Week Ahead: Central Banks

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Marc Chandler
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There has been a dramatic adjustment to US rates. The two-year yield was near 4.40% before the US employment report on March 8 and it reached near 4.73% before the weekend. The 25 bp surge is the largest weekly increase since last May. For the first time in four months, the Fed funds futures strip is no longer has at least three rate cuts discounted. The interest rate adjustment underpinned the dollar, which rose against all the G10 currencies last week.  Like the US two-year yield, the 10-year yield also rose every day last week, and its 23 bp increase was the most since the last October. The Dollar Index's 0.70% gain was the largest rise in eight weeks, and ended a three-week decline. Rising rates helped lift the greenback almost 1.4% against the Japanese yen, despite heightened speculation that the Bank of Japan (finally) lift its policy rate out of negative territory (-0.10%). 

The week ahead is dominated by central bank meetings. Most central banks are not expected to change policy. The Summary of Economic Projections by the Federal Reserve may be the key, and while we do not expect significant changes, the risk seems tilted toward reducing the number of cuts (3) it anticipated in December rather than increasing them. We lean toward the Bank of Japan waiting until April to adjust rates. The Bank of England, the Reserve Bank of Australia, and Norway's central bank are likely to stand pat. We continue to suspect that the risks of a cut by the Swiss National Bank are under-appreciated. Inflation is low and growth has slowed. For exchange rate purposes, the SNB may want to cut rates before the ECB. Among emerging market central banks, Czech, Brazil, and Colombia may deliver 50 bp cuts. Mexico's central bank is a closer call. We lean toward a cut as inflation continues to moderate and growth has slowed. In addition, we assume that the central bank wants to make policy less restrictive, and at the same time, given the approaching national elections, it may want to avoid even the appearance of politization. To that end, it may be better to change policy in March than at the next meeting May 9, less than a month before the national election.

United States: At the end of last year, the Fed funds futures had a 25 bp cut fully discounted for this week's FOMC meeting. Even after the January jobs report and until the day before the January CPI on February 13, the market had more than an 80% chance of a cut. The market now recognizes the odds are negligible. Fed Chief Powell told Congress earlier this month it its confidence was getting closer to the point that would allow it to cut, but the market knows this does not mean this week or even the next meeting on May 1. Indeed, in recent days, the market has downgraded the chances of a June cut to about 65%, the least since last October. It seems unreasonable to expect Powell to change the substance of what he told Congress when speaking to the press following the FOMC meeting. Some observers suggest that President Biden, who recently said that the Fed would likely cut interest rates shortly was revealing something new, but he was not. The president was simply echoing what Powell already said.

Another point that confuses some observers is the idea that the Fed will cut rates before inflation has reached 2%. This is not a new revelation. This has been evident in the Summary of Economic Projections for over a year. It seems to follow logically from the observation that changes in monetary policy impact with lags. Federal Reserve officials will update the Summary of Economic Projections. We do not expect major changes from December, even though Powell has warned that these projections are a snapshot based on current data and views. Still, quarter-to-quarter, the adjustments tend to be small. In December, the median Fed forecast was for 1.4% growth this year, down from 1.5% in September.

The latest monthly Bloomberg survey (from late February) was 2.1%. These economists expected above 2.5% growth in H1 and about 1.5% growth in H2. The median forecast from economists was for a 4% unemployment rate, while the median projection from Fed officials was for 4.1%. The median Fed dot saw both the headline and core PCE deflator at 2.4% this year. The median from the Bloomberg survey was close at 2.2% and 2.4% respectively. 

The most important dot is the one for the Fed funds rate. In December, the median dot was consistent with 75 bp in rate cuts this year and 100 bp next year. Some foreign critics have argued that the Federal Reserve is a slave to the markets, but several times last year and already once this year, market expectations have converged with the Fed's: Not the other way around.

When the FOMC meeting concluded in December, with the signal that three rate cuts would likely be appropriate, the market was pricing in nearly twice as much. The day before the December CPI was reported on January 13, the Fed funds futures were pricing in almost 170 bp of cuts. A combination of data and official comments saw the pendulum of sentiment swing dramatically, and by late February, the Fed funds futures market had nearly returned to the Fed's December dot plot indication. However, before the February jobs report on March 8, the underlying bias was reasserting itself. The market had almost 70% of a fourth cut discounted. After the jobs data, the probability increased to slightly above 80%. The odds were downgraded every day last week and for the first time in four months, the market does not have at least three cuts discounted. The risk is asymmetrical. It is more likely that the median dot is reduced to two cuts rather than increased to four. 

The market is also keen for some guidance on how the Fed is thinking about its balance sheet. Under "quantitative tightening," the central bank is not selling assets as some pundits suggest, but rather the Fed is simply not replacing all the maturing Treasuries and agency bonds. The balance sheet is shrinking. There seem to be two considerations that many are wrestling with. First, how much can the balance sheet be reduced without jeopardizing ample levels of reserves, which is what happened in 2019? Second, reducing the balance sheet is thought to impart a tightening impulse, though we think the communication channel may be more important than quantities. Does it make sense for the Fed to continue to shrink the balance sheet when it begins cutting rates (easing or making policy less restrictive)?

There are some operational issues that may also draw attention. Federal Reserve Chair Powell and Governor Waller seem sympathetic to reducing the duration of the Fed's portfolio. This would entail holding more short-term coupons than longer-term bonds. Ostensibly, this would maximize flexibility. There is also some indication that allow the Fed bought mortgage-backed bonds from Fannie Mae and Freddie Mac, many would prefer a portfolio of only Treasuries. 

The Dollar Index looks constructive. The momentum indicators have turned higher. The trendline off the mid-February and March 1 high starts the new week near 103.70. That area also houses the (50%) retracement of the decline since the mid-February high and the 200-day moving average. Above there, and the return to the 104.00-30 area looks likely. 

Japan:  The Bank of Japan meeting concludes on March 19, the day before the FOMC meeting ends. The market perceives a greater risk of a BOJ hike. It has been encouraged by comments from a couple of officials, stronger than expected wage growth, strong wage demands, and firm CPI. We have favored an April move, though the results of the spring range round would be in hand for the March meeting. It is the start of the new fiscal year and the government's subsidies for household energy consumption would end, which would push up measured inflation by 0.4%-0.5%. Also, the BOJ updates its economic forecasts at the April meeting. A Japanese press report suggested that the BOJ may also end its yield-curve control policy, which caps the 10-year yield (now 1.00%), but shift the focus to back to a fixed quantity of bonds to be purchased rather than the price (yield). We do not think that revisions that showed that the Japanese economy growing in Q4 23 rather than contracting as initially estimate, is not a decisive factor for the BOJ. Moreover, the owing in no small measure to the earthquake that struck on January 1, the Japanese economy is off to a weak start to the year with sharper than expected declines in industrial production, housing starts, and household consumption. 

The dollar reached six-day highs ahead of the weekend near JPY149.15. This met the (61.8%) retracement of the dollar's losses since the high in late February near JPY150.85. The daily momentum indicators have turned up as the greenback rose for the past four sessions, decisively ending a five-day slide. The exchange rate's 30-day correlation with changes in US 10-year yield near 0.70, the upper end of where it has been since last June. The correlation of changes in the exchange rate and Japan's two-year yield is around 0.2. We suspect that if the BOJ does hike the target rate to zero, the dollar could extend its recovery on "sell the rumor buy the fact" type of activity. If the BOJ does not move, the dollar would likely tick higher initially on "disappointment". Yet, if the BOJ does not move next week, many will see an April as even more likely.

Eurozone:  Quietly and without fanfare, on March 6, Germany reported a record 27.5 bln euro January trade surplus. It suggests some upside risk for the aggregate trade balance that will be reported on March 18. In Q4 23, the eurozone recorded an average monthly trade surplus of about 13.1 bln euros. That is the highest quarterly average since Q1 21. The flash March PMI (March 21) will draw attention, but the market impact may be minimal given the central bank meetings. Among the central banks that meet, the Swiss National Bank meets on March 21. We suspect the risk is greater of a cut than the roughly 30% probability that is priced into the swaps market. The economy is slowing, and the EU harmonized CPI fell to 1.2% in February from 1.5% in January, and 3.2% in February 2023. At the end of last year, the Swiss franc traded at eight-year highs against the euro but has unwound those gains and returned to levels that prevailed last November. Being the first (G10) to cut rates could weigh on the Swiss franc more, giving it some cushion, as it were, for when Fed and ECB cut rates.

The euro set a two-month high near $1.0980 on March 8 and recorded a last week's low slightly below $1.0875 ahead of the weekend. This nicked the uptrend line drawn off the year's low on February 14 (~$1.0695) and the March 1 low (~$1.08). It approached the (61.8%) retracement of the rally from the March 1 low seen a touch below $1.0870, which is also around the (38.2%) of the rally off the mid-February low. Resistance now is seen in the $1.0910-30 area.

United Kingdom:  The UK will report February CPI on March 20, the day before the Bank of England meets. The year-over-year rate is likely to be halved in the coming months from 4.0% in January. The BOE may be data dependent but regardless of the CPI, or the preliminary March PMI, which will be reported a few hours before the BOE meeting, it is on hold. The market anticipates the ECB to cut rates before the BOE. The question raised in recent days is whether the BOE will cut before the Fed.  The swaps market has about 50% chance of a June cut. It is fully discounted at the next meeting in August. BOE Governor Bailey seemed to play down the contraction in H2 23, noting that it was shallow and that a recovery already has begun. Apparently, the BOE is also reconsidering its balance sheet strategy. Recently, Deputy Governor Ramsden suggested that the all the assets bought under QE could be unwound. Meanwhile, the BOE's staff are getting on average a 4% pay increase (central bank is forecasting 2% inflation this spring before ending the year near 2.75%), plus a 1% salary top-up, despite the Bailey's previous counsel to British workers not to ask for large pay increases. It has been the subject of much derision. 

After its best week of the year with a 1.6% rally through March 8, sterling had its worst week for the year, falling by nearly 0.95% last week. It pulled back from an eight-month high near $1.29 and fell to about $1.2725. The $1.2710 area holds the 20-day moving average and is the (61.8%) retracement of the rally from the March 1 low (~$1.2600). The daily momentum indicators have turned lower. A break of $1.27 could spur on a test on $1.2650-60.

Australia:  The Reserve Bank of Australia will likely standpat at the conclusion of its policy meeting on March 19. The economy has slowed, and inflation has moderated. However, the RBA has signaled that it has not strong sense of urgency to reduce rates. The futures market has almost a 35% chance of cut, but this seems too high. A quarter-point cut is not fully discounted until September, which seems too long. Bullock, perceived as a dove, took the helm of the central bank last September and delivered a quarter-point hike in November. The economy was already slowing and on a per capita basis, the economy contracted by 0.3% in Q423 and was 1% lower than a year ago. On March 21, Australia reports February employment data. Job growth has slowed. In the three-months through January, Australia created about 10k jobs, the least since October 2021. It lost about 102k full-time position in H2 23. Australia's unemployment rate was 3.5% in February 2023 was at 4.1% in January 2024. 

After peaking near $0.6670 on March 8, the Australian dollar was sold to almost $0.6550 before the weekend. This met the (61.8%) retracement target of the rally from the March 5 low (~$0.6480) and the (50%) retracement of the rally from the year's low set on February 13 (~$0.6445). The Aussie could bounce if the central bank repeats it tightening bias but resistance in the $0.6600-25 area may cap it ahead of the FOMC meeting.

Canada:  Barring a significant surprise, high-frequency economic data from Canada will likely be lost amid the central bank meetings. Still, Canada's CPI has fallen, not just moderated. In the five months through January, Canada's headline CPI has fallen at an annualized rate of about -0.05%. This overstates the case. The risk is of a small uptick in the headline rate from 2.9% in January. The underlying core measures that the central bank emphasizes may stagnated after edging lower. January retail sales will be reported on March 22. Retail sales are likely to slow after jumping by 0.9% in December (0.6% ex-auto). The Bank of Canada's preliminary data suggests a 0.4% decline.  The swaps market has the first cut nearly fully discounted now in July.  

In a week in which the US dollar rose against all the G10 currencies, the Canadian dollar fared best, losing only about 0.40%. Still, the US dollar has fallen in only two weeks in the first 11 weeks of the year against the Canadian dollar. The greenback remains in the upper end of this year's range (~CAD1.3230-CAD1.3605). It is not clear if the greenback's upside correction to the roughly 5.20% sell-off last November and December is over. Maybe, continued range trading between CAD1.3400 and CAD1.3600 is the most likely scenario.

Mexico:  Banxico meets on March 21, the day after the FOMC meeting concludes. The outcome is a close call. On balance, the strength of the Mexican peso and the central bank's downgrade of this year's growth (2.8% vs. 3.0%) amid a continued moderation of price pressures give the central bank latitude to join other Latam central banks in cutting rates. Also, we have suggested a calendar consideration too. The next central bank meeting is May 9. For a central bank that fiercely defends its independence, it might be too close to the national election (June 2) to change policy. Brazil's central bank meets on March 20. It began to cut rates last August and has delivered five half-point cuts that brought the Selic Rate to 11.25% (the same as Mexico's target rate). Colombia's central bank meets on March 22. It has delivered two quarter-point cuts (to 12.75%) starting at the end of last year. Moderating inflation and weak growth will allow the central bank to continue to cut rates.

The US dollar fell to new lows for the year against the Mexican peso near MXN16.6470 last week. The eight-year low set last July was near MXN16.6260. The low volatility in the foreign exchange market in general favors carry trade strategies and the Mexican peso remains a market darling. It is strongest currency in the world here in Q1 24 with about a 1.6% gain against the US dollar. However, peso's upside momentum stalled in the last couple of sessions. Prudence warns of the risk of a bout of position adjustments ahead of the FOMC and Banxico meetings. Initial dollar resistance may be in the MXN16.80-MXN16.85 area. 

China: Beijing sent an important signal to the market before the weekend. In a high-profile move, using an important policy tool, the one-year Medium Term Lending facility to drain liquidity from the banking system, for the first time in around 18-months. It does not mean that there will not be more stimulative measures to boost the chances of reaching the 5% growth target. Rather, it appears aimed at driving home a point to Chinese banks. They are ostensibly using the liquidity to buy government bonds, driving yields to 20-year lows. To be sure, the drain was small (CNY94 bln or ~$13 bln), but the message could be that the banks better enthusiastically support the government's stimulative efforts. The drain was announced shortly before the February lending figures were published. Loan growth slowed to less than 10% year-over-year for the first time in at least 20 years. Households on balance paid down its medium- and long-term debt (mostly mortgages). Early Monday, China reports February retail sales, industrial production, fixed asset investment, and surveyed joblessness. We note that retail sales (which in the US, account for around half of consumption) continues to grow faster than investment and industrial output). Often, it seems that China moves in the direction many of its critics want, but at a slower pace than they desire.

The dollar set new highs for the week against the Japanese yen in the North American afternoon before the weekend. It warns that the dollar will continue to challenge the defense of the CNY7.20-level. The dollar has come close but has not traded there since last November. To the extent that this is officially encouraged (or facilitated), it seems tactical rather than strategic. At the same time, officials would be trying to stop the yuan from weakening. Many critics are more vocal when the PBOC resists the yuan from strengthening. Our linkage of the yen and yuan is partly causal, after all the yen is in the basket (CFETS) used by the PBOC. They also share some common characteristics, like low yields. For example, this means that the offshore yuan and yen have been attractive funding currencies. Also, they share a common sensitive. The 30-day correlation between changes in the offshore yuan and the 10-year US yield is near 0.60, near the highest it has been in more than six years.