FX Weekly: Has inflation turned the corner to influence a lower terminal rate?

Market Bias: mixed 

• Inflation appears to have flattened in recent months in the US and other countries bringing a degree of relief as central bankers begin to signal their intention to slow down the pace of future rate hikes.
• In the US, the latest batch of economic data have shown that the economy is indeed slowing down after the four consecutive sets of outsized +75 bps hike by the Fed.
• Personal consumption expenditure (PCE) a key measure of inflation for the Fed, retails sales, purchasing manager index (PMI) and Institute of supply management index (ISM) all came in weaker than expected.
• Recent Fed speak also suggests that there is consensus building to downshift the pace of rate hikes to +50 bps in December. With the Fed funds rate at 4.50%, we are probably just 50-75 bps away from reaching the terminal rate as the futures market has it priced at 4.92% currently.  
• Last week, Jerome Powell stressed that he and colleagues do not want to raise interest rates excessively and put them in a situation to cut them later. However, he did warn that rates may stay higher for longer.  This will probably be the path moving forward as the Fed doesn’t want to repeat the same policy mistakes for acting too late to control inflation.  
• Despite the soft patches of economic weakness, the US labor market has been somewhat resilient. JOLTS job openings showed 10.3 million jobs still needs to get absorbed.  Also, the stronger non-farm payrolls and the doubling of average hourly earnings in Nov tells us that the Fed’s job is far from done. 
• There is still more data for the Fed to comb through with the crucial consumer price index (CPI) on 13 Dec (Nov forecast 7.3% versus 7.7% prior month) before the next rates decision on 14 Dec.

Market Bias: mixed

• In the UK, the latest batch of data that includes, PMI, employment, and retail sales indicates there is a fair bit of resiliency in the economy. However, housing statistics have been poor and inflation remains stubbornly high at around 11%. 
• Bank of England is expected to raise rates by 50bps on 15 December. With a much steeper path to tightening as overnight index swaps have implied rates priced at 4.60% by Q3 2023 versus 3.00% currently and quantitative tightening in motion, there are concerns it could sink the UK economy into a deep recession.

Market Bias: mixed

• EUR/USD continue to perform well on the back of the USD’s underperformance as expectations of a dovish Fed pivot grows. This was despite much weaker Purchasing Management Institute (PMI) readings across the Eurozone, softer retail sales and inflation data that suggest it may have peaked at around 10.6%. 
• Later this week, we get Eurozone’s employment and growth data before the European Central Bank (ECB) rates decision on 15 December. Expectations for a +50bps hike to 2.00% in the main refi-rate are well entrenched, but with the futures market pricing in terminal rate at 2.85% by Q3 2023, it shows that the ECB may be close to pausing as well. 

CNY/CNH

Market Bias: mixed 

• The announcement by China’s health authority on 29 November to speed up vaccination for the elderly above 80 years and shortening the time gap between vaccination and booster shots to 3 months suggest the government is starting to rethink their restrictive zero COVID policies.
• News that many Chinese cities have dropped COVID testing requirements to enter all public venues such as buses, subway, taxis and other public venues suggests China is getting closer to reopening despite rising cases. There are reports that the government may also announce 10 new easing measures on 7 December.
• As the world’s production hub and one of the largest importers of global commodities, an early reopening of China’s economy is positive for global growth. With supply chain bottlenecks clearing up, it should help lower prices and take the edge off inflation.
• Together with the government delivering a property rescue package, it brought optimism as Chinese equities soared in November. The Hang Seng and Shanghai Shenzhen CSI 300 index rallied by 22% and 9% respectively.  The Chinese yuan has also appreciated by 6% against the USD to a 3 month’s low at 6.9300.   
• The risk-on sentiment has spillover to other emerging market currencies with close trade ties to China as the Korean won, Taiwan dollar, Thai baht and Brazilian real all made meaningful gains against the greenback.

JPY

• The Japanese yen has appreciated +11.65% against the USD since peaking at 151.95 on 21 Oct.
• While the -8% sell off in the USD index (DXY) and profit taking by traders contributed to the move, other factors were also at play and it's not about Japan’s stellar performance at the World Cup!
• The 35% decline in crude oil and natural gas prices since June have been positive to the economy. With the decent performance in Japanese bonds in recent months, it has allowed Bank of Japan’s (BOJ) purchases of government bonds, as part of yield curve control (YCC), to normalize. Net portfolio flows are also positive as Japan have been selling foreign bonds which has benefited the Yen marginally. 
• With BOJ’s Chief Kuroda stepping down at the end of April, there is speculation of a BOJ tilt. This is where the central bank may review their ultra-loose monetary policy, YCC and inflation target.  While the likelihood of change is plausible, it seems to be in the distant future.