The coming weeks will likely continue the correction of the trends that began last month. The markets recognize that tightening cycle is over. However, they swung hard, pricing in aggressive easing by most of the G10 central banks, including the Federal Reserve and the European Central Bank. Official comments and some high-frequency economic data have encouraged participants to rein in their expectations, reducing the odds of a rate cuts in Q1 and paring back the extent of the cuts this year. 

The pendulum of market expectations reached an extreme. In the first part of January, pricing of the Fed funds futures strip implied a rate cut at each of the remaining seven FOMC meetings. While this is possible, it is not the most likely scenario, especially given what we know about the national labor market and in the context of still elevated price pressures and above trend growth in Q4 23.

Similarly, at the extreme in late December, the swaps market had discounted 190 bp of ECB cuts this year. It had returned to around 140 bp (five quarter-point cuts and a 60% chance of a sixth) in late January, which still seems aggressive compared with ECB signals. Comments from ECB President Lagarde and the record from the December meeting suggest a timeframe of the first rate cute toward the middle of the year. The market thinks April is a reasonable timeframe and will coincide with a sharp drop in measured inflation. With the eurozone continuing to struggle to sustain economic traction, the disruption of Red Sea transit, which means greater costs and slower deliveries, is the latest exogenous shock. 

The earthquake in Japan at the start of the year and the diminishing price pressures, framed by official comments, have strengthened the emerging consensus for an April policy adjustment. This would allow for the completion of the spring wage negotiations and corresponds to the end of the government's gas and electric subsidies, which could boost measured inflation by 0.4%-0.5%.

China's may have met last year's 5% growth target, according to its own assessment but it is not satisfactory for Beijing. More stimulus is expected in the form of government loans and lending by the PBOC. Given weak prices pressures (deflation), there is still scope for ore targeted measures after reserve requirements were cut in late January by 50 basis points. New formal and informal efforts to stem the hemorrhaging of Chinese stocks on the mainland, and especially in Hong Kong may be tested in the coming weeks. The fact that officials needed to resort to such measures feeds the sense that China is stumbling. Its enormous size means that the scale of whatever it does is globally significant. Coupled powerful economic nationalism and the lack of transparency contributes to economic anxiety in developed and developing countries.

However, the economic rivalry, while intense, is manageable. We often forget that the heated rivalry between the US, Europe, and Japan previously, and the tactics included tariffs and restrictions on the exports of some technology. Europe and Japan, no more than China, have chafed under US leadership, but there the competition was limited to the economy and trade. Not so with China, and Beijing's aggressive tactics, not only toward Taiwan, but others Pacific nations, including the Philippines, and Nepal and Bhutan, while aligning with Russia and Iran, remains particularly troubling.

Yet broadly, one cannot tell by looking at the capital or commodity markets the geopolitical tensions are the highest in at least a generation. Shipping costs between Europe and Asia reflect the disruption, but crude oil prices are more than 10% below Q4 23's peak, and gold was a couple percentage points lower through the first four weeks of January. The G10 currencies usually associated with risk-off, the Japanese yen and Swiss franc have not been beneficiaries of the geopolitical tensions, falling about 4.8% and 2.6%, respectively, against the dollar.

The reversal of the November and December trends in the dollar and interest rates in January was seen in emerging markets too. We know that Chinese equities fell sharply in January, but the MSCI emerging market equity index, excluding China was off about 2.8% in the first four weeks of the year. It had risen by a little more than 17% in the last two months of 2023. The premium of emerging market bonds (JP Morgan Index) over Treasuries tightened by about 50 bp last November-December. It widened a little in January but remains near the lower end of where it has trading over the past two years. Emerging market currencies generally weakened, as well. The JP Morgan and the MSCI emerging market currencies indexes fell by about 1.7% and 1.1%, respectively in the first four weeks of January. 

Bannockburn's World Currency Index, a GDP-weighted basket of the currencies of the 12 largest economies, fell by a little more than 1%. This reflected that most of the components falling against the US dollar in January, retracing some of the gains registered in late 2023. Among the G10 currencies in the BWCI, the Japanese yen was the weakest, falling by a little more than 4.5%, dragged lower, arguably, by the more than 20 bp rise in the US 10-year yield. Sterling was the strongest currency, and it rose by a modest 0.2%. All the emerging market currencies in the BWCI fell, except the Indian rupee, which eked out a minor (0.1%) gain. The South Korean won fell by about 3.6%, the most of the emerging market constituents. The Chinese yuan fell about 1.1%, and among the currencies that declined at the start of the year, only the Russian ruble (-0.5%) and the Mexican peso (-1.05%) in the index fell by less. 

The BWCI downtrend in January may not be complete, but we suspect the lion's share of the adjustment is behind it. We think that markets are still too ambitious in pricing the timing and extent of Fed rate cuts, and until it adjusts more, there is still upside risk for the dollar, especially as the economic impulses from Europe remain weak. If new initiatives from China get traction, better cyclical news could be forthcoming, even without structural reforms.

U.S. Dollar: There are often many factors that drive exchange rates in $7.5-trillion average daily turnover market, but most recently the dollar has broadly tracked interest rate expectations. In Q4 23, the market recognized the Fed was pivoting, US interest rates fell sharply and dragged the dollar lower. This year, official comments and economic data persuaded the investors that it had been too aggressive and as interest rates rose, the greenback was recovered. The Summary of Economic Projections issued in December was a clear recognition by officials that the next move will be a rate cut. However, officials do not have the same sense of urgency that had been expressed in the market. The median Fed forecast anticipated that three interest rate cuts would be appropriate this year. Ahead of the January 30-31 FOMC meeting, the market is pricing five cuts and a 40% chance of a sixth cut. We suspect there may be convergence toward four cuts. During this election year, it seems in neither party's partisan interest to force a government shutdown, but the path toward agreeing an appropriations bills for a dozen departments four months after the start of the fiscal year remains difficult. Spending authorization was extended into early March. We expect solid, even if not spectacular job growth in January, but recognize that the harsh winter conditions for much of the country in the middle of the month likely dampened activity. Because we think the interest rate adjustment may not have been completed, we suspect the dollar's correction from the November-December slide can extend further. This could translate into the 104.00-50 area in the Dollar Index (settled January 26 ~103.40). 

Euro: The eurozone seems ill-prepared to address the economic and political challenges that may lie ahead. The political leadership appears particularly weak. The German coalition government is terribly unpopular. In France, President Macron has begun the year by sacking his prime minister and appointing Attal, a young popular French politician, in an apparent bid to revive his political fortunes. Le Pen is running ahead of his party in the mid-year EU parliament election. The economic performance remains moribund. The external balance has recovered from the disruptions associated with Russia's invasion of Ukraine, but the domestic growth remains poor, and the near-term prospects, through the first half, is not much better. One of the bright spots is that the weak economy and rate hikes have not spurred much of a rise in unemployment (so far). The ECB has signaled that it is in no rush to cut rates, with a cut maybe near mid-year. The euro traded between about $1.0815 and $1.10 in the first four weeks of January. We suspect most of the correction from seven-cent Q4 23 rally has been achieved, but it may not be over. The risk may extend by a little more than a cent to the downside. The ECB has signaled a rate cut is likely near midyear, yet the swaps market has almost an 88% chance of a hike in April. 

(As of January 26, indicative closing prices, previous in parentheses)

Spot: $1.0855 ($1.1040) Median Bloomberg One-month forecast: $1.0875 ($1.0990) One-month forward: $1.0865 ($1.1055)   One-month implied vol: 6.2% (6.9%) 

Japanese Yen: The combination of the backing up of US rates and greater confidence that the Bank of Japan will not hike rates until at least April dragged the yen lower in January. It fell by about 4.6%. The dramatic slide in US rates November and December 2023 saw the dollar drop from nearly JPY152 in mid-November to almost JPY140 in late December. The greenback recovered to almost JPY149 in the first four weeks of January before settling near JPY148. Despite fiscal efforts, an extraordinary monetary policy, and an undervalued currency, the Japanese economy struggled in H2 23. It contracted almost 3% at an annualized rate in Q3 23, with consumption and business investment falling in Q2 23 and Q3 23. Although the economy is expected to have returned of growth in Q4 (GDP is due February 15), it may take the better part of three quarters to recoup the activity lost in Q3 23. Public support for Prime Minister Kishida and the cabinet is weak. The Liberal Democratic Party had not recovered from the negativity around its ties with the Unification Church before a campaign financing scandal erupted, hobbling some of the largest factions within the party. Still, one of Kishida's achievements has been the stronger defense posture, which includes acquiring offensive capabilities and reduced barriers to the export of armaments. Ironically, core CPI is likely to fall below the central bank's target before it finally exits its negative interest rate policy, seen most likely in April. The dollar's rally in January stretched the momentum indicators suggesting that the "correction" may be nearly complete. We suspect the JPY150 area may hold as a consolidative phase in both US rates and the dollar seems likely after the large adjustment in January. 

Spot: JPY148.15 (JPY141.05) Median Bloomberg One-month forecast: JPY145.65 (JPY142.05) One-month forward: JPY147.45 (JPY140.35) One-month implied vol: 8.25% (10.7%) 

British Pound: Since the middle of December, sterling has been chopping in a two-cent range between $1.2600 and $1.2800. Twice in December, the upper end was frayed, and once in January, the lower end was violated, but not on a closing basis. The consolidation is alleviating the overbought technical condition that resulted from the roughly eight-cent rally in Q4 23. We are more inclined to see an eventual downside break, which initially could be worth a cent. The swaps market suggests the Bank of England easing cycle may begin after the Fed and ECB and deliver fewer cuts this year. Specifically, the market does not have the first cut fully discounted until June, and it has 105 bp of easing discounted for this year. At the end of last year, the swaps market discounted slightly more than 170 bp of cuts. The Bank of England meets on February 1, with practically no chance of a change in policy. The economy has been struggling since growing by 0.3% (quarter-over-quarter) in Q1 23. It was stagnant in Q2 and contracted by 0.1% in Q3. GDP for Q4 23 is due February 15. The risk is of another small contraction. The near stagnant conditions may persist through the H1 24. At the same time, the base effect warns that measured inflation will fall sharply in the coming months. In the February-May 2023 period, the UK's CPI rose at an annualized rate of almost 11.5%. As these large monthly increases drop out of the 12-month comparison, with conservative assumption, the year-over-year pace could be halved from the 4% pace seen at the end of last year. The Sunak government is unpopular and support for the Tory party is around 25% according to recent polls. Labour is holding on to almost a 20-percentage point lead. Chancellor Hunt will deliver the Spring budget (March 6), and it is expected to offer tax cuts ahead of the national election expected later this year.

Spot: $1.2705 ($1.2730) Median Bloomberg One-month forecast: $1.2655 ($1.2650) One-month forward:  $1.2735 ($1.2710) One-month implied vol: 6.6% (7.2%) 

Canadian Dollar:  The Bank of Canada left its policy rate steady at 5.0% last month. Citing the persistence of underlying inflation, officials expressed little sense of urgency to ease policy. While Governor Macklem refused to rule out an additional hike, he was clear that should economic activity evolve as officials expect, the question becomes when it should cut. The central bank chopped its forecast for Q4 23 GDP (due on February 29) to flat from 0.8% It projects 0.5% annualized growth in Q1 24. The Bank of Canada sees headline inflation remaining around 3% in H1 24 before slowing to 2.5% by the end of the year. The swaps market has the first cut fully discounted by mid-year and looks for almost 100 bp in cuts this year, back loaded. What seems to drive the exchange rate on most days are the broad direction of the US dollar (think Dollar Index) and the general risk-appetite. The Canadian dollar is often among the most sensitive dollar pairs to the movement of the S&P 500. Contrary to popular wisdom, the Canadian dollar's exchange rate does not appear tightly linked to oil prices. After falling by about 5.2% in November-December 2023, the US dollar recovered rose by about 1.6% in the first four weeks of January. We suspect the move is not complete and look for the greenback to test the CAD1.3600-20 area, but a break of CAD1.3400 would bolster the chances that a high is in place.

Spot: CAD1.3455 (CAD 1.3245) Median Bloomberg One-month forecast: CAD1.3475 (CAD1.3300) One-month forward: CAD1.3445 (CAD1.3235) One-month implied vol: 5.0% (5.7%) 

Australian Dollar:  In the last two months of 2023, the Australian dollar appreciated by about 9.5% against the US dollar. Momentum indicators were stretched, and combination of soft inflation and a disastrous labor market report provided the precipitating drivers that forced the Australian dollar to surrender more than half of its gains in the first four weeks of the year. The loss of nearly 107k full-time jobs in December is a record outside of a couple of months early in the pandemic. This outsized loss was not confirmed in other high-frequency time series, which appear to confirm the general slowing of economic activity, not a collapse. The January job report is due February 15. However, even as inflation falls and the economic pulse is faint, the market has pushed out the first cut from May (at the end of 2023) to September now. It has also reduced the amount of cuts this year from 68 bp at the end of December to about 40 bp in late January. The Australian dollar's downside correction may not be complete, and the initial risk could extend to $0.6450-$0.6500.

Spot: $0.6575 ($0.6810) Median Bloomberg One-month forecast: $0.6635 ($0.6775) One-month forward: $0.6585 ($0.6820)    One-month implied vol: 9.0% (9.4%) 

Mexican Peso: Mexico's economy is slowing, and inflation is falling. This will set the stage for the first rate cut in the cycle. A case can be made for a cut at the February 8 Banxico meeting, but on balance, a cut at the March 21 meeting, a day after the FOMC meeting, may be more likely. The central bank forecasts growth to slow to nearly 2% this year from about 3% in 2023. The IMF and the median forecast in Bloomberg's survey concur with the central bank. Progress to restore price stability has been extensive. The headline CPI peaked in July 2022 near 8.15%. It reached about 4.25% in October 2023 and finished the year near 4.65%. The core rate peaked in November 2022 around 8.50% and finished last year slightly below 5.30%. The headline rate accelerated to an almost 7% annualized rate in Q4 23 from about 4.4% in Q3. The core rate rose at annualized rate of around 4.35% in Q4 23 after a 4.10% annualized pace in previous three months. The peso has been a darling of the market for some time, and given market positioning (over-weight asset managers, and speculators carry a large net long peso position in the futures market), we think the risk is for some liquidation ahead of the June election. It could be expressed as greater sensitivity to risk-off developments. The high carry still makes it an expensive short. In the middle of January and against in late January, the dollar jumped and tested the 200-day moving average (~MXN17.37-38) and the first retracement of the November-December downtrend. It held. Support may be seen in the MXN17.00-05 area and a break could signal a retest on the January low near MXN16.7850. 

Spot: MXN17.16 (MXN16.97) Median Bloomberg One-Month forecast: MXN17.33 (MXN17.20) One-month forward: MXN17.25 (MXN17.06) One-month implied vol: 10.3% (11.2%)

Chinese Yuan: Beijing has managed to deliver a stable exchange rate. The US dollar has largely been confined to a CNY7.10-CNY7.20 for more than two months. Although conventional wisdom often attributes malevolent intentions to the PBOC efforts, it seems that the exchange rate movement is understandable as a reactive function to the dollar's broad movement, especially against the yen and euro. After leaving key interest rates steady, the PBOC delivered a 50 bp cut in required reserves, which frees up an estimated CNY1 trillion (~$140 bln). More stimulus is widely expected, even if the timing is difficult to anticipate. While 10-year yields US and European rose in January, they fell slightly in China. Short-term rates are also low making the offshore yuan an attractive funding leg in structured trades. After a sharp sell-off of Chinese shares on the mainland and in Hong Kong, Beijing's pain threshold was discovered. Although Beijing eschews the performance of the equities as a key metric, officials appear to be stepping up their support using formal and informal channels. Of course, China and the US have different institutional configuration and authority, but Beijing's effort to stem the equity sell-off seems to have a similar goal in mind as the so-called "Fed Put" that used monetary policy to stop a destabilizing equity market decline. In this context, a broadly stable exchange rate may act as a bit of a fire break to a potentially vicious cycle. 

Spot: CNY7.1775 

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