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Currency Market Sub-Plots Lift Greenback

The dollar is creeping upward as conflicting cross-currents in the foreign exchange markets contrive to keep most majors tightly rangebound. Yields are broadly flat, and equity futures are setting up for a slightly weaker open.

Mexico’s Banxico yesterday became the second central bank—after the Reserve Bank of Australia—to defy increasingly-dovish policy expectations, sending the peso soaring by raising rates by half a percentage point in a move that surprised virtually every observer. In a statement accompanying the decision, policymakers said “Given the dynamics of core inflation, on this occasion it is necessary to continue with the magnitude of the reference rate adjustment,” and “Given the monetary policy stance already attained and depending on the evolution of incoming data, for its next policy meeting, the upward adjustment to the reference rate could be of lower magnitude”. By keeping Mexican policy rates at least 600 basis points above their US equivalents (and now widening the spread), the Banxico has driven the real effective exchange rate to post-2015 highs, taking a toll on competitiveness and the domestic economy – while arguably raising the risk of a valuation-driven reversal.

The yen briefly gained almost 1.3% on a Nikkei report suggesting former board member Kazuo Ueda would be nominated as the Bank of Japan’s next governor. Ueda is considered slightly more hawkish than current Governor Kuroda or front-runner Masayoshi Amamiya, but has previously argued for keeping policy in stimulative territory, meaning that he would be considered extremely dovish at any other major central bank. A formal announcement is expected within days.

Britain’s economy contracted by more than expected in December, shrinking -0.5% as rising prices, higher interest rates, and a series of unusual business interruptions took a toll on activity. For the fourth quarter as a whole, output flatlined, meaning that the country avoided technical recession (a distinction generally lost on people in the real world), but the Bank of England’s projections show growth contracting through 2023 and early 2024, only returning to pre-pandemic levels by 2026.

Oil prices climbed after Russian Deputy Prime Minister Alexander Novak said his country would cut output by 500,000 barrels a day in March. In a statement, Novak said “Russia believes that the ‘price cap’ mechanism in the sale of Russian oil and oil products is an interference in market relations and a continuation of the destructive energy policy of the countries of the collective West,” warning “We will not sell oil to those who directly or indirectly adhere to the principles of the ‘price cap’”. Both global benchmarks—Brent and West Texas Intermediate—are up roughly 2.3% on the day.

Chinese lending volumes jumped in January as the government authorized banks to support the corporate and property sectors. New yuan loans jumped to 4.9 trillion yuan from 1.4 trillion in December, with businesses taking out 95% of overall volume as consumer borrowing slumped in the face of still-weak real estate prices and the Lunar New Year holiday. Observers expect aggregate credit creation to accelerate in coming months as policymakers try to steer a broader economic recovery – but widespread malinvestment and the growing risk of a financial crisis should make a repeat of 2009’s surge unlikely.

Economists think Canada generated another 15,000 jobs in January, down from a revised (but still astonishing) 69,200 in December. The unemployment rate might inch up to 5.1% as businesses begin to slow hiring. According to the last Bank of Canada Business Outlook Survey, only 35% of firms plan to expand headcount over the next year, down from almost 77% in late 2021.

The Canadian economy has proven surprisingly resilient in the last six months, but we suspect that the lagging impact of last year’s rise in interest rates is only beginning to hit households where it hurts. Even with the recent softening in longer-term yields, aggregate mortgage servicing costs will continue to climb for months to come, and overly-indebted consumers are likely to react by slowing spending on the products and services that drive overall growth. We have difficulty imagining sustained outperformance in the Canadian dollar until borrowing costs subside and rate differentials begin to flip.

The University of Michigan’s consumer sentiment index is expected to print close to the 65 mark in early February, up slightly from January’s 64.9 reading as strong labour markets and weaker inflation pressures translate into brighter spirits. Year-ahead inflation expectations are seen climbing incrementally from 3.9% to 4.0%, while longer-term forecasts are likely to remain anchored near the 2.9% mark – levels that should give Fed officials some comfort.

Federal Reserve speakers include Governor Christopher Waller on digital assets—which hardly anyone cares about anymore—and Philadelphia’s Patrick Harker on consumer finances and spending—which remains relevant to the strength of the economic recovery.

Next week’s consumer price index report looms as a potential event risk, with growing signs of complacency in financial markets conflicting with the likelihood of a more turbulent path for prices. We worry that markets are expecting one-off declines in used car and energy costs to translate into a steep and unrealistically-smooth decline in underlying inflation rates, and think the dollar could stage a meaningful short-term rebound on a higher-than-expected month-over-month rise in core measures. Terminal rate expectations have been creeping up in recent weeks and could move higher if price pressures fail to subside in line with the ‘Goldilocks’ scenario that so much of early 2023’s trading activity has been predicated upon.

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Twists & turns

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