Divergence Highlighted by Back-to-Back Quarterly Contractions in Japan and the UK but Little FX Reaction

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Marc Chandler
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Overview: There has been a string of disappointing economic news today. Japan’s economy surprisingly contracted in Q4 23 and the Q3 contraction was a little deeper than initially estimates. Australia’s jobs growth was weaker than expected and unemployment rose to 4.1%, matching the highest since November 2021. The UK’s economy contracted more than expected in Q4 23, its second consecutive quarter without growth. That seems like poor news ahead of today’s two byelections. The reaction in the foreign exchange market is just as surprising as the data. The yen strengthened, and the dollar briefly traded below JPY150. The Australian dollar dipped but recovered. On the other hand, sterling is languishing and is the only G10 currency that is trading lower today in the European morning. Emerging market currencies are more mixed. Most currencies in central Europe are lower, while the South African rand, a few Asian currencies, and the Mexican peso are a little firmer.

Asia Pacific equities were higher after the US equity market gains yesterday. The main exception was South Korea’s Kospi. Taiwan led the rally with favorable news from the chip space, and the Taiex rose by 3%. The Nikkei gapped higher to new multiyear highs. Europe’s Stoxx 600 is up a little more than 0.5% to set new high for the year. US index futures are trading firm ahead of a slew of data before the session begins. Benchmark 10-year yields tumbled in the Asia Pacific region, playing a bit of catch-up, while European yields are 1-3 bp lower. The 10-year US Treasury yield is off about three basis points to 4.22%, which puts it up about five basis points this week. Gold reached almost $1984 yesterday, a two-month low, but has steadied today, though still below $2000. April WTI recorded a bearish outside day yesterday and rising US inventories and worries about weak demand are pushing back to the week’s low set Monday near $75.50.

Asia Pacific

In an unexpected development, Japan’s economy shrank for the second consecutive quarter in Q4 23. The 0.4% contraction quarter-over-quarter stands in stark contrast to the median forecast in Bloomberg’s survey that anticipated 1.1% expansion after contracting by 0.8% in Q3 (revised from -0.7%). Consumption and business investment contracted again. Consider the backdrop, the fiscal support (~5% budget deficit last year), the monetary support, including negative policy rate and negative real interest rates, the weak yen. Policy would seem to facilitate growth. Yet, one is also reminded that Japan’s population has been falling for 14 years and any growth itself is remarkable. There are two key questions. If the economy is contracting with such policy settings, what will it take? With the national core inflation rate likely to follow Tokyo’s and move below target, will BOJ Governor Ueda’s plans to exit the negative policy rate be disrupted? New tax cuts at the start of the new fiscal year and the spring wage round are important (as we already knew). Ueda’s plan to raise rates has not met opposition from the political or business circles. This seems unlikely to changed that. Negative real rates are where the economic stimulus arises. Even at zero (and the effective rate is already at -0.005% rather than at the target of -0.10%), overnight target rate must be regarded as stimulative. It seems more like a technocratic approach than an economic judgement.

Australia disappointed too. After a horrific December that saw Australia lose 63k jobs and about 109.5k full-time positions (revised from ~106.5K), the labor market barely stabilized last month. Australia gained 500 jobs (median in Bloomberg’s survey was for 25k jobs). About 11k full=time positions were filled. After falling by 0.4%, the most since September 2021, the participation rate was unchanged at 66.8%. It had reached a record of 67.3% last November. The unemployment rate ticked up to 4.1% (from 3.9%). It is not only higher than expected, but it matches the highest since November 2021. The employment data spurred the market to boost the chances of an August cut to around 95% from 63% yesterday. Still, it was about 88% at the end of last week. The market has about 46 bp of cuts discounts for this year, while up from 35 bp yesterday, it had finished last week at 50 bp. Earlier this month, the futures market had two cuts discounted and a little more than a 70% chance of a third.

The dollar’s range yesterday (~JPY150.35-JPY150.85) was set in Asia Pacific hours. Consolidation was seen in the European and North American sessions. Softer US rates seems to be outweighing the poor GDP news in Japan. The dollar trended gently lower through the Asia Pacific session and reached a low slightly below JPY150 early European turnover. The intraday momentum indicators are stretched, but a recovery in the greenback may depend on the reaction to the string of US data today. After bottoming near $0.6440 on Tuesday, the Australian dollar trended higher all day yesterday. It was trading slightly below $0.6500 late in the North American afternoon. It backed off to about $0.6480 on the disappointing jobs report but recovered to probe the $0.6500 area in the European morning. Initial resistance is seen around $0.6520, but the key to the near-term outlook by be the $0.6550 area. A push above it would lend credence to the idea that Tuesday’s leg down completed the move. The somewhat heavier US dollar tone also spilled over against the offshore yuan. The greenback made a marginal new session low after the Asia Pacific session ended near CNH7.2200 and held above there today. The dollar remains in the range set on Tuesday (~CNH7.2125-CNH7.2335).

Europe

With Q4 GDP confirmed yesterday at flat, the eurozone economy has not grown net-net since Q3 22. The Bundesbank is warning that the German economy will stagnate in Q1 “at best.” and the finance ministry has warned a contraction is possible. In fact, the Germany economy has not grown since Russia invaded Ukraine in Q1 22. With Q4 eurozone GDP behind us, there is not much interest in today’s December eurozone trade figures. For the record, it reported a 13.0 bln euro trade surplus in December. Last year’s average monthly trade surplus was about 5.0 bln. On a 12-month moving average basis, this is the most since the end of 2021.

The UK reported that the economy contracted by 0.3% in Q4 23, the second consecutive quarterly contraction and a bit more than expected. Consumption, exports, and government spending fell in the fourth quarter. Yet, it seems that the back-to-back quarterly contraction will not be enough to get the Bank of England to change its rhetoric. Still, due to the base effect and weak economy, inflation is likely to fall sharply in the coming months, and it could still get the BOE to cut rates before September, which is when the swaps market has the first cut fully discounted.

Around the time European markets closed yesterday, the euro set the session high near $1.0735. Several hours in the Asia Pacific session and in the European session yesterday, it traded below $1.07 for the first time in three months. The euro edged a little higher today to about $1.0740, the lower end of a resistance band that extends to $1.0765. Without taking out the upper end of that band, the bears will feel emboldened and the late euro longs, more pressure. In the past two CFTC reporting weeks, (the last one ending Feb 6, after the jobs data), the non-commercials (speculators) have added to their gross long euro position (by 7.2k contracts or 900 mln euros). Sterling was the only G10 currency that failed to gain against the dollar yesterday and it is trading a bit heavier today. Still, it is holding above yesterday’s low (~$1.2535), which is above last week’s low (~$1.2520). Key support is seen at $1.2500, and sterling has not traded below there since last November. A convincing break would target the $1.2430 area, at least initially. It is the (50%) retracement of sterling’s Q4 23’s eight-cent rally.

America

We had suggested yesterday, despite the dramatic market reaction to the January CPI report. we did not think the Fed’s views would be altered significantly. Subsequently, press reports lent credence to our suspicions. Fed Chair Powell met with some congressional representatives after the CPI. A congressman was quoted indicating that Powell said the report was “consistent with what they had anticipated.” Powell also noted that the PCE deflator later this month would provide “more intel”. Indeed, the wedge between the CPI and the PCE deflator looks set to widen further, i.e., the PCE deflator may not show the same impact of shelter and medical services.

After stronger than expected job growth in January and the largest monthly increase in average hourly earnings, there is risk that January retail sales is firmer than expected. The headline rate may have been dragged down by the decline in auto sales (15.0 mln SAAR from 15.8 mln last December). We also already know that the average price of retail gasoline in the US slipped by a little more than 1% in January, the fourth consecutive monthly decline. Excluding autos and gasoline, the median forecast in Bloomberg’s survey calls for a 0.2% increase. The US also reports January industrial production. A small gain is likely, but it probably comes from utilities and mining/drilling, rather than manufacturing, Still, with the manufacturing employment rising 23k in January, there could be a modest upside surprise to the median forecast of a flat report. The US also sees the February Empire State and Philadelphia Fed surveys. Recall that the Empire State survey collapses in January to -43.7 from -14.5 in December. The Philly Fed survey did not confirm the dramatic weakness of the Empire State survey. Economists look for the Empire State survey to recover January’s spill in full, while the Philadelphia Fed survey may improve marginally.

It seems there is a steady drum beat blaming China for all that ails America, in what often seems to be typical externalization. An old issue is being revisited. China is said to be exporting deflation. We are skeptical. First, China’s producer prices are falling but that is because of the price of commodities, which have fallen as supply chains re-opened, amid demand worries. Of course, with the Middle East conflict, new disruptions are possible. The correlation between changes in China’s producer prices and US import prices is less than 0.2 over the past 36 months and slightly more than that over the past 60 months. Second, the deflation in Chinese consumer prices is largely a function of food prices. In fact, over the past two months, China’s CPI has risen by about 2.4% at an annualized rate. Third, even if China’s surplus capacity makes for cheaper goods exports, the eventual cost to the American consumer is considerably higher, given storage, shipment, marketing, and insurance costs that are incurred onshore, not to mention profit-margins. Fourth, American consumers spend more on services than goods typically and key elements of the CPI/PCE basket like shelter, medical costs, food, and energy are driven by domestic considerations. Of the forces impacting US inflation, we would not put China’s deflation very high on that list.

The US dollar saw its session low yesterday against the Canadian dollar in the European morning, near CAD1.3530. It set a high in North America around CAD1.3560. Given the recent run-up, the pullback from Tuesday’s high (~CAD1.3585) is shallow. The (38.2%) retracement of the last leg up is around CAD1.3520, and the US dollar is approaching it in European turnover. Nearby support is in the CAD1.3480-CAD1.3500 area, but the CAD1.3450 area is more important. Meanwhile, the US dollar gave back most of the CPI-inspired gains yesterday. Tuesday’s low was slightly below MXN17.0650. Yesterday, the dollar recorded its low late in the session below MXN17.09, and today, reached about MXN17.0455. The dollar has not traded below MXN17.00 since mid-January. Options for about $580 mln expire there today another batch for around $545 mln expire there next Tuesday.