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This Week
Bilal gives his bearish EUR/USD view; Dominique outlines her call for a 50bp Fed cut in March; Mustafa discusses QT tapering, arguing MBS will likely cheapen relative to Treasuries; Mirza argues EMFX will struggle to extend recent gains with the Chinese economy mired in property-sector fallout; Caroline argues the NBP will remain firmly on hold today; Henry watches ECB comments for signs they continue to favour pausing, and for good entry points to fade March/April cuts; John sees equities range-trading ahead as high expectations meet evolving realities.
Bilal Hafeez – Global Macro
Cycle similarities have prevented a trend emerging in EUR/USD. Both the US and Europe are seeing inflation fall, growth momentum dip, and recession risks shrink. And markets expect both the Fed and ECB to cut by 150bps in 2024. Rates spreads have therefore moved sideways recently, likely capping EUR/USD to the top of its 1.06-1.11 range.
So what is driving the euro? Risk markets. For example, the S&P 500 rally coincided with the euro rally and dollar weakness (Chart 1). This suggests the euro is acting more like a ‘risk-on/risk-off’ currency than a ‘rate-spread’ one.
Until cyclicals diverge, rate spreads will remain in the back seat. Instead, risk will drive the euro. And after an impressive Q4, we think risk could lose steam. US stocks typically struggle to exceed 1.5 std dev. three-month gains, and Q1 seasonals are poor.
Therefore, we are bearish on EUR/USD and see it trading towards 1.07. The risk to this view is a blowout earnings season or emerging clarity that the Fed is targeting equities over inflation.
Dominique Dwor-Frecaut – US Macro
I expect the Fed to cut in March as insurance against/to prevent the US sliding back into ‘lowflation’. This reflects the Fed changing its assessment of the balance of risks of monetary policy being too tight versus too loose on the back of November 6m core PCE falling to 1.9%, below the Fed target (Chart 2).
On balance, I see the Fed cutting 50bp in March. My subjective probabilities are 55% for 50bp, 40% for 25bp and 5% for no cut. This is based on core PCE printing below 20bp in the runup to the March meeting, i.e., December and January, compared with average monthly core PCE prints of 18bp over the past three months and 15bp over the past six months.
Besides inflation inertia, the reasons for expecting the low prints are falling energy prices and weak transmission of low unemployment to wage growth. I will discuss this in greater detail in my Thursday weekly.
This week’s CPI will offer a first hint of whether the 50bp cut is likely. The consensus core CPI of 0.2% suggests core PCE is more likely than not to be below 20bp, as historically monthly core PCE has been about 4bp below monthly core CPI.
Mustafa Chowdhury – US Rates
As Dominique argues, this week is crucial for data, with the CPI announcement on Thursday. We will likely see significant repricing in the front end of the OIS curve, which could go in either direction.
Additionally, the market will be reminded of Treasury supply concerns with $52 billion in 3-year, $37 billion in 10-year, and $21 billion in 30-year notes and bonds. It will be interesting to see how the market absorbs a surge of duration in the new year. We do not expect great performance in the auctions, as the rate levels are much lower than just two months ago.
The 10-year SOFR spread widened slightly to -37bps after Dallas Fed President Logan’s speech at the AEA Conference last weekend. She essentially confirmed what the market has been anticipating this year: that the Fed should start tapering QT soon, regardless of when they begin the easing cycle.
Current bank reserves are $3.26tn. Although there is a wide distribution among banks in terms of reserve needs, $2.5tn is considered a reasonable lower limit beyond which the banking sector is likely to face liquidity issues. We expect no significant announcement effect from QT tapering. However, unlike the QE tapering announcement of 2013, MBS will likely cheapen relative to Treasuries.
Mirza Baig – Emerging Markets
Emerging markets have done well since the Fed pivot, with sizable rallies in local curves and improvement in capital inflows. We believe these gains will be difficult to extend in the near term given more challenging valuations and substantial easing now discounted into local curves.
While EMFX has benefited from the Fed pivot, a more sustained appreciation requires softer US growth to be paired with improving cyclical performance in China. Unfortunately, this is not the case as the Chinese economy remains mired in the fallout from the property sector. The market has already discounted six rate cuts from the Fed, and any disappointment over inflation converging to target could again increase FX volatility.
As such, we are operating a more nuanced portfolio, preferring to avoid outright short USD/EM exposures, while focusing on relative value opportunities. We took profit on our short PHP/THB position last week and initiated long SGD/THB and long IDR/PHP trades. We remain short EUR/TRY and long EUR/CZK. In rates, we remain outright received in Brazil and rolled our position from DI25 to DI27. Meanwhile, in Mexico, we are running a 5Y10Y TIIE steepener and waiting for better entry to turn outright received. Finally, we took profit on our received position in 5Y South Africa swaps.
Caroline Grady – Emerging Markets
The NBP’s first meeting of the year is expected to be uneventful. Last week’s downside surprise on December CPI (6.1% YoY versus 6.5% consensus) will not trigger a rate cut, or even a dovish-sounding statement from the NBP. Only once new forecasts are released in March will the NBP think about cutting rates again. But with a new government now in place, the MPC have more clarity on fiscal policy. As such, Glapinski will likely use the press conference to highlight the inflationary risks and uncertainties from fiscal policy.
Henry Occleston – Eurozone & UK Macro
The main releases for next week will be Eurozone industrial production data (throughout the week), final December CPI data in France and Spain (Friday), and UK monthly GDP (Friday). I will be watching ECB and BoE speakers most closely.
ECB speakers this week include Villeroy, de Guindos, Vujcic and Lane. In line with our and market expectation, December core inflation came out at +3.4% YoY. The modest uptick in headline inflation was widely anticipated. The ECB had pencilled in an unreasonably hawkish near-term inflation trajectory, and this will be the first time we hear from policymakers after inflation has been confirmed below their expectations.
Lane will be particularly important to hear from on this front. I expect they can wait until the June meeting to make their first cut, given they will lack a good view of the inflation and wage picture before then. I will watch for indications that this is the case, and that cuts priced for March and April can be faded.
The main BoE speaker this week is Bailey. Market pricing has become more dovish lately and is now pricing our base case of a May cut. Inflation recently surprised to the downside, and official wage growth numbers have (finally) dropped. This should provide some room for dovishness, but I also expect he will want to caveat that some of the November disinflation was likely due to sample timing changes. As such, we could see a tick up in the December inflation number.
John Tierney – US Equities
Coming off a great December and year, it is hardly surprising that equities took a break last week. Even with aggressive earnings outlooks, forward P/E ratios are well above pre-pandemic levels (Chart 5).
Investors are clearly pricing in high expectations for earnings, rate cuts, and the economy in 2024. We look for equities to trade in a narrow range in coming weeks as investors weigh the evolving reality against their high expectations.
Q4 earnings season kicks off on Friday with reports from several major banks (including Citigroup, JP Morgan Chase, and Wells Fargo) and Delta Airlines. We look for insights into bank views on lower rates and any shifts in consumer demand for travel experiences.