The Market Appears to Shrug Off the Fed’s Warning

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Marc Chandler
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Overview: The US dollar is consolidating in a mixed fashion today. The FOMC minutes drew much attention but failed, at least initially, to spur a significant shift in expectations. The pricing in the Fed funds futures strip is still consistent with a cut later this year, which the minutes were clear, no officials anticipate. Today's US ADP jobs estimate, and November trade balance are being overshadowed by tomorrow's nonfarm payroll figures. The Fed's Harker, Bostic, and Bullard speak today. They should be expected to stay on message, which is leaning against any premature easing of financial conditions.

Meanwhile, strong buying of Chinese stocks through the Hong Kong link, and the rally in mainland shares that trade in Hong Kong suggest investors continue to look past the current Covid disruptions. Beijing continues to promise measures to support the economy. The yuan traded at new four-month highs today. Europe's Stoxx 600 is struggling to sustain gains, with a three-day rally in tow. US futures are slightly firmer. Among the G10 currencies, the Swiss franc and Japanese yen have edged up, while sterling and the Canadian dollar are laggards, off about 0.25% near midday in Europe.

Asia Pacific

As others have noted, one of the problems with the basic balance approach to foreign exchange valuation is that is does not necessarily pick-up hedging transaction, and this is particularly important in trying to understand the impact of the BOJ's decision to double the yield band of the 10-year JGB. What the basic balance approach will pick-up is that foreign investors sold a record of nearly JPY5 trillion (~$36.2 bln) of Japanese bonds in the week ending December 23.  Ironically, many observers seem more concerned that with higher yields at home, Japanese investors would dump foreign bond holdings. In fact, they did sell, but less than half of what they divested in the previous week and about a tenth of what foreign investors sold. What the basic balance won't be able to explain well is the surge in the yen. The yen strengthened by nearly 4% against the dollar on December 20, the day the BOJ moved.  For the week as a whole, while foreign investors were dumping Japanese bonds, the yen strengthened by 2.8% and subsequently extended those gains.  Some observers may scoff at foreign investors buying the near-zero yielding JGBs in the first place, but that is mostly, it seems, because they do not understand the trade: Long JGBs short the yen. The profit was not to be found buying the JGBs but in swapping the yen for dollars. This is to say, the attractiveness of the play was in the hedge not the initial purchase of JGBs, and that hedge is not found in the basic balance approach to foreign exchange.

Today, the Japanese government sold JPY2.7 trillion (~$20.5 bln) 10-year bonds at an average yield of 0.5%, the new upper limit of the BOJ's band and the highest rate since 2015. Demand outstripped supply by 4.76-times, which is higher than the average of the past ten auctions. After being surprised by the BOJ last month, many see it as a step toward normalization with more steps likely this year.  BOJ Governor Kuroda denied this and the BOJ record purchases of JGBs last month underscored his claim. Still, the BOJ's next meeting concludes on January 18 and new forecasts will be provided. The focus is on its inflation forecasts and several reports suggest that it may revise up its core rate forecast up from 2.9% this fiscal year and 1.6% in the next two years. Yet, the median forecast in Bloomberg's survey sees the core rate at 2.0% this year and 1.4% in 2024.

The dollar recovered from its brief dip below JPY130 yesterday, and following the FOMC minutes, settled near session highs above JPY132.60. Follow-through buying was limited to the JPY132.90 area, a new high for the week. Nearby support is seen around JPY132.00. A move above JPY133.50 lifts the technical tone. The Australian dollar traded above its 200-day moving average yesterday for the first time since last June (~$0.6850) but failed to sustain it on a closing basis. Today, it is consolidating in a half-cent range above $0.6800, where there are nearly A$700 mln in options expiring (and another A$385 mln at $0.6805). It looks likely to be a consolidative session in North America too. The dollar traded heavily against the Chinese yuan today and recorded a new four-month low near CNY6.8680. The yuan may have been helped by demand for Chinese stocks, amid promises for more pro-growth policies, even though the lack of transparency over Covid was criticized by the World Health Organization. Demand for Chinese stocks via the link with Hong Kong rose to its highest level in seven weeks. The PBOC set the dollar's reference rate at CNY6.8926 compared with the median forecast in Bloomberg's survey for CNY6.9131, tight against the median projection in the Bloomberg survey for CNY6.8917.

Europe

News that the eurozone's producer prices fell in November and slowed the year-over-year pace to 27.5% from 30.8% seems largely immaterial from investors' and policymakers' perspective.  Tomorrow's December CPI is more important. Each of the Big Four reported lower than expected harmonized CPI headline figures. This is owing to lower energy costs, for which governments have offered tax breaks or subsidies. Headline eurozone CPI is likely to have fallen below 10% for the first time since last August. Core inflation is seen to be sticky. It was at the cyclical high of 5.0% in both October and November. There is risk that it ticks up.

Germany's trade surplus rose for the third consecutive month in November. The 10.8 bln euro surplus is the largest since last January. The three-month average stands at 6.7 bln euros, the highest in nine months. Month-over-month exports to outside of the eurozone rose by about 9.1%. Exports to the US rose by 5%, while shipments to China rose 9.3%. German exports to the UK surged nearly 26% month-over-month in November.  However, overall, exports fell by 0.3%, but shipments in October were revised to a 0.8% gain from an initial 0.6% decline. Meanwhile, weakness in domestic demand (the median forecast in Bloomberg's survey is for the German economy to have contracted by 0.5% in Q4 22, and to shrink by the same amount in Q1 23) weighed on imports. Imports fell 3.3% in November, more than three-times what the median forecast anticipated. Tomorrow German reports November retail sales, which may have bounced back after the 2.7% decline reported in October. Factory orders are also due, and here weakness in domestic and foreign demand is likely to be evident.

The Bank of England's business survey found expectations that inflation is still accelerating, and wage pressures continue. The survey results come during extending public sector strike activity that has closed the large rail stations today and limited train access to some airports. The survey found expectations for year-ahead inflation to rise to 7.4%, up from 7.2% in the previous month's survey. Wage expectations rose 0.5% to 6.3%, even as few companies reported hiring difficulties. Separately, the final service and composite PMI readings were in line with the flash report. The services PMI slipped to 49.9 from 50.0 preliminary but retains the bulk of the improvement from 48.8 in November. The composite PMI remained at 49.0, up from 48.2, where it was in October and November. 

The euro is in narrow range at the upper end of yesterday's (~$1.0540-$1.0635). There is no momentum to speak of and the market appears to be waiting for North American leadership.  Our bias is lower, on ideas that tomorrow's US jobs data may begin the shift of expectations toward a 50 bp hike by the Federal Reserve. We note that the 5-day moving average looks set to slip below the 20-day moving average for the first time since mid-October, reflecting the stalling of the euro's recovery from the multi-year low in late September. For its part, sterling is in a three-quarter-cent range above $1.20 today. There are options for about GBP755 mln at $1.20 that expire today. Sterling has not managed to trade above $1.21 yet this week. A break of $1.20 could see $1.1950, though the week's low is closer to $1.1900.

America

The US also reports its November trade figures today. The deficit widened in September and October and narrowing consistently since the supply chain disruption/inventory management challenge led to record shortfall in March 2022 of nearly $107 bln.  The deficit shrank to $65.8 bln as of August, but in October had widened to $78.2 bln. However, the advanced report on merchandise trade suggests a substantial improvement took place in November. The goods trade deficit narrowed to $83.3 bln from $98.8 bln in October. Of the $15.5 bln improvement, nearly two-thirds are accounted for by the small deficit on consumer goods. Exports fell 3.1% in November, while imports were reduced by 7.6%. 

The ADP changed their methodology in estimating the change in US employment and caution against using it as a lead indicator for the BLS nonfarm payroll report. Nevertheless, some market participants will react to today's report as if it were. What comes out from a broad array of readings on the labor market is that it remains quite resilient. Yesterday's JOLTS data showed about 400k more job opening than economists expected, the October data were revised higher by around 180k. Weekly jobless claims fell in the survey week but the four-week moving average has stable around 220k-230k for the past 10 weeks. The ISM manufacturing employment diffusion index has been straddling the 50-level in H2 22 and rose to 51.4 in December, it highest since August.

The FOMC minutes generated much discussion with its caution against easing financial conditions and it reported that no official sees a rate cut this year. That said, the Fed funds futures marginally increased the likelihood of a 50 bp hike on February 1 to about 38%. The spread between the implied yield of the September and December Fed funds futures contracts continues imply expectations for a rate cut late this year. The December yield has been at last 20 bp lower than the September yield since the softer than expected CPI report on November 10.

Canada reports its November merchandise trade balance today. The improvement in the Canada's trade balance faltered in recent months. Consider that the Q2 average was a C$3.35 bln surplus, while in three-months through October its was at less than C$0.5 bln. That said, the market does not appear particularly sensitive to the report. The US dollar frayed support yesterday and today near CAD1.3480, but it is still largely holding. We suspect there may be potential toward CAD1.3550 today, ahead of tomorrow's jobs report. The greenback recovered from the MXN19.26 area yesterday to settle a little above MXN19.38. It poked above MXN19.43 earlier today but has come back offered in the European morning. Still, the intraday momentum indicators suggest yesterday's lows look safe, at least in North American morning.