Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead

Economic

Forex

Summary:

Yen’ decline resume today after release of Japan’s latest CPI data, which suggests that BoJ is not be under immediate pressure to exit its negative interest rate policy.

Yen' decline resume today after release of Japan's latest CPI data, which suggests that BoJ is not be under immediate pressure to exit its negative interest rate policy. Economists have noted a crucial aspect of Japan's inflation dynamics: while cost-push inflation is clearly easing, the transition to demand-pull inflation remains unconfirmed. The market's attention is now turning to BoJ's meeting next week, where new economic forecasts will be published. Although many analysts consider April as the most likely month for a rate hike, this remains contingent on the upcoming projections.

Amidst the Yen's decline, USD/JPY is approaching 150 psychological level, prompting verbal interventions from Japanese financial authorities. Finance Minister Shunichi Suzuki reiterated the importance of stable currency movements that reflect economic fundamentals. He assured that the government would continue to closely monitor forex markets. However, these comments have not provided a sustainable boost to Yen.

For the week, Dollar remains the strongest performer, but its rally is pausing with the rebound in stocks overnight. However, there is no indication of a reversal in Dollar's strength at this stage. Sterling and Euro are following as the second and third strongest currencies, respectively. Yen remains at the bottom of the performance chart, trailed by New Zealand Dollar and Swiss Franc. Australian Dollar is also showing softness, while Canadian Dollar displays mixed performance.

Technically, AUD/CAD's break of 0.8875 support indicates that rebound from 0.8562 has completed at 0.9063, after hitting 50% retracement of 0.9545 to 0.8562 at 0.9054. Further decline is now expected as long as 55 D EMA (now at 0.8920) holds. Next target is a retest on 0.8562 low. It's still a early to assess, but further downside acceleration would raise the chance of breaking through 0.8562 to resume larger down trend from 0.9991 (2021 high). Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead_1

Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead_1

In Asia, at the time of writing, Nikkei is up 1.34%. Hong Kong HSI is down -0.66%. China Shanghai SSE is down -0.60%. Singapore Strait Times is up 0.31%. Japan 10-year JGB yield is up 0.0133 at 0.668. Overnight, DOW rose 0.54%. S&P 500 rose 0.88%. NASDAQ rose 1.35%. 10-year yield rose 0.038 to 4.144.

Fed's Bostic foresees rate cuts in Q3, sets high bar for earlier action

Atlanta Fed Raphael Bostic said overnight that he now projects Fed to begin cutting interest rates in the third quarter of this year, a shift in timing from his previous expectation of the fourth quarter.

This adjustment is a response to the recent economic data, as he explained, "Because I'm data dependent, I have incorporated the unexpected progress on inflation and economic activity into my outlook, and thus moved up my projected time to begin normalizing the federal funds rate to the third quarter of this year from the fourth quarter."

While Bostic does not entirely dismiss the possibility of an earlier rate cut, potentially as soon as July, he emphasizes that the criteria for such a decision would be stringent. "The bar will be high," he stated, indicating that any move to cut rates before the third quarter would require substantial and convincing evidence.

He elaborated on this point, saying, "If we continue to see a further accumulation of downside surprises in the data, it's possible for me to get comfortable enough to advocate normalization sooner than the third quarter." However, he stresses that the evidence supporting such a decision would need to be compelling.

Japan's CPI core dips to 2.3%, remains above BoJ's target for 21st month

Japan's CPI core, excluding fresh food, decelerated slightly in December, moving from 2.5% yoy to 2.3% yoy, aligning with market expectations. This slowdown brings core inflation rate to its lowest since June 2022, yet it notably remains above BoJ's 2% target for the 21st consecutive month.

Overall headline CPI also showed a slowdown, decreasing from 2.8% yoy to 2.6% yoy. Additionally, CPI core-core, which excludes both food and energy, saw a modest decline, moving from 3.8% yoy to 3.7% yoy.

A notable aspect of CPI data is the stability of services prices, which rose by 2.3% yoy, maintaining the pace from the previous month. This rate marks the fastest increase in services prices in three decades when periods affected by sales tax hikes are excluded.

A significant factor contributing to the slowdown in inflation was the substantial drop in energy prices, which decreased by -11.6% yoy. This decline was driven by reductions in electricity and city gas prices, which fell by -20.5% yoy and -20.6% yoy, respectively, largely due to government subsidies.

NZ BNZ manufacturing falls to 43.1, 10th month of contraction

New Zealand's BusinessNZ Performance of Manufacturing Index fell from 46.5 to 43.1 in December. This latest figure marks a continued contraction in the manufacturing sector, which has now been shrinking for ten consecutive months.

The index components reveal a widespread decline across various manufacturing activities. Production fell from 43.5 to 40.5. Employment decreased from 47.9 to 46.7. New orders dropped from 47.4 to 44.0. Similarly, finished stocks and deliveries both saw declines, from 50.4 to 45.9 and 47.8 to 43.4, respectively.

Manufacturers' feedback further underscored the industry's challenges, with 61% of the comments in December being negative. This is a slight increase from 58.7% in November, though an improvement from 65.1% in October. The predominant concerns revolved around a lack of demand and sales, which have been significant hurdles for many manufacturers.

Stephen Toplis, BNZ's Head of Research, echoed these sentiments in his assessment of the PMI data. "The December PMI reaffirms our view that economic conditions remain very difficult," he stated. Toplis anticipates that while the economy and the manufacturing sector might gain some momentum by the end of 2024, the immediate future appears challenging, particularly with pressures in retail spending and construction activity.

Looking ahead

UK retail sales and German PPI will be released in European session. Later in the day, Canada will publish retail sales. US will release existing home sales and U of Michigan consumer sentiment.

USD/JPY Daily Outlook

USD/JPY's rally resumed after brief retreat and intraday bias is back on the upside. Current rise from 140.25 should target a retest on 151.89/93 key resistance zone. On the downside, below 147.64 minor support will turn intraday bias neutral again and bring consolidations, before staging another rise. Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead_2

Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead_2

In the bigger picture, stronger than expected rebound from 140.25 dampened the original bearish review. Strong support from 55 W EMA (now at 141.89) is also a medium term bullish sign. Fall from 151.89 could be a correction to rise from 127.20 only. Decisive break of 151.89/93 will confirm resumption of long term up trend. This will now be the favored case as long as 140.25 support holds. Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead_3

Yen's Decline Persists Following Japan CPI Release, Dollar Upholds Its Lead_3

Source: ActionForex

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Swissquote

Economic

Stocks

Forex

Forget about the Federal Reserve (Fed) dovish expectations that should be dialed back because the American economy is too strong to require a rate cut as early as March from the Fed. Forget that strong US economic data is not good news for the market. And forget about the fact that the rally in tech stocks should temper, to let the rest of the market catch up with the Magnificent 7. Because it isn't happening. Nasdaq 100 hit a fresh ATH yesterday, even though the latest US data showed that the initial jobless claims fell more than expected to the lowest level in more than a year, the mortgage rates slipped after a two-week rise, and home data was better than expected, as well.

In the bonds space, the US 10-year TIP auction saw a strong demand and settled at a 1.8% yield, versus more than 2% in the previous two auctions, suggesting that investors continue to see a potentially high inflation, while betting that the Fed should start cutting rates in a few months. Another paradox.

One weak spot is the US manufacturing sector. The weaker-than-expected Philly Fed manufacturing index came as another proof that manufacturing in the US remains weak. But who cares; US consumers spend and that's keeping the US economy robust. The Atlanta Fed's GDPNow forecast predicts a 2.4% growth for the Q4 in the US.

The US 2-year yield was steady below 4.40%, while the 10-year yield advanced to 4.16%. There is a stronger case for the US 10-year yield to surpass the 2-year yield: the Fed cut bets and the strong economic data are supportive for the end of the 2-10-year yield inversion.

In equities, a set of stronger-than-expected US data could've led to a further selloff in US equities, but it didn't. And higher US yields could've led to a further selloff in equities, but they didn't.

TSM, the main chipmaker of Apple and Nvidia, jumped nearly 10% yesterday, after the company said that it expects a return to solid growth this quarter. Nvidia hit a fresh record. Reflation trade is not happening, long technology is the most crowded trade of the moment. The Nasdaq 100 net long positions are at the highest levels in nearly two years. The stretched long positioning makes Nasdaq stocks vulnerable to selloff, but the softening Fed expectations and robust AI-demand should keep the technology space well-funded.

In the FX

The US dollar index consolidates gains near its 200-DMA. The fundamentals and the technicals are in a comfortable place for an extension of the recent rebound. The EUR/USD is rangebound between its 50 and 200-DMAs, near the limit of the major 38.2% retracement on October to January rally, which should distinguish between the continuation of the positive trend or a medium term bearish reversal. I think that the latter is more likely.

The USD/JPY continues to extend gains above the 148 level, boosted by the latest inflation data from Japan that showed that inflation fell to a 17-month low of 2.6% in December from 2.8% printed a month earlier, and core inflation dropped to an 18-month low of 2.3%. The tertiary activity industry index unexpectedly dropped in November, as well. Weak economic data, combined with the earthquake at the wake of New Year encourages investors to trim their bets for Bank of Japan (BoJ) normalization and pushes the USD/JPY higher, along with a broad-based USD strength. The BoJ meets next week and will certainly push back on the normalization bets. Yet at the current levels, the USD/JPY is subject to verbal intervention from the BoJ to cool down the selling pressure. Therefore, buying the USD/JPY at the current levels is risky.

To stay updated on all economic events of today, please check out our Economic calendar

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SAXO

Forex

Economic

Central Bank

Understanding the Bank of Japan toolkit

The BOJ currently has a range of policy tools, mainly:

Policy rate, or the overnight rate – This is the short-term interest that is applied to the Policy-Rate Balances in current accounts held by financial institutions at the central bank and purchases of Japanese government bonds (JGBs). The BOJ has fixed the policy rate at -0.10% since January 2016, and hence this policy is also called the Negative Interest Rate Policy (NIRP).

Yield curve control (YCC) – This is the policy through which the BOJ controls short- and long-term interest rates through market operations to seek a decline in real interest rates. When the YCC is used to fix long term interest rates, it means that there is an implicit commitment from the central bank to acquire (or sell) securities in the amount necessary to keep rates in line with the target.

After short-term interest rates were cut to negative, yields across the curve plunged. So, BOJ introduced YCC to pull long-term rates back higher, and set a 0% target for 10-year bond yields. The idea was to control the shape of the yield curve to suppress short- to medium-term rates - which affect corporate borrowers - without depressing super-long yields too much and reducing returns for pension funds and life insurers.

The YCC mechanism has been tweaked three times in the last 12 months, and the ceiling for the ten-year bond rate has been raised from 0.25% to 0.5% to 1%, and subsequently, 1% became just a “reference,” and operation of the mechanism will be “nimbly conducted” around 1%. This greater tolerance for the fluctuation in the 10-year yield around the threshold reflected concerns that defending that limit too strictly could impact the ordinary functioning of the market.

Quantitative and qualitative monetary easing (QQE) – In addition to the above, the BOJ has also adopted measures such as fixed-rate purchase operations and the Funds-Supplying Operations against Pooled Collateral in order to achieve the smooth conduct of yield curve control.

After more than two decades of QE, there have been signs of a deflation exit in Japan. This prompted the BOJ to initiate a broad-perspective review of its QE programme at the first meeting under current Governor Ueda in April 2023, to be held over the next 1-1.5 years.

What supports the case for BOJ normalization?

Global monetary policy out of sync

The desynchronization between the global central bank policies that went generally on a tightening path last year and that of Japan which continued its massive easing has been a huge driver of yen weakness. Higher US yields have also exerted upward pressure on JGB yields, which in turn has forced a gradual adjustment of the BOJ's YCC policy. It can however be expected that this divergence in monetary policy stances is likely to narrow this year as the Fed and other global central banks start embark on a rate cut cycle, but with global rates unlikely to go back down to their earlier lows, some of the gap will have to still be covered by the Bank of Japan.

Return of inflation

Headline inflation in Japan has returned to be above the 2% target since April 2022. While part of this is imported inflation due to supply chain imbalances and a weak yen, authorities are still trying to understand how much of the uptick in inflation is demand-led. Wage growth still looks to be depressed, and BOJ has the 2024 spring wage negotiations (Shunto) on watch to see if they bring enough of an increase to justify policy normalization.

Considerations that could make a BOJ pivot difficult

Despite the yen and inflation focus, there are other considerations for the BOJ that necessitate that any steps towards normalization from years of massive easing are taken carefully. A rapid tightening of monetary policy could hinder economic growth, undermine financial stability, or even complicate the fiscal situation. The 7.6-magnitude earthquake in Japan on January 1 has shifted out BOJ tweak expectations from January to April.

However, there are other considerations that could make it tougher for the BOJ to normalize its monetary policy, such as:

Macro conditions turning less supportive

While headline inflation stayed at or above 3% since August 2022, the November print was down to 2.8% YoY and December printed expected to cool further to 2.5% YoY. Governor Ueda has highlighted that even though inflation is running above 2%, he lacks sufficient certainty that the inflation target is being met in a “stable and sustainable” manner. In fact, inflation has exceeded nominal wage growth, leading to a fall in real wages. Growth has also surprised on the downside for the third quarter, with the Japanese economy entering a contraction. This weakens the conviction around whether inflation is really driven by a virtuous cycle of increased real income and spending.

Wage negotiation results also remain a key watch, so timing of any BOJ move, if one was to happen, will likely have to be after the results of shunto wage negotiations are announced. BOJ credibility could be at risk if it moved in January and the wage negotiations underwhelmed in March/April. Preliminary results of shunto are likely to be available on March 15, while the final results will be available in July.

Global landscape is shifting again

As global central banks shift to neutral-to-dovish policies, any normalization move by the BOJ will still stand in contrast again. The Fed and the ECB are priced in to cut rates by about 150bps this year, while the Bank of England is priced in for 120bps of easing. Although any tightening move by the BOJ will likely remain modest, it will be in contrast to the global monetary cycle.

Financial stability concerns

Steps towards policy normalization will expose the BOJ to SVB-type risks. The central bank has warned in its recent Financial Stability Report that regional banks and shinkin financial co-operatives were exposed to interest rate risk after piling into long-term loans and securities. Given that the prolonged phase of ultra-low interest rates has driven financial institutions to shift toward longer-term loans and bonds in pursuit of higher yields, the magnitude of the valuation losses brought about by the increase in interest rates is not expected to be trivial.

After the July tweak to YCC, Japan's 97 regional banks reported unrealised losses on bonds and investment trusts totalling about 2.8 trillion yen at end-September, up 70% from the end of June, according to calculations by Nikkei. This would limit the banks' capacity to make new investments to buy higher-yielding bonds when interest rates rise, posing a threat of stagnation.

Global financial stability risks would also be under consideration, given Japanese investors are the biggest foreign holders of US government bonds and own everything from Brazilian debt to European power stations. An increase in Japan's borrowing costs threatens to amplify the swings in global bond markets. Flow reversal is already underway, with Japanese investors repatriating as local yields rose in anticipation of a BOJ pivot.

Balance sheet risks

Raising the policy rate above zero could also impose a cash-flow burden for the central bank, as it increases its interest burden for the financial institutions' reserves parked at the central bank. The Fitch said that the BOJ will face significantly higher interest expense on bank reserves and potentially large losses on its bond holdings when it raises policy rates. Weaker income would cut transfers to the government, hitting the BOJ's capital, similar to developed-market peers. This could in theory hurt its policy credibility and/or create a contingent liability for the sovereign.

Fiscal sustainability risks

The BOJ will also need to take fiscal sustainability risks into account if it was to embark on the path of policy normalization, especially given that the fiscal policy is likely to remain expansive as global economy faces recession threats with the increase in interest rates. Meanwhile, elections are due in Japan and PM Kishida's approval ratings have been slipping.

Raising the interest rate will increase the burden of the government's massive debt load. The BOJ owns more than 50% of the JGBs, and an increase in interest burden could use up the scarce fiscal space that may be needed this year. Risks of a failure to repay government debt could threaten the public confidence in government bonds and diminish the potency of the BOJ's monetary easing measures. A Reality Check on Bank of Japan’s Policy Normalization and JPY appreciation Expectations _2

A Reality Check on Bank of Japan’s Policy Normalization and JPY appreciation Expectations _2

Summing up

This long laundry list of considerations suggest that any BOJ normalization remains nuanced both in terms of timing and magnitude.

In terms of timing, it may be premature to expect a move before the wage negotiation results are out and the BOJ's policy review will be complete. This means that a tweak, if one was to happen, is unlikely in January. Both April and July meetings could be live as they come with the updated outlook. If early results of shunto suggest over 3% wage hike, then expectations could build up for a July tweak. However, if the wage increases remain subtle, then expectations could be slashed or shift forward to July. However, markets will continue to price in some expectations of a pivot, causing significant volatility in the yen and the rates market over the course of the next few months.

In terms of the magnitude, there is a case for the BOJ to not raise its rates significantly. At most, the negative interest rate policy could be scrapped, but raising rates above zero seems to remain difficult especially given the government debt burden and lack of a JGB market. This is still an important move, but not substantial to reverse the yen's carry advantage.

Is yen appreciation really possible in 2024?

As I wrote in the Q1 Quarterly Outlook, Japanese yen is a BOJ problem with a Fed solution. Given that the Fed is likely to cut rates this year and yields will go down, there is room for the policy divergence between the Fed and the BOJ to narrow even if the BOJ continued its massive easing. In fact, several automated FX trading algorithms over the past many years have remained dependent only on US yields, with Japanese yields stuck at 0%. It may be safe to assume that yen reacts more to changes in Treasury yields.

However, recent price action has once again brought rates volatility in focus, and a fragile geopolitical landscape this year could continue to fuel volatility. USD/JPY got close to testing the 140 support at the end of 2023, but has since rallied to 148+ levels as on 18 January. Dollar-yen risk reversals have also jumped to -0.98 from -1.48 at end-2023. This signals that implied volatility premium for USD/JPY puts over calls is trending lower, or that the demand in the options market is decreasing for downside protection in USD/JPY. This could mean a higher perceived risk of USD/JPY gaining than falling in the options market.

A Reality Check on Bank of Japan’s Policy Normalization and JPY appreciation Expectations _3

Overall, this suggests a bearish tactical picture for the yen but USD/JPY close to 150 could limit the upside from here. However, traders could continue to be compelled to go long if USD/JPY trades below 145 and US yields remain volatile. However, a bullish structural picture is intact given the yield dependence and valuation, but the negative carry is a hinderance. Piling into long JPY positions could become attractive closer to April meeting if wage numbers are optimistic. EUR/JPY and AUDJ/PY could be particularly interesting as EUR is likely to remain under pressure amid growth challenges in the Eurozone and RBA rate curve seems to have room for a catchup as inflation and labor market data disappoints. Until April, carry will continue to make efforts to bid the yen futile and FX options may be an easier play.

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Samantha Luan

Forex

Stocks

Commodity

Economic

Stock markets are modestly higher on Thursday, recovering some of Wednesday's losses as investors seemingly struggle to determine where things stand.

There's clearly a desperate desire to cling on to the optimism that enabled such a strong end to the year but unlike in that period, the data isn't really playing ball. The releases we've seen so far this month have been fine and in the main, perfectly in keeping with the expectations people had coming into 2024. But is that enough?

Pricing on interest rates was very aggressive at the end of 2023 and perhaps the data needed to keep overdelivering to keep the party going. There's still a sense that it could again which is why there's seemingly so much reluctance to allow markets to correct in any significant way but at some point, the data needs to justify such loyalty or investors may start to worry that central banks won't be swayed.

Promising jobs and housing data from the US

Data from the US today has been a little positive, although, in the case of jobless claims, it's hard to say at this stage how much. Initial claims unexpectedly fell below 200,000 but arguably more promising, continuing claims have continued to edge down which suggests the market for those laid off has improved slightly.

The housing data trend is also looking better than it has for some time which suggests, as interest rates start to fall, we should see a pickup in the market once again.

Markets look kindly on weaker Australian jobs data

Australian jobs data overnight was a good reminder that, as far as the economy is concerned, bad news is good news for investors. Ultimately, it's inflation that will determine whether central banks start cutting rates but not every country will manage to get inflation to target while the economy performs well, as it looks like the US is on course to do.

As a result, weaker labor market figures and general economic performance is being well received at the moment in the hope that it convinces policymakers that they have succeeded in cooling demand and will achieve their goal of price stability. The Aussie dollar declines suggested the jobs data succeeded a little in that.

Oil could continue to consolidate despite choppiness

Oil prices are continuing to consolidate, with Brent still very choppy between $75 and $80. There are various upside and downside risks for the oil price, the upside currently being very prominent given events in the Middle East but as things stand, there's little signal of a significant shift in prices either way. It will happen eventually but there may be more consolidation ahead in the near term, barring a significant catalyst one way or another.

Gold nears $2,000 as traders pare back rate expectations

Gold has drifted lower over the last couple of days before running into some support around $2,000. Traders have slightly pared back expectations for rate cuts this year compared with the end of 2023 which has weighed on the yellow metal and could continue to do so if the data doesn't perform. A move below $2,000 could be a significant psychological blow but as things stand, the trend and momentum aren't looking particularly favorable.

Bitcoin optimism cools after ETF decision

Bitcoin has fallen quite a lot over the last week but continues to trade above $42,000, a level it's repeatedly tested in recent days. Optimism has naturally cooled a little since the ETF approvals as traders look to what's next that will be the catalyst for a rally higher. The halving in April is the obvious event that springs to mind, albeit with no guarantee for the price, but in the short term, the environment more broadly may have a bigger role to play.

Source: MarketPulse

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Westpac

Economic

Central Bank

Australia has been later to the inflation surge and disinflation than peer economies. So the RBA will be later than its peers to cut rates, too. Central banks can move policy according to domestic needs rather than be led by the Fed. Exchange rates are likely to respond.

The world is entering 2024 with global inflation declining, but still high. Goods price inflation has retreated as pandemic-related disruptions to supply chains have resolved. Services inflation is still high in many economies but it, too, is decelerating as domestic economies and especially labour markets soften. This means that, in most cases, a near-term rebound in domestic inflation is not a material concern.

Markets are looking ahead to the point that central banks can start cutting interest rates from current contractionary policy stances. This is likely to happen once they are confident inflation will return to target soon. They do not have to wait until inflation actually reaches the target. This is an implication of the lagged effects of monetary policy: central banks need to be forward-looking, reacting to shifts in the outlook and the risks around that outlook, and not necessarily to the latest data surprise.

Several major central banks have started communicating publicly about the timing of future rate cuts. In some cases, including the Federal Reserve and the ECB, this has been to hose down market expectations that these policymakers consider overly enthusiastic. Nonetheless, these policymakers are acknowledging that rate cuts are coming within the year.

Australia has been later to the inflation surge and disinflation than peer economies. We were later to open up after the pandemic, and for institutional reasons, some of the other supply shocks have had a more drawn-out effect here as well. For example, while Russia invaded Ukraine in February 2022, it was July 2023 before Australian households started seeing the effects of higher energy prices in their electricity bills. The extraordinary surge in labour supply here has both delayed and dampened the upswing in wages growth; our wage bargaining institutions have played a role here as well.

As a result, the RBA will be later than its peers to cut rates, too. We currently expect that the RBA will reach that point around its September meeting. This is noticeably later than market pricing for the Fed or the ECB.

We are often asked whether the RBA (or the central bank of any other small open economy) can operate on such different timing. The answer is that they can. When the exchange rate floats, monetary policy can move quite independently in response to domestic needs. Global factors will have a common influence on the actions of all monetary policymakers, as we saw during the pandemic. But as long as the exchange rate floats, central banks can respond to the domestic implications of that common factor, not to the responses of their larger counterparts.

An examination of recent history makes this clear. Central banks do move their policy rates on different timetables. For example, in early 2008 and in the mid 2010s, the RBA and the Federal Reserve were moving in opposite directions. The domestic situations differed and so did the monetary policy response.

The floating exchange rate regime makes this possible because the exchange rate then adjusts to absorb the shifts in investment flows attracted by changing relative yields. Yes, higher rates relative to the major economies attract capital flows, but they also push the exchange rate up. This makes the trade more expensive, and so less attractive. So there are limits to the speculative capital flows that will be induced by the interest differential, if that is the kind of thing that worries you.

That exchange rate adjustment is in fact part of the transmission mechanism of monetary policy and works to support what the central bank is trying to achieve. If the rate differential increases (or in the near term for Australia, becomes less negative than before), and the exchange rate appreciates, that tends to put downward pressure on the domestic prices of internationally traded goods and services. This includes domestically produced tradable items, which must compete with foreign producers. The result is lower inflation, at least for a time.

There are situations when this adjustment is uncomfortable. But this is more of an issue for emerging markets, where sudden shifts in capital flows can cause market disruption. Countries with dominant trading relationships with another economy might be reluctant to see too much appreciation against its currency, because of the impact on exporting businesses. That isn't the situation for Australia in relation to the United States.

We therefore do not see any barriers to the RBA operating on its own timetable, driven by its own view of the domestic inflation outlook, different from that in the United States. This timing difference also underpins our view that the Australian dollar will appreciate over 2024, especially against the US dollar.

Of course, if everyone expects central banks to act as we expect, that will already be priced into exchange rates and there is no further impetus for them to move. When we talk about year-end expectations for an exchange rate, though, it's a more subtle story of the balance of risks and where markets are more likely to be surprised relative to current pricing. Once the US Fed starts to move, that source of uncertainty is removed – and shifts in beliefs about RBA timing will be the remaining source of pricing action from interest differentials.

There are many risks around this central view, including geopolitical events and the headwinds to growth in China. Short-term movements in exchange rates can be driven by risk sentiment. In Australia's case, the outlook for key commodity prices also tends to shape the outlook for the exchange rate. The outlook for both interest and exchange rates will always evolve with events.

The important thing to remember is that the rates outlook in each economy depends on the economic outlook in that economy. Central banks don't have to follow the Fed mechanically. They can work to the beat of their own drum.

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Winkelmann

Central Bank

Economic

Nearly half a year has passed since the Fed's last rate hike in July 2023. According to historical practice, most of the first interest rate cuts after previous interest rate hike cycles are about to happen half a year after the end of the rate hike. However, this time is markedly different, as no one in the Fed, or even the global financial markets, will expect a rate cut in February, and the earliest rate cut will be in March, or even later.

Central bankers dampen expectations of interest rate cuts

Back in November last year, aggressive interest rate cut expectations began to flood the market. The most important discussion right now is not whether central banks will cut rates, but when and how quickly it will be. This was reflected earlier in the bond market. A race to buy the bottom followed the end of an unprecedented sell-off in US Treasuries that lasted almost a year. The corresponding Treasury yields then peaked and fell. Also, the dollar has weakened sharply. Therefore, a rate cut seems to be imminent and a certainty.

The Fed Will Cut Rates in March? Don't Be Too Optimistic_1

However, the Fed and its global peers have recently poured cold water on the hot rate cut trading, making the market to calm down and reflect on whether it was overly optimistic. Investors had almost certainly expected the Fed to launch a round of easing in March, cutting rates by more than 150 bps for the year. But now it seems that this possibility is decreasing, and even the dollar index is firmly above the 100 mark and has repeatedly rebounded.

The Fed Will Cut Rates in March? Don't Be Too Optimistic_2

Christopher Waller, a Fed Governor, delivered a very hawkish speech recently, saying that the US is "close" to the Fed's inflation target of 2%. But until it becomes clear that lower inflation will continue, the Fed is not in a hurry to cut its benchmark rate. Waller also said that whenever interest rate cuts begin, they should be done "methodically and carefully," rather than in the way that the Fed has done sharply and quickly as it has done when trying to save the economy from a shock or an impending recession.

Christine Lagarde, the ECB President, said at the Davos forum that while the central bank may cut interest rates in the summer, market expectations for more aggressive easing could backfire. In the UK, investors are undergoing similar repricing, and the unexpected acceleration in inflation caused UK bonds to fall.

Overall, in the context of gradual economic normalization, it is difficult for central banks to adopt an aggressive easing policy similar to the one at the time of the pandemic. The cautious approach adopted by central bankers is based on several factors, including employment and the relative resilience of the economy, as well as fears that price growth will become more persistent and stay above target. As in the early days of tightening policy to fight inflation, many central bankers should still be reeling. At first, they generally expected that the rebound in inflation would be temporary. However, they had to admit that they misjudged the situation then.

Inflation reduction continues unevenly

Since last year, the core logic of trading rate cuts has been around the end of the Fed's rate hikes and the expectation of rate cuts. It was also affected directly by the slowing inflation and a cooling job market.

A series of data shows that the Fed's anti-inflation mission is working, and the possibility of a soft landing for the economy still exists. The job market, while also slowing down, is still broadly unchanged from its pre-pandemic level.

The Fed Will Cut Rates in March? Don't Be Too Optimistic_3

However, while the market is confident in the Fed's pivot, the December non-farm payrolls report and inflation data appear to be deliberately catering to the constant warnings of officials, making interest rate cut expectations quickly taper.

Data from the U.S. Department of Labor showed that the consumer price index (CPI) unexpectedly rose more than expected in December and was well above 3%, especially with services inflation remaining high. By December 2023, the US CPI core services excluding housing rents remained high at 5.7%, which reminds people that the battle against inflation has not yet been won. In addition, since the second half of 2023, the sudden change in the Middle East situation and the recent conflict in the Red Sea have caused some shocks to the global supply chain in the short term, increasing the risk of higher inflation again.

As for the job market, the extent to which the market has cooled has not been optimistic. By December 2023, the U.S. unemployment rate remains low at 3.7%. The increase in non-farm payrolls in December also exceeded expectations and wage growth has been bothering the Fed, so it has to actively pay attention to the relationship between wages and prices.

The good news is that the MoM producer price index (PPI) fell in December, rising by only 1% YoY. The PPI has some advantages in predicting the path of inflation, especially in the current situation. It tends to be a better leading indicator of how the prices of various commodities change at different stages of production. In addition, it does not measure the cost of housing, which is important because the Fed has recently focused specifically on service inflation, which strips out housing costs. The non-farm payroll data for the job market have been revised downward in recent releases, which is likely to be no exception in December. The cooling of the job market is just slow.

The tug-of-war between interest rate cut expectations

Central banks such as the Fed and the market generally share the same view on rate cuts. A rate cut is a certainty, but the timing is up for debate. Fed officials don't want to see the aggressive easing expectations materialize, which will is not conducive to fighting inflation.

Ahead of the March Fed meeting, rate cut expectations may remain a tug-of-war. Both the market and the Fed need more data to consider it, and they need to see a steady slowdown in inflation and the job market, rather than an unexpected rebound and uncertainties.

To stay updated on all economic events of today, please check out our Economic calendar

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Wall Street ended the day higher with much credits to strength in big tech stocks, as the Nasdaq 100 index pushed to yet another new record high. A positive guidance from the Taiwan Semiconductor Manufacturing Company Limited (TSMC) on artificial intelligence (AI) demand outlook set the stage for a stellar bounce in semiconductors, while Apple defended its key 200-day moving average (MA) to jump 3.3% overnight - its best day since May 2023.

Further Federal Reserve (Fed) rate guidance saw Atlanta Fed Raphael Bostic saying that he expects rate cuts to take place only in the third quarter of this year, but him pulling forward his timeline from the initial fourth quarter expected came with a shade of dovishness that was very much cheered. US two-year Treasury yields were broadly flat, while the 10-year yields edged slightly higher by 4 basis point (bp). The US dollar continues to hang just below its 200-day MA, proving the trendline as a key immediate resistance to overcome.

Ahead, the US consumer sentiment data will be on watch, with expectations for a more stable read (70 versus previous 69.7) from December – resilient but not too overblown. A brief look at the Russell 2000 revealed the index retracing back to a 38.2% Fibonacci retracement at around the 1,900 level. Buyers may seek to defend this level, with any failure for the level to hold potentially leaving the 1,860 level on watch, where the next support confluence stands with the lower edge of its daily Ichimoku cloud, alongside its 200-day MA. Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience_1

Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience_1

Asia Open

Asian stocks look set for a positive open, with Nikkei +1.35%, ASX +0.87% and KOSPI +1.05% at the time of writing, as the bounce in big tech overnight paves the way for risk-on sentiments to reignite. The Nikkei continues to hover around its multi-decade high, flirting with the key 36,000 level in today's session which will serve as immediate resistance to reclaim. The Hang Seng Index (HSI) may attempt to stabilise after its 6% sell-off this week, but broad sentiments may remain subdued.

This morning's economic calendar saw further easing in Japan's December inflation to its lowest level since June 2022, which gives the Bank of Japan (BoJ) room to exercise more patience and to stand pat on policies at the upcoming meeting. The positive wage-inflation and sustainable 2% inflation conditions for a BoJ policy pivot are still largely on the lookout. The BoJ Governor Kazuo Ueda did acknowledge last month that prices and wages appeared to be moving in the right direction, but he mentioned that conditions remained uncertain, seemingly calling for more time to assess that the pricing and wage trend will stick.

Widening US-Japan bond yield differentials have driven a recovery in the USD/JPY lately, with the pair reversing back above its Ichimoku cloud on the daily chart while its daily relative strength index (RSI) reclaimed its 50 level for the first time since November 2023. Further upmove could leave the 150.00 level of resistance on watch, where the BoJ has intervened in October 2022 with aggressive yen-buying. On the downside, the 146.50 level may serve as immediate support to hold, where the upper edge of the cloud stands. Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience_2

Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience_2

On the watchlist: GBP/JPY looking for a retest of its November 2023 high

The GBP/JPY has managed to find support off the 179.20 level lately, where a 23.6% Fibonacci retracement stands from its September 2022 bottom to November 2023 top. A reaffirmation for a high-for-longer rate outlook from the Bank of England (BoE), along with broad expectations for further dovish hold from the BoJ, has kept the pair on its upward trend on higher lows, with the pair seemingly setting its sight to retest the 188.73 level – its previous eight-year high. Any break to a new multi-year high may leave the 195.30 level on watch next, with its weekly RSI still defending the key 50 level for now. Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience_3

Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience_3

To stay updated on all economic events of today, please check out our Economic calendar

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The Beats of Their Own Drums

The Fed Will Cut Rates in March? Don't Be Too Optimistic

Central bankers dampen expectations of interest rate cuts

Inflation reduction continues unevenly

The tug-of-war between interest rate cut expectations

Bounce in Big Tech Lifts Sentiments, Japan’s Inflation Provides BoJ Room for Patience

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