Becalmed FX market doesn't conceal the greenback's strength

Overview: The foreign exchange market is becalmed today, with most of the major pairs trading in narrow ranges. The economic calendar is light and the North American session features benchmark revisions in US CPI and Canada's January employment figures. The US quarterly refunding supply has been absorbed without much fanfare. The dollar-bloc currencies and the Norwegian krone are firmer today. A bank forecast that the central bank will hike rates later this month is lifting the New Zealand dollar to new highs for the week near $0.6150. Emerging market currencies are narrowly mixed today. Most of the freely accessible emerging market currencies are lower, including the South African rand, Hungarian forint, and Turkish lira. 

Japanese equities were mixed, and the Hang Seng slipped in the abbreviated session ahead of the holiday. Mainland shares that trade there were off almost 1%. Other large markets in the region settled higher. Europe's Stoxx 600 is slightly firmer after closed lower in the past two sessions. US index futures have a slightly upside bias after the S&P and Nasdaq set new record highs yesterday. The 10-year Japanese government bond yield rose a couple of basis points to 0.71%, a marginal new high for the week. European yields are also slightly firmer and setting the week's high today. The same is true for the 10-year US Treasury yield, which is posting above 4.16%. Gold is in a narrow $5 range above $2030. It settled slightly below $2040 last week. March WTI is extending its recovery into the fifth consecutive session. After tumbling by almost 7.4% last week, it is up nearly 5.7% this week. It is trading near $76.40 after setting a low on Monday around $71.40.

Asia Pacific

It is not just that the dollar is strong, but the Japanese yen is also weak. Valuation in the foreign exchange market does not seem to matter unless it is extreme. According to the OECD's model of purchasing power parity, which is not the final word, but a useful metric that has a long history, the yen is around 56% undervalued against the dollar. When the G5 met in the Plaza Hotel (1985) to coordinate intervention to drive the dollar lower (and the German mark and Japanese yen higher), in a highwater mark of coordination, the yen was about 25% undervalued, according to the OECD. According to the Bank for International Settlements calculation of real equilibrium exchange rates the yen is more undervalued than the Chinese yuan, but one would not know that. Ironically, similar arguments and tactics, including export restrictions used against Japan in the 1980s and 1990s are now deployed against China.

Sometimes, when two series appear correlated, like the number of mortuaries and the number of churches in a city, it is because they are correlated to a third factor, in this case population size. Despite obvious differences, one common characteristic of the (offshore) yuan and yen is that both have low interest rates and are attractive funding currencies. Although Japan runs a trade deficit and China, a surplus, both record current account surpluses. Japan's is around 3.4% of GDP and China reports a current account surplus half has large in proportionate terms. Some critics argue China's current account surplus is larger than officially acknowledge, and even so, countries with current account surpluses often have lower rates than deficit countries. Given the managed nature of the yuan's exchange rate, a stabilization and recovery of the yen would likely facilitate a stronger yuan.

With the mainland markets closed now until February 19, the lurch lower by the yen might be a limited drag on the offshore yuan. Although the offshore yuan is not limited by the 2% band against the dollar off the onshore yuan, it is mostly respected. Given that yesterday's fix was at CNY7.1063, it suggests that the dollar will likely trade mostly between about CNH6.9640 and CNH7.2485. It is little changed today, inside yesterday's range. 

The BOJ's deputy governor comments yesterday and the rise in US rates has sparked a new leg up in the dollar and the move does not seem complete. The comments appeared to have been reiterated by BOJ Governor Ueda, who also played down the likelihood of a tightening cycle even after a rate adjustment. The dollar made a marginal new high today near JPY149.60, about 10 pips higher than yesterday, and found support ahead of JPY149.20. In terms of the intervention escalation ladder, so far not a peep, but the probability of one is increasing. This is the sixth consecutive week, the dollar has risen against the yen, the longest advance in a year. Still, one-month implied volatility is at approaching 8%, its lowest since last November. Japanese officials may want to slow the depreciation of the yen as the JPY150 psychological level is approached. There are nearly $1.4 bln in options struck there that expire next Tuesday, shortly after the US January CPI. After being turned back near $0.6540 on Wednesday, the Australian dollar has struggled to sustain even modest upticks. It tested support in North America yesterday and nearly returned to the week's low set Monday near $0.6470, around where the lower Bollinger Band is found. The Aussie is trading quietly today inside yesterday's range. It is in less than a 15-tick range on either side of $0.6500.

Europe

The eurozone goes into the weekend amid light news developments and next week's economic calendar highlight is another look at Q4 GDP and its details. The market impact should be minimal. A key issue that emerged is renewed economic divergence with the US economy appearing to grow faster than trend, while Europe stagnates or worse. One implication is that the ECB is seen likely to cut rates before the Federal Reserve. That said, the odds of an April ECB rate cut have fallen to about 55% from nearly 75% at the end of last week. Meanwhile, the odds of a Fed cut in May has slipped below 75%, which is the least in more than two months. The swaps market has about 118 bp of ECB cuts this year compared with about 115 bp the Fed.

The UK's economic calendar empty today but next week is important with a new employment report, January CPI and PPI, December GDP and details, and Q4 23 GDP. The labor market is slowing, and the base effect warns of an uptick in the year-over-year rate of UK CPI, but the real story is the sharp slowing of UK inflation in the February-May period. Net-net, the monthly GDP figures show an economy that stagnated in October and November and likely did not do much better in December. The swaps market has about an 72% chance of a cut in June (down from 100% at the end of last week). It is fully discounted in August. There are three quarter-point cuts fully discounted and about a 20% chance of a fourth cut this year (or roughly 80 bp). 

The euro briefly traded below Wednesday's low in North America yesterday, falling to almost $1.0740 before recovering. It approached the session high set in Asia Pacific turnover on Thursday a little below $1.0790, which is more or less where it settled last week. It is also the (38.2%) retracement of the drop from the $1.09 level it approached before the jobs data. The single currency is an exceptionally narrow range today (~$1.0760-$1.0785). With the momentum indicators stretched and the euro down for five of the six weeks to start the year, we look for some kind of reversal pattern to suggest a bottom is in place. Sterling, like the euro, is nearly flat on the week. It did close twice below $1.26, the bottom of the multiweek trading but recovered and closed back into the range in last two sessions. Still, sterling has stalled in front of Wednesday's high near $1.2640. It is in about a third of a cent range today above $1.2600, that has been approached in the European morning. There are options for about GBP330 mln at $1.2560 that expire today. Yesterday's low was almost $1.2570.

America

Economists will digest the implications of today's CPI revisions, but we suspect the impact on the market and policymakers will be minimal. At his recent press conference, Fed Chair Powell said that officials will review the revisions, but he did not seem to put much weight on them. After a quiet week of economic reports, the week ahead will be richer. Headline January CPI may have dipped below 3% on a year-over-year basis for the first time since Q1 21. The core rate is seen slipping to 3.7% from 3.9%. After going on shopping spree in December, boosting retail sales by 0.6% (headline) and 0.8% (core/control), the US consumption likely was tempered in January. Industrial output contracted in Q4 23, but likely began the new year on a firm note. The 0.4% increase that the median forecast in Bloomberg's survey anticipates, would be the strongest since last July. 

Canada's January employment report is the highlight of today's North American session. Canada lost full-time positions in two of the last three months. In 2023, Canada fill 324.2k full-time positions, of which 33k were in Q4 23. The unemployment rate, which was at 5.0% as recently as last April, finished the year at 5.8% and may have ticked up again last month. Net-net, the participation rate was flat last year at 65.4%. The problem for the Bank of Canada is wages. The hourly wage rate for permanent employees increased 5.7% year-over-year in December. This was a new cyclical high and well above the 3.4% CPI. The market does not have the first Bank of Canada rate cut discounted until July (thought there is about 2/3 chance of a hike in June), according to the swaps market. Canada's inflation is likely to fall sharply in the coming months as the strong increases in the first part of last year (6.3% annualized rate in the Jan-Apr 2023) drop out of the 12-month comparison.

The US dollar drifted lower against the Canadian dollar yesterday. It settled below the 20-day moving (~CAD1.3460) for the first time since the US jobs data. The greenback recorded a new low for the week, slightly below CAD1.3450, which is the (50%) retracement of the rally that began in the middle of last week. The greenback is pinned near yesterday's low and has not been much above CAD1.3465 today. Mexico's central bank laid the groundwork for a cut as early as next month. This confirms what had already seemed priced into the swaps market. The peso was sold, and the dollar set session highs in the hour following Banxico's announcement near MXN17.17. It reached almost MXN17.50 in early European turnover, but the dollar was sold to nearly MXN17.12. Initial support is seen near MXN17.10 ahead of the week's low slightly above MXN17.00. Other Latam currencies, but the Colombian peso weakened yesterday and the Mexican peso's loss (~.55%) was in line with the Brazilian real (-0.50%).