Higher for Longer Helps the Dollar while Weighs on Equities
The jump in prices paid in yesterday’s US ISM manufacturing coupled with the stronger eurozone inflation, with a new cyclical high reported in the core rate, underscores the market theme of higher-for-longer. This is seen as dollar supportive but also negative for risk-assets, including and especially equities. European benchmark 10-year yields are up another couple of basis points today and the 10-year US Treasury yield is pushing above 4% for the first time since last November. European two-year yields narrowly mixed, while the two-year US rate is reached almost 4.94%, a new high since 2007.
Asia Pacific equities were mostly lower, with South Korea, returning from holiday, and Australia, notable exceptions. Europe’s Stoxx 600 is lower for the third consecutive session. US equity futures are narrowly mixed. All the G10 currencies are weaker today, with the Scandis and New Zealand dollar (which outperformed yesterday) off around 0.6%, while the Canadian dollar and Swiss franc, the best performers today, are off about 0.2%. Most emerging market currencies are also softer. Here, the Korean won is a notable exception. Central European currencies are hit the hardest. Gold, which rallied nearly $50 in the past two sessions is being dragged lower by the rising dollar and interest rates. April WTI is trading at an eight-day high above $78.00. Last month’s high was around $80.80.
Japan reported Q422 capex and company profits/sales. These do not drive markets. Still, Japanese profits declined 2.8% year-over-year from a heady pace of 18.3% year-over-year in Q3. The median forecast in Bloomberg’s survey was for an 8.4% gain. Sales growth slowed to 6.1% year-over-year, well below expectations after an 8.3% increase in Q3. This is still high, relative to the 1.3%-1.4% average for the five- and ten-years before Covid.
Tomorrow is the first test of the hypothesis that inflation in Japan has peaked. Tokyo’s CPI for February is due. Government subsidies, the drop in energy prices, and the gains in the yen on a trade-weighted basis should help dampen price pressures, and the Tokyo figures give much insight into the national inflation, which is not reported until later in the month. This should help give the new BOJ team some time to review policy and set an exit strategy (sequence of steps).
Separately, we note that the Ministry of Finance weekly data showed Japanese investors continued to buy foreign bonds after having been substantial sellers last year. Last week was the fourth consecutive week of net buys. In the first eight weeks of the year, Japanese investors have bought JPY5.5 trillion (~$41 bln)
The dollar recovered from a three-day low yesterday near JPY135.25 to settle around JPY136.20 and has extended its gains to almost JPY136.80 today. The high for the year was set on Tuesday a little closer to JPY137.00. The 200-day moving average is around JPY137.25, and the greenback has not traded above it since the December surprise. We have noted the correlation between the change in US yields and the exchange rate has tightened and we project gains toward JPY140.00. The Australian dollar posted a key reversal yesterday by trading on both sides of Tuesday range and then settling above its high. There has been no follow-through buying today, and the Aussie looks more likely to retest support around $0.6700. A break could signal another leg down toward $0.6665 initially. The greenback is snapping a three-day drop against the Chinese yuan and is up about 0.4% today. It is trading well within yesterday’s range (~CNY6.8625-CNY6.9350). The PBOC set the dollar’s reference rate a little weaker than expected at CNY6.8808 (median projection in Bloomberg’s survey was CNY6.8821).
Germany joined France and Spain in reporting higher than expected February CPI figures. It is little wonder then that the aggregate figure proved firmer than anticipated. The headline rose by 0.8%, the first increase since October and offset the three-month decline. The year-over-year pace slowed slightly to 8.5% from 8.6% in January. The core rate rose to 5.6% from 5.3%, a new cyclical high. Looking a little ahead, in March 2022, the aggregate CPI jumped 2.4% month-over-month. As we have noted, market expectations have ratcheted up, as they have in the US, and the terminal rate in both areas are seen around 50 bp higher than at the start of the year, 5.50% for the Fed and 4.0% for the ECB. The knock-on effect has been to push the US-German two-year rate differential, which often tracks moves in the exchange rate, toward 160 bp from the peak near 187 in early February after the strong US employment report and service ISM. It is now near 168 bp, little changed from where it settled last year (~170 bp).
Separately, the eurozone reported January unemployment was steady at 6.7%, given the slight revision to the December series (6.7% vs. 6.6%). It has been mostly at 6.7% since last April, down from 7.0% at the end of 2021. It was at 7.5% before Covid struck. It has not been lower since the beginning of the EMU era. The ECB sees it rising to 6.9% this year, which matches the median forecast in Bloomberg’s survey, while the OECD sees it at 7.1%. The record from the ECB’s meeting will be reported shortly. However, a 50 bp hike later this month has been strongly signaled and another 50 bp move at the following meeting in May seems increasingly likely.
Meanwhile, the Democratic Unionist Party of Northern Ireland continues to study the “Windsor Framework,” but it is clearly not satisfied. The so-called “Stormont brake” does not go far enough for the DUP. Ostensibly, it would allow the Northern Ireland Assembly, which is not sitting now because the DUP is protesting the Northern Ireland protocol, to reject EU rule changes on goods. However, the UK would have the final say and the DUP fears that UK would be reluctant to exercise a veto for fear of retaliation. Moreover, the idea is that without DUP support, a group of Tory MPs, perhaps led by the European Research Group, will be emboldened to oppose the proposal. The measure could still pass with Labour’s support but that would also put Prime Minister Sunak in a vulnerable position.
The euro stalled yesterday near $1.0690, fraying the 20-day moving average, which it has not closed above since February 2, the day before the last US jobs report. It is better offered today and bids around $1.0620 were easily absorbed in European turnover. Support is not seen until closer to $1.06 and then yesterday’s low (~$1.0565).Initial resistance pegged in the $1.0640-60 area. For its part, sterling is also holding below the 20-day moving average on a closing basis. It is found near $1.2050 today. Sterling is spending more time below $1.20. At the end of last week and the start of this week, sterling found support near $1.1925. Today’s low through much of the European morning is slightly above $1.1955.
The market’s reveal preferences continue to show it putting more stock in the ISM than the PMI. Recall the jump in January ISM services (from 49.2 to 55.2) encouraged the market to take seriously the US jobs data that had been reported a few hours before. The focus yesterday was not so much on the ISM manufacturing index, which essentially confirmed the continued challenges that had been identified by the PMI (ISM 47.7 vs. PMI 47.3) but the prices paid component. It jumped to 51.3 from 44.5. It was the second increase in a row to rise above 50 for the first time since last September. It plays on fears that the easing of goods inflation has mostly run its course. The next leg down in US inflation may come from shelter as lagged data the government uses catches up to what has been happening to prices and rents.
Unit labor costs and productivity are not measured directly but are derived from the GDP data. The downward revision to Q4 GDP will likely translate into slower productivity and higher unit labor costs (initially 3.0% and 1.1%, respectively). which will be reported today. Unit labor costs, one of the most wholistic measures of labor costs because it puts them in the context of productivity, averaged about 1.7% in the five years before Covid. In the last three years, unit labor costs have average about 4.2%. However, this is picking up distortions caused by Covid and policy response. They have been consistently slowing since the 8.5% print in Q1 22. In Q2 22, they slowed to 6.7% and then 2.0% in Q3.
The “higher for longer” rate outlook in the US and Europe does the Canadian dollar no favors as the Bank of Canada is on hold. There is practically no chance that it lifts rates at next week’s meeting. Heavier equity markets take a toll as well and the S&P 500 looks poised to fall through its 200-day moving average (~3940). The greenback is likely to challenge the recent highs seen around CAD1.3660-5. The year’s high, seen in early January is closer to CAD1.3685, and the December 2022 high was a little higher still (~CAD1.3705). The US dollar is steady against the Mexican peso after falling to new five-year lows yesterday, helped by reports that Tesla will spend at least $5 bln to build EV production there. Yesterday’s low was near MXN18.07. Initial resistance may now be in the MXN18.20-25 band. While we have been bullish the peso, our target near MXN18.00 has been approached quicker than we expected. Technically, it looks stretched, and the political backdrop is looking a little less secure.
Bannockburn Global Forex