European rate surge continues

Overview:  The capital markets are calmer today, but the re-pricing of interest rates continues. The German 2-year yield is rising for the tenth consecutive session. The yield is minus 23 bp. It was at minus 65 bp when the sell-off began. Japan's 10-year yield reached its highest level since 2016 and no response from the BOJ as the yield approaches the cap of the yield-curve control policy. Equities are mixed. China's market re-opened with solid gains; Hong Kong and Taiwan markets also rose. Japan, South Korea, Australia, and India moved lower, among the regional markets. Europe's Stoxx 600, which lost 3% in the past two sessions is slipping after opening higher.US futures are slightly softer. The US 10-year yield is hovering around 1.90%. Italy's 10-year yield is up nearly 13 bp, and Greece's benchmark yield has risen twice as much. Core yields are 3-5 bp firmer. The greenback is mixed. Among the majors, the Australian and Canadian dollars, alongside the yen are posting small gains. The euro, sterling and Norwegian krona are off 0.25-0.50% lower. Most emerging market currencies are weaker  The Russian rouble is the chief exception. It snapped a five-week drop with a nearly 2.7% rise last week. With today's gains its year-to-date loss is pared to about 1.1%.  The JP Morgan Emerging Market Currency Index is slightly softer after rising about 0.75% last week, the fourth weekly gain in the first five weeks of the year. Turning to commodities, gold tested a seven-day high around $1815. Crude is around $2 off last week's high, which culminated in a seven-week rally. After pushing to almost $93.20 last week, March WTI slipped below $91 today. Natural gas in Europe and the US is under pressure. Iron ore eased 0.7% last week, but rose in the last four sessions, and advanced 2.4% today and is at new six-month highs. Copper is paring last week's 4% gain.  

Asia Pacific

China's markets re-opened today after last week's holiday. There were three notable developments. First, the Caixin January service PMI fell to 51.4 from 53.1, which was not quite as weak as expected. Recall that the Caixin manufacturing PMI had fallen to 49.1 from 50.9. The net result is that the composite fell to 50.1, just above the 50 boom/bust level. Second, China's reserves fell for the first time in four months to stand at $3.221 trillion. Even though the other major reserves currencies and bonds fell, economists surveyed by Bloomberg expected a small increase. The $28.5 bln decline can be accounted for by valuation adjustments, it appears. Third, the PBOC set the dollar's reference rate at CNY6.3580. The median projection (Bloomberg survey) was CNY6.3328.  The big miss likely reflects 1) the difficulty the market had in its assessment after the long holiday and 2) the PBOC making its desires known. 

The rise in Japan's leading economic indicator in December to 104.3 was higher than expected but seems dated. Japan reintroduced quasi-emergency protocols late last month and have a cooling off effect on the economy. Last week, the Markit January composite PMI fell slipped below 50 for the first time since last September. Meanwhile, progress has been reported that will soon allow the US steel tariffs to be partly lifted, while the aluminum tariffs look likely to remain in place. 

The dollar is trading quietly within the pre-weekend range against the Japanese yen (~JPY114.80-JPY115.45). The market appears to be finding support around JPY115.00 near midday in Europe. A $570 mln option at JPY115.00 expires today. The trendline drawn off last month's highs comes in today around JPY115.50. Australia's Q4 real retail sales were stronger than anticipated and this appears to have helped the Australian dollar stabilize after falling nearly 1% before the weekend that snapped a four-day advance. The Aussie is straddling the $0.7100 level, where a A$730 mln option expires tomorrow. Last week's high was near $0.7180 and a move above there lifts the technical tone. We noted the much stronger dollar fix today in China, but the greenback was confined to the pre-holiday range (~CNY6.3545-CNY6.3615). Many participants are expected more stimulus measures to support the economy, while its lockdown Covid policy is working in the opposite direction, it would seem.

Europe

Given dramatic reaction to last week's ECB meeting and Lagarde's reluctance to pledge no hikes this year, the focus remains on the ECB. Lagarde speaks later today. A leading hawk (Dutch central bank Governor Knot) spoke over the weekend in favor of an early end to bond purchases and a hike in Q4 followed by another in early 2023.  Finland's Rehn, a dove, suggested a hike "by 2023", Latvia's Kazaks pushed against a July hike, but seemed think an early end to QE is possible.  

Investors already know that the German economy contracted in Q4 22. This should take away the sting from today's industrial output figures. Industrial production fell by 0.3% while the median forecast in Bloomberg survey called for a 0.5% increase. The November series was revised to show a 0.3% gain rather than a 0.2% decline. It is a quiet week for eurozone data, though and today's small gain in the Sentix investor survey (to 16.6 from 14.9) is it. Still, later in the week the European Commission updates its economic forecasts. 

It is a bigger week for the UK, where highlight is Q4 GDP and the December details. Politics threatens to overshadow the data. Prime Minister Johnson is re-staffing after last week's flurry of resignation. Reports suggest that 35-40 Tory members of parliament have signed letters of no confidence, while 54 are needed trigger a vote.  Some ministers, including the Sunak and Javid are seen offering lukewarm support. 

According to Bloomberg, the euro made a marginal new high (1/100 of a cent) before the weekend but has come back offered today. It has held above pre-weekend low (slightly above $1.1410) in the European morning. A break of $1.1400 could push more momentum traders to the sidelines.There are options for about 960 mln euros that expire there tomorrow. The US two-year premium was a little above 181 bp on January 27. Today it is near 153 bp. Sterling is trading heavily in the European morning and is testing the $1.3500, where a GBP410 mln option expires tomorrow. A convincing break see sterling test the $1.3450-$1.3460 area. The upside many be capped near $1.3560, where a GBP1.04 bln option also expires tomorrow.

America

The implied yield of the December Fed Funds futures contract jumped 13.5 bp to 2.37% after the stronger than expected jobs growth. The perceived odds of a 50 bp hike next month doubled to a little more than 40%. Many accept that the data were flattered by the new seasonal adjustment factor and revised population estimate. It does not jive with other reading of the labor market. The increase of 151k leisure and hospitality jobs seems at odds with other signs of the cooling effect from the virus. Still, the 709k upward revision in November and December goes a long way recasting the sluggish job growth in late 2021. In fact, the Q4 average now sits at 611k, the third consecutive quarterly acceleration. 

Last week, several Fed officials, including St.Louis Fed's Bullard, the leading hawk, argued against the need for a 50 bp move. Many do not appear to expect officials to push against market expectations, but the next FOMC meeting is not until mid-March. There will be another employment report. The dramatic flattening of the yield curve is also a key issue for market participants and official remarks will be closely monitored. Even if one recognizes that the yield curve is often not driven by only one factor, and that the curve's predictive vs.contemporaneous value is debatable, the flattening is a yellow flag. The 2-10-year curve peaked near 160 bp at the end of Q1 21. It hovers now around 60 bp, the flattest since Q4 20. Meanwhile, the 10-year breakeven (difference between the yield of the inflation protected security and the convention 10-year note) peaked in the middle of last November near 272 bp and is now slightly above 240 bp.  

A flattening curve and a falling breakeven is what one would expect with a credible central bank policy. However, much further in these directions and a stronger case of a policy error could be made. Many pundits have focused on the Fed being arguably behind the inflation curve. But the more serious risk may be that to overcome the pundits' criticism, it impales itself on the other horn of the policy dilemma. Aggressive rate hikes in combination of tightening fiscal policy and the energy shock (experienced by households like a tax) act as a brake on the economy.

Given the state of emergency declared in the Ottawa following the protest over the vaccine mandate over the weekend the Canadian dollar is faring fine. Prime Minister Trudeau heads up a minority government and polls show he is being blamed for the rising inflation. Canada's economic schedule is light this week with the main feature being tomorrow's December trade report. Mexico reports January CPI figures on Wednesday, the day before the central bank meets. Most economists in Bloomberg's survey look for the new central bank governor to start with a 50 bp rate hike (which would bring the overnight rate to 6%).  The economy contracted slightly in Q3 and Q4 22. Still a 25 bp hike could disappoint, leading to pressure on the peso. Brazil reports January IPCA inflation figures Wednesday and December retail sales the following day. 

The US dollar has chopped in a CAD1.2650-CAD1.2800 range in recent days.  After rising a little more than 0.6% ahead of the weekend, matching its largest rise since January 4, it is a bit softer today near CAD1.2730 near midday in Europe. It looks likely to remain rangebound today. The broad risk environment seems more important than crude oil prices. The greenback rose by around the same amount against the Mexican peso before the weekend and is also a little softer now. It is consolidating in a narrow range around last week's close (~MXN20.68). Consolidation in the MXN20.50-MXN20.80 range seems the most likely near-term scenario. The dollar rose against the Brazilian real ahead of the weekend as well. It settled near BRL5.3260. A move above BRL5.3650 may confirm a low is in place.