The new year began with a bang. Rising inflation, less government bond buying, and anticipation of more central banks tightening, fueled a substantial rise in interest rates and a dramatic drop in equities. The geopolitical backdrop also lent itself to a weakening of investor confidence.
The US 10-year Treasury yield rose by more than 25 bp, the most since last February. The German benchmark yield rose above zero for the first time since mid-2019, albeit briefly. The yield on the 10-year Japanese government bond pushed a little above 17 bp for the first time in nearly a year and has not been above- 0.20% in six years. After peaking near $18.5 trillion in December 2020, the amount of negative yielding bonds fell almost $9 trillion in January, the lowest since March 2020.
The market is pricing in more aggressive central bank tightening than it had at the end of last year. The implied yield of the December 2022 Fed funds futures contract rose by about 55 bp in January. It has four hikes discounted this year and is confident that the first hike is delivered on March 16. There is more. The market is pricing in about a 2 in 3 chance of a 50 bp hike in March and is pricing in around a 75% chance 125 bp this year rather than 100 bp. The market has moved to nearly discount six hikes by the Bank of Canada this year. At the end of last year, a little more than five hikes were expected. The market leans heavily (~70%) that the Bank of England raises rates five times rather than four. On New Year's Eve, the market was solidly pricing in four hikes.
The Federal Reserve, the Bank of England, and the Bank of Canada will complement their rate hikes with passively reducing their balance sheets by not fully reinvesting maturing principle. To normalize the use of the central banks’ balance sheets, it is essential that they are used when necessary and unwound quickly. Compared to after the Great Financial Crisis, it will happen more quickly this time. The Bank of England has indicated that when the base rate reaches 50 bp, which looks likely at the February 3 meeting, it will allow its balance sheet to begin shrinking. This will happen almost immediately with a large maturing issue in March.
Equities struggled in the face of rising interest rates and stretched valuations. There also seemed to be a rotation out of growth and toward value. This can be seen by the slump in the NASDAQ Composite, which has approached bear market territory (20% decline from the record high set last November). In contrast, the Dow Industrials set a record high on January 5th and the pullback approached the "technical correction" of 10%. Note that in the second year of the presidential term, going back to 1934, the average drawdown is about 16%. Over the last five terms, going back to 2002, the average is a drawdown of 15.8%.
Consider that the Russell 1000 Growth ETF (NYSE:IWF) is off about 11.3% this year, while the Russell 1000 Value ETF (NYSE:IWD) is off less than a third as much. We should not draw any hard and fast conclusion about 2022 based on the January performance, but the Value Index has not outperformed the Growth Index for a year since 2016.
The European Central Bank and the Bank of Japan are expected to be laggards in this cycle, but the market anticipates some movement. There is about 20 bp of tightening priced into the euro swap curve over the next year. That is about twice what was discounted at the end of last year. Speculation of an early Bank of Japan move was dashed by Governor Kuroda. It seems unlikely that the BOJ raises rates until after Kuroda's term ends in April 2023.
Another dimension of the international investment climate that further crystallized was the monetary policy divergence with China. The People's Bank of China delivered a small (10 bp) cut in the key medium-term lending facility to 2.85%), the first reduction since April 2020. This was followed up by the second 10 bp cut in the one-year loan prime rate in as many months. The rate of the five-year loan prime rate, a benchmark for mortgages, was shaved to 4.60% from 4.65%. It is also allowed other money market rates fall. Officials have signaled more policy support will be forthcoming but hopes for a cut in required reserves before the Lunar New Year holiday were disappointed. Mainland markets will re-open on February 7. The policy divergence that some had thought would be particularly negative for China was offset but the record trade surplus and portfolio capital into its bond and stock markets.
The surging Omicron form of COVID has adversely impacted economies even though it appears less fatal than earlier mutations. The widespread infection though has disrupted work, delayed a return to offices in many countries, including the US. Some countries, like Japan, have re-imposed some restrictions until the middle of February. The rate of infection seems to be passed its peak in the US and UK, but the impact will likely shave Q1 GDP. China's zero tolerance has led to city-wide lockdowns ahead of the Olympics (Open Ceremonies February 4) and stressed supply-chains.
The geopolitical backdrop remains fraught with risk in Europe. Russia has amassed troops and artillery along its border with Ukraine. Moscow is under the impression that bringing NATO to the Russian border contradicts earlier assurances. It has been clear, well before the annexation of Crimea (2014) that Putin would not easily accept Ukraine and Georgia to join NATO. Russia argues that Ukraine stealthily joined NATO in all but name. Ukraine has been supplied with weapons and has conducted joint exercises with NATO.
There seems to be a widespread consensus against conceding a sphere of influence in eastern and central Europe to Russia. Any suggestion to the contrary is dismissed as appeasement, with allusions to Hitler. Yet, without Russia feeling secure, security in Europe will remain elusive. Therein lies the tragedy that is Europe. It has been a source of instability for well over a decade. The threat of economic and financial sanctions may not deter Putin because it is an existential issue.
The US bilateral goods trade with Russia is about $30 bln a year. Europe's total bilateral trade is more than four-times greater. The asymmetry fosters different sensitivities to economic sanctions. This seems to be the case with removing Russia from the SWIFT system. Also, unlike the US and UK, German law prevents selling armaments to countries engaged in conflict. However, the new German government seems willing to put the Nord Stream pipeline as a possible sanction target if Russia invades Ukraine.
An unintended consequence of the US approach to Russia is that in encourages Moscow (and Beijing) to develop chits that can neutralize. Russia has threatened to put troops in Cuba and/or Venezuela. Recall that the 1963 Cuban Missile Crisis was resolved when Russia dismantled its missiles in Cuba and the US removed its missiles in Turkey. China's Belt-Road Initiative is making headway in the Caribbean and parts of central and South America. Brazil is not formally a member of the BRI, but it is one of biggest recipients of China's development funds in the region.
Emerging market currencies were more resilient than one would have expected given the aggressive turn by the Federal Reserve and the risk-off sentiment reflected in the equity market volatility. The JP Morgan Emerging Market Index managed to eke out a fractional gain through January 28 even though it fell by 1% in the last full week of January. Latam currencies were in favor. They accounted for the top four performing emerging market currencies (Chilean peso, Peruvian sol, Brazilian real, and Colombian peso).
The Chinese yuan rose to its highest level in almost five years but reversed lower at the end of the month, ahead of the Lunar New Year holiday. It also rose to record highs on a trade-weighted basis. However, the sentiment toward Chinese stocks and bonds appears to have dimmed recently, and among asset managers, Brazilian assets are preferred. This may take some upside pressure off the yuan. Brazil raised rates aggressively last year and is thought to be near a peak, making the bonds a favorite overweight. Its equity market is heavily weighted toward commodity producers, which is also a popular theme.
Bannockburn's World Currency Index fell by almost 0.5% in January, reversing December's gain. All the currencies but the Brazilian real fell against the dollar in January. The real rose by almost 3.5%. Net-net, the Chinese yuan fell less than 0.1%, making it the second-best performer. The Australian dollar and Russian rouble were the weakest. They fell 3.8%-4.0%.
In the big picture, our GDP-weighted currency index rose sharply after the initial reaction to the pandemic. It peaked in June 2021 and ground lower until November. It "corrected" higher through mid-January and has begun weakening again over the last couple of weeks. It appears to have scope to fall another percentage point or so, consistent with additional dollar strength.
Dollar: The first half of January proved particularly challenging. The dollar broke higher against the yen to start the month and quickly unwound the gains. Then the euro broke out of its mostly $1.12-$1.14 trading range only to fall back. The two main drivers of the foreign exchange market broadly were the risk off signaled by the stock market volatility and the more aggressive expectations for Fed policy. In past cycles, the dollar has generally rallied ahead of the first rate hike and then retreats when it is delivered. This fits very much into the "buy the rumor, sell the fact" type of activity with which we are familiar. Our concern remains that the Fed waited too long to taper and that the headwinds facing the economy are stronger than appreciated. The budget deficit is now expected to fall by about five percentage points. It took a couple of years after the Great Financial Crisis to achieve that. Oil prices have more than doubled in the past year or so. The last three recessions were preceded by a doubling of oil prices. The rebuilding of inventories has been a tailwind for growth in recent quarters. It cannot be counted on as much going forward. The pent-up savings are being drawn down, especially in lower and middle income households.
Euro: Often the EUR/USD exchange rate appears to be sensitive to the two-year interest rate differential between the US and Germany. The US premium in January rose by about 40 bp around 180 bp. At the end of 2019, the US premium was almost 225 bp. The previous 40 bp increase took nearly two and a half months (mid-October to end of December last year). Of course, it does little to explain the euro's upside breakout to $1.1485 in the middle of January. Still, it helps draw attention to the divergences at work. Consider that while the US economy, spurred by strong inventory rebuilding, grew almost 1.7% quarter-over-quarter in Q4, the German economy, the biggest in the euro area, contracted by 0.7%. The virus appears to be a drag on activity at the start of Q1. The January composite Purchasing Manager's Index fell more than expected and stands at its lowest level since February 2021. It has fallen in five of the past six months. The swaps market is discounting a hike in Q4, while the Bloomberg survey of economists finds that the first hike is not expected until early 2023. We continue to see risk of the euro falling toward the $1.10 area.
(January 28 indicative closing prices, previous in parentheses)
- Spot: $1.1150 ($1.1370)
- Median Bloomberg One-month Forecast $1.1175 ($1.1325)
- One-month forward $1.1160 ($1.1350) One-month implied vol 6.0% (5.1%)
Japanese Yen: The exchange rate's correlation with US 10-year yields (30 days, percentage change) and the Japanese yen fell about 0.3 from above 0.8 in December. The volatility in the equity market appears to have been a significant disruption. Early in January, the correlation with the S&P 500 rose to its highest level since March 2020, a little above 0.5, but by the end of the month, it had fallen back to the level seen in December near 0.3. The greenback initially extended December's gains to reach JPY116.35, its highest level since early 2017, but as equities losses broadened and deepened, it was sold back down to around JPY113.50 where a base was forged. For the first time since 2014, the Bank of Japan shifted its assessment of inflation. It no longer said that the risks are skewed to the downside. Instead, it suggested the outlook is generally balanced. Many observers are looking for a rise in Japan's CPI and core measure when the cuts in mobile phone charges drop out of the 12-month comparison in April. Still, BOJ Kuroda pushed hard against expectations of policy normalization. While the market is pricing in no change, the 10-year yield has risen and may challenge the BOJ's yield curve control efforts. As January drew to a close, Japan's 10-year yield rose above 17 bp, its highest in a year. The YCC policy caps the 10-year yield at 0.25%, but it may not respond if it thinks a move is temporary. Still, if global yields continue to rise and drag up Japan's yield, the YCC is a potential flashpoint for officials and investors.
- Spot: JPY115.25 (JPY115.10)
- Median Bloomberg One-month Forecast JPY115.15 (JPY114.80)
- One-month forward JPY115.20 (JPY115.05) One-month implied vol 6.1% (5.4%)
British Pound: Sterling continued to recover from the 2021 low set in mid-December (~$1.3165) and peaked near the 200-day moving average in mid-January around $1.3750. The broad dollar recovery saw cable fall back to $1.3360. The Bank of England meets on February 3. It was widely expected to lift the base rate by 25 bp to 0.50%. This is also the level that it had previously indicated would start the balance sheet unwind. The first element will be the end of recycling maturing proceeds. Over the course of the January, the swaps market has shifted more toward five hikes this year instead of four. Unresolved negotiations about the Northern Ireland protocol and the "sticky wicket" that may be threatening the political future of Prime Minister Johnson do not appear to be having much market impact. Indeed, sterling has risen to its best level against the euro since the pandemic first struck.
- Spot: $1.3400 ($1.3530)
- Median Bloomberg One-month Forecast $1.3450 ($1.3495)
- One-month forward $1.3395 ($1.3535) One-month implied vol 6.5% (5.9%)
Canadian Dollar: The Bank of Canada is expected to pursue the most aggressive monetary policy within the G7 this year. The swaps market is discounting 160 bp of hikes over the next 12 months. Although the central bank did not hike in January, which we had thought likely, by indicating that the output gap had closed, it signaled that its tightening cycle would start at its next meeting (March 2). Still, the adjustment of views, saw Canada's two-year premium over the US fall to around eight basis points, the least since last April. Despite campaign promises and previous commitments, Canada's budget deficit is expected to fall dramatically. It was a little more than 13% of GDP in 2021 and is projected to fall below 3% this year (Bloomberg survey). The Bank of Canada forecasts a 4% expansion this year. The IMF and OECD concur (4.1% and 3.9%, respectively). The risk environment is also an important factor in the exchange rate. The correlation of the Canadian dollar to the S&P 500 (percentage change over the past 30 sessions) reached a five-month high at the end of 2021 near 0.75. It has fallen steadily to about 0.25.
- Spot: CAD1.2770 (CAD 1.2635)
- Median Bloomberg One-month Forecast CAD1.2690 (CAD1.2625)
- One-month forward CAD1.2765 (CAD1.2640) One-month implied vol 7.1% (6.4%)
Australian Dollar: The combination of risk-off and aggressive turn by the Federal Reserve drove the Australian dollar below important support around $0.7000. However, at losing around 3.7% in January, we think the Australian dollar is oversold and is poised to recover smartly when risk appetites stabilize. From a technical perspective, it moved nearly three standard deviations below its 20-day moving average. In terms of positioning, in mid-January speculators in the futures market had a record net short Australian dollar position. It has only begun being trimmed. From a policy point of view, the central bank meets first thing on February 1 and is likely to adjust its forward guidance. While confirming the end of its bond buying operations, the RBA may also soften its opposition to a rate hike sooner than the 2023 that Governor Lowe has suggested. The swaps market has about 45 bp of tightening priced in the next six months.
- Spot: $0.6990 ($0.7265)
- Median Bloomberg One-Month Forecast $0.7090 ($0.7245)
- One-month forward $0.6995 ($0.7270) One-month implied vol 10.4% (8.0%)
Mexican Peso: January was a month of two halves for the peso. It ground a bit higher to test its 200-day moving average (for the dollar this was around MXN20.30). But, as risk soured, the peso trended lower in the second half. The more aggressive Fed tone helped lift the dollar to its best level in roughly six weeks, a little above MXN20.80. The central bank, with a new governor, meets on February 10. Headline inflation was above 7% in November and December. The biweekly updates suggest it probably remained above there in January. The swaps market has about 100 bp of tightening priced in for the next three months. A 50 bp hike would establish Rodriquez's anti-inflation credentials, but the economy is fragile, without much fiscal support. Given the more aggressive approaches by the central banks in other Latam countries, including Brazil, Chile, Colombia, and Peru, it may be understandable when the Mexican peso has underperformed in the region in recent weeks (except against Argentina, which reduce rates). Disappointment could see the dollar rebound into the MXN21.20-MXN21.45 area.
- Spot: MXN20.80 (MXN20.53)
- Median Bloomberg One-Month Forecast MXN20.78 (MXN20.66)
- One-month forward MXN20.90 (MXN20.62) One-month implied vol 10.6% (11.0%)
Chinese Yuan: The yuan's gains to a record high against its trade-weighted basket and its best level against the dollar since April 2018 came despite official efforts to stem the rise. The record trade surplus, almost $95 bln in December alone and foreign portfolio inflows seemed to offset divergence of monetary policy concerns. The Regional Economic Cooperation Partnership free-trade agreement tariff reductions begin in earnest in February and its impact is expected to be positive. The PBOC reduced some key rates on the margin, but it was the more the aggressiveness of Fed tightening that the market discounted after the FOMC meeting that may have put in the dollar's bottom near CNY6.32. Despite somewhat faster growth than expected reported for Q4 21 (1.6% instead of 1.2%), domestic growth challenges remain, including the restructuring of the property sector. With consumer prices pressures subdued, official have shifted toward promoting new lending and local government spending. The lockdowns associated with the virus threatens additional economic (and supply chain) disruption in the first part of the year. In late January's update, the IMF revised down its forecast for Chinese growth this year to 4.8% from the 5.6% projection made last October, citing COVID and financial stress.
- Spot: CNY6.3615 (CNY6.3560)
- Median Bloomberg One-month Forecast CNY6.3895 (CNY6.3680)
- One-month forward CNY6.3820 (CNY6.3830) One-month implied vol 3.1% (3.3%)