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Macro Themes And Price Action

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(Due to an extended business trip, this weekend’s commentary has been consolidated into one note)

There are a few main themes in driving the foreign exchange market that may be useful noting as we begin the second half of Q1. The two overarching considerations are steady US warnings of a pending Russian invasion of Ukraine and adjustment of interest rate expectations amid rising inflation in many countries, even if not China and Japan, the world’s second-and third-largest economies.

One can despise the authoritarian regime in Moscow, but one needs to recognize the perverse incentives. NATO will not accept a member whose borders are disputed. Moscow does not want Ukraine to join NATO. It follows like night from the day that by threatening Ukraine’s border, Russia effectively keeps Ukraine out of NATO. In addition, many observers insist on linking the type of regime that rules Moscow with its geographic national interest. Yet surely even a casual understanding of history, one grasps the strategic importance of the Ukrainian plains to Russia’s security.

Heightened inflation and the easing of the pandemic restrictions have turned the monetary cycle. There is little doubt that the US and Canada are going to join the UK and Norway who have already begun their adjustment process. The Reserve Bank of New Zealand is likely to deliver its third hike in the cycle in the week ahead. Despite a series of stronger than expected US data (January CPI, retail sales, and industrial production), the swaps market has cut the odds of a 50 bp hike by more than half to less than 40%. Formal and informal surveys show that many expect the US inflation is likely to ease, perhaps starting in March or April. An acceleration of the pace of Fed hikes seems more likely if CPI does not begin rolling over.

As Vice-Chair of the FOMC, the NY Fed President has a permanent vote on the FOMC. Williams seemed to speak for the leadership when he said before the weekend that there was no compelling case for a “big step” in March. Moreover, for a Federal Reserve that recognizes the significance of the disparity of wealth and income and seemed to put an emphasis on the “maximum and inclusive employment,” it will be raising rates while real earnings are falling.

Japan’s Q4 deflator and the January CPI show that even at this stage deflationary forces persist. They are being masked by higher energy and commodity price, which is sparking a negative term of trade shock. It puts the Bank of Japan in a difficult position. It does not think tightening financial conditions is appropriate so it will have to defend the 0.25% cap on the 10-year bond yield. The yield is rising as the price of capital is rising across the world.

The European Central Bank and the Reserve Bank of Australia continue to push against market expectations for early rate hikes. The ECB holds an informal meeting on February 24. It appears that a consensus is emerging to modify the asset purchase plans to allow for an earlier rate hike if necessary. The March 10 meeting will have updated forecasts and new forward guidance.

The 2-10-year yield curve in the Anglo-American economies (US, UK, Canada, and Australia) flattened so far this year. Australia’s has flattened the most—around 45 bp. The curve has flattened by 31 bp in the US, and a little less than 20 bp in the UK. Canada’s 2-10-year curve has flattened by nearly 10 bp. On the other hand, the Germany curve has steepened by about 20 bp, while Italy’s curve is almost 50 bp steeper than it began the year. The difference between the two and 10-year yield in Japan edged wider (less than 10 bp). China’s 2-year yield has fallen by almost 20 bp, while the 10-year yield has risen by three basis points this year.

China may have removed its supportive efforts too early and has again returned the punchbowl. Its yield premium on 10-year borrowing over the US has narrowed, which may deter foreign investors, especially those segments that saw it as a relative-valued trade. On the other hand, equities, especially outside of property developers and technology seem to be attracting international interest. Earlier in the year, Chinese officials seemed to caution against pressing the yuan higher, and it even raise the reserve requirements for foreign deposits. However, in recent sessions, the PBOC’s dollar reference rate was lower than the market expected.

Emerging markets more broadly are faring better than one might have expected given the rise in US market rates, anticipated Fed hikes, and the slowing of China. EM is not a homogenous group and Latam is outperforming. Year-to-date, the three strongest emerging market currencies are from the region the Brazil real, Peruvian sol, and Chilean peso are each up more than 7% this year. The MSCI Emerging Market Equity Index is slightly positive for the year, up almost 0.9%, while the MSCI World Index of developed markets is off nearly 7%.

Let’s turn to the currencies themselves.

Dollar Index: A range of roughly 95.65-96.50 was carved last week. It was essentially flat on the week, which itself is impressive given the swing away from a 50 bp hike in March and a 10 bp decline in the implied yield of the December Fed funds futures. It was the first weekly decline since the end of last November. The high for the week (and month, so far) was set at early and in the last three sessions chopped up to around the middle of the range. It closed slightly above 96.00 on the week. The range could be extended by 0.50 in either direction…

Read More: Macro Themes And Price Action

2022-02-20 05:47:00

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