It is now near $85. The price of wheat (CBOT futures) is slightly lower than when the invasion began.

Rising US rates and the dollar's gains against the G10 currencies often is disruptive for emerging markets. The JP Morgan Emerging Market Currency Index fell by about 2.0% last month, its worst monthly performance since last September. However, the Mexican peso shined in this challenging environment. It was the strongest in the emerging market space, appreciating by more than 2%. Despite concerns about President AMLO's policies, the central bank demonstrated its independence and anti-inflation credentials by surprising investors with a 50 bp hike last month. Portfolio and direct investment inflows and strong worker remittances help underpin the peso, which rose to new five-year highs in February. On the other hand, the South Korean won was the weakest among emerging market currencies, falling about 6.9%. The central bank paused its tightening cycle with the key rate at 3.5% (January CPI was 5.2% year-over-year), and exports, led by semiconductor chips, continue to decline.  

We had anticipated the BWCI to return to January lows, but it fell further to reach its lowest level since early December, as the foreign currencies pared gains scored over in the October-January period. We suspect the bulk of the pullback is behind it and look for a modest recovery in March, driven by weaker US economic data and a new peak in the anticipated terminal rate for Fed funds. March may be a consolidative phase.

Dollar:  The dollar rose broadly last month. On a trade-weighted basis, it snapped a four-month decline. The key driver was the reassessment of the outlook for Fed policy, and the market concluded the policy rate will be higher for longer following a string of strong US economic data. Price pressures were also stronger than expected. As a result, the market now sees the risk of Fed tightening into Q3 and the peak closer to 5.5% rather than 5.0%. The two-year note yield surged from almost 4% on February 2 to 4.85% by the end of the month. The swings in the pendulum of market sentiment are powerful, and we suspect they have swung too far. January data is most unlikely to repeat itself. The US is not growing half a million jobs a month, and retail sales are not rising by 3% a month. While we expect the data to considerably soften in the weeks ahead, one critical piece will be the Fed's Summary of Economic Projections at the March 22 meeting. The issue is whether the median dot for this year is boosted from the 5.1% in December, which is to ask whether the recent high-frequency data changed the outlook for officials. That said, they may not think it strategic to appear more dovish than the market.

Euro:  The euro snapped a four-month rally and fell about 2.25% against the dollar in February. It seemed to be largely a case of a strong dollar and market positioning, rather than a negative European development. The US data surprised more to the upside, while the left-hand tail risk in Europe had already been reduced. The market also sees the ECB raising rates more and longer than previously. After a slow start last month, the German two-year rate kept up with the US. The US premium over Germany had fallen to about 156 bp at the end of January (from 277 bp at its peak last August). A session after the employment data, it peaked at around 186 bp and settled in a 173-178 bp range until the end of the month when it fell to about 165 bp, coinciding with almost a cent gain in the euro off the month's low. The terminal ECB rate is now seen near 4.0%. At the end of January, the swaps market was divided between 3.25% and 3.50%. The ECB meets on March 16. There is little doubt that it will hike 50 bp. Two issues may have greater impact than the hike itself. First, will it pre-commit to another 50 bp hike at the next meeting in May? Second, and not unrelated, are the new staff forecasts. In December, it forecasted the eurozone economy to nearly stagnate this year (0.5% year-over-year growth) and recover to 1.9% and 1.8% in 2024 and 2025. Inflation was seen slowing from 8.4% last year to 6.3% this year and 3.4% in 2024 before falling to 2.3% in 2025.
 
(February 28 indicative closing prices, previous in parentheses)
 
Spot: $1.0575 ($1.0795)
Median Bloomberg One-month Forecast $1.0635 ($1.0745)
One-month forward $1.0600 ($1.0580)   One-month implied vol 8.1% (8.1%)    
 
 
Japanese Yen:  Rising US rates and growing acceptance that the new leadership at the central bank will most likely not make dramatic changes in the immediate future weighed on the yen, which fell by almost 5% in February. Many expect a change in policy in early Q3 after a policy review. After loosening since the December surprise, the correlation between changes in US yields and the exchange rate tightened. There are two key dates for Japan in March. March 10, the BOJ meeting concludes hours before the US February employment data. It is Governor Kuroda's last meeting. The market had been wary of a "goodbye surprise," but it seems unlikely now that his replacement has endorsed the current settings. On March 24, Japan reports February CPI. In his appearance before the Diet, the next BOJ governor lent more credibility to our argument that inflation is peaking in Japan. Tokyo's CPI on March 2 will provide an early test for the hypothesis. Barring fresh surprises, the dollar looks positioned to extend its recent recovery against the yen. While the JPY137.50 area may offer some resistance, the upside risk may extend toward JPY139.50-JPY140.00.
 
Spot: JPY136.20 (JPY131.20)    
Median Bloomberg One-month Forecast JPY134.40 (JPY130.55)
One-month forward JPY135.55 (JPY130.70) One-month implied vol 12.2% (12.2%)
 
 
British Pound: Stronger-than-expected economic data, including a surprise increase in January retail sales, a jump in the flash composite February PMI to a six-month high (53.0), and sticky inflation (headline remained above 10% in January) encouraged the market to price in a more aggressive outlook for monetary policy. The terminal rate is now seen closer to 4.75% from 4.25% in January. The Bank of England meets on March 23, and a quarter-point hike is fully discounted. The day before the meeting, February's CPI will be reported. Many observers are also more optimistic about a deal on the Northern Irish protocol and the labor strife. Although technically, a parliamentary vote for the new agreement (Windsor Framework) may not be needed, political necessity will force one, perhaps in March. The Chancellor of the Exchequer delivers the budget on March 15. A critical fight is shaping up with the Conservative Party over the planned corporate tax hike. Since mid-December 2022, sterling has been consolidating in a roughly $1.1840-$1.2450 range. A convincing break of it signals a deeper correction of sterling's run-up from the record-low around $1.0350 last September. However, the favorable news stream suggests continued range-bound trading is likely in the month ahead.

Spot: $1.2015 ($1.2055)   
Median Bloomberg One-month Forecast $1.2060 ($1.2080) 
One-month forward $1.2025 ($1.2065) One-month implied vol 9.8% (9.8%)
 
 
Canadian Dollar:  The shift toward "higher for longer" rates in the US and Europe weighed on the Canadian dollar, where the Bank of Canada announced a pause in late January. The sell-off in US equities is also correlated with a weaker Canadian dollar. On the other hand, in a strong US dollar environment, the Canadian dollar often outperforms on the crosses. This was the case in February. The Canadian dollar fell by about 2.0% in February, the third best among the G10 currencies behind the Swedish krona, where the central bank made a hawkish pivot and sterling, with a favorable news stream. The swaps market is pricing in another hike later this year, but it is not clear what will move the central bank. We suspect another outsized rise in employment (121k full-time jobs in January) would push it in that direction. The Bank of Canada meets on March 8, two days before the employment report and nearly two weeks before the February CPI (5.9% in January). The BoC forecasts the economy will slow this year to 1.0% (~3.6% in 2022) and sees inflation slowing to 3.6% (6.8% last year). The CAD1.3700 area is technically important. A move above it could spur a run toward the previous year's high set in mid-October, a little shy of CAD1.40. It would probably coincide with weaker US equities. 

 
Spot: CAD1.3640 (CAD 1.3400) 
Median Bloomberg One-month Forecast CAD1.3535 (CAD1.3400)
One-month forward CAD1.3635 (CAD1.3395)   One-month implied vol 7.1% (7.2%) 
 
 
Australian Dollar: From October 2022 through January 2023, the Australian dollar rose by 10.3% against the US dollar, and in February, it gave back almost half. While this is largely a function of a high-beta currency, there are also a few Australian-specific knocks, including being one of the few G10 countries with a sub-50 composite PMI and a labor market that may be cracking. While China has lifted its embargo against many imported products from Australia, investors appear less enamored with the mainland, and the Aussie is the G10 proxy. The weakness in gold and copper prices was also seen as a drag. The Reserve Bank of Australia meets on March 7; another quarter-point hike is likely (bringing the target rate to 3.60%). The swaps market anticipates a peak rate of about 4.25%. Australia's February employment report is on March 16, and the (newly launched) monthly CPI report is due on March 29. The composition of the central bank's board will likely change dramatically in the coming months. Two of the six non-executive directors' terms expire, and reports suggest they do not seek re-appointment. More importantly, Governor Lowe's term expires in September, and he may not be granted a second term. An independent review of the central bank will give a final report to Treasury Chalmers at the end of March. The Australian dollar peaked near $0.7160 in early February, the highest level in eight months. It reversed lower and tested $0.6700 late in the month. The $0.6665 area marks the halfway point of the rally that began last October (near $0.6170. A break warns of risk toward $0.6550, while a move above $0.6800 (also the 200-day moving average) would lift the technical tone. 

Spot: $0.6735 ($0.6925)     
Median Bloomberg One-month Forecast $0.6800 ($0.6910)    
One-month forward $0.6740 ($0.6930)    One-month implied vol 12.5% (12.8%)

 
Mexican Peso:  The peso was the market's darling in February. It was one of the only currencies to appreciate against the recovering US dollar. It gained about 2.8% and rose to new five-year highs. The central bank surprised the market by delivering a half-point rate hike (11%) and signaled that the stubborn core inflation would require higher rates. The high rates and relatively low currency volatility make it a favorite for carry strategies. Even with the pullback in February, Mexico's Bolsa is up almost 9.5% (and ~16.5% in dollar terms). Also, with near-shoring and friend-shoring the rage, Mexico is reportedly drawing direct investment flows. Banxico meets on March 30 and is expected to match the Federal Reserve's quarter-point move. The swaps market sees a terminal rate of about 11.75%. Measures that weaken an election oversight agency passed the Senate in late February and will most likely be signed by the president, even though legal challenges are pending. The capital markets showed little reaction. There are two governor elections this year (June) and the presidential election next year.

Spot: MXN18.31 (MXN18.97)  

Median Bloomberg One-Month Forecast MXN18.50 (MXN19.25)  
One-month forward MXN18.43 (MXN19.06) One-month implied vol 10.5% (10.1%)
  
 
Chinese Yuan:  Through February 24, the yuan had fallen for five consecutive weeks as the exchange re-adjusts to higher US rates for longer. Also, investors seem less enamored with the re-opening story that led to yuan and equity strength in January. The index of mainland shares that trade in Hong Kong rallied 10.7% in January, giving it all back, and some in February. China's 10-year bond yielded about 50 bp less than the US Treasury in early February, and by the end of the month, the discount was slightly more than 100 bp. The dollar is tested the CNY7.0 area, and the next important chart area is CNY7.08-CNY7.10 and then CNY7.15. The yuan seems to be broadly tracking the dollar's movement, and the rolling correlation with the euro and yen remain notable. Still, the February PMI was considerably stronger than expected and the recovery story may gain new traction in March. The dollar could fall back toward CNY6.80. The heightened tension between the Washington and Beijing has not directly impacted the exchange rate. Still, if China is going to be lagging in using advanced semiconductors, it could have knock-on effects on foreign direct investment. As a significant bilateral lender, China is in the middle of the growing emerging market debt problems. The US is seeking reform of the multilateral lending institutions in one direction. China is pulling in another, seeking greater voting authority, and some of its lenders are preferred, like the World Bank and International Monetary Fund. In terms of Ukraine, Beijing, which we argue, is at a greater disadvantage because of Russia's invasion. It has galvanized countries like Japan, Australia, and South Korea. NATO will likely be larger in terms of numbers and the ability to project power. The more Beijing plays its Russian card to frustrate the Americans, the more it alienates Europe.

Spot: CNY6.9355 (CNY6.7980)
Median Bloomberg One-month Forecast CNY6.9020 (CNY6.80) 
One-month forward CNY6.9300 (CNY6.79) One-month implied vol 9.5% (8.9%)