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The USD attempted to push higher overnight amidst continued "risk off" sentiment, but it stumbled a bit during the early European session. Equity markets are still in the red due to softer-than-expected China activity data, higher-than-expected UK inflation that might delay rate cuts, and warnings from the ECB about excessive easing expectations. Interestingly, it appears that, at least for this morning, the EUR and GBP are finding support from local hawkish re-pricing rather than the prevailing "risk off" mood. Nevertheless, there is always room for unexpected policy observations. With equities remaining uneasy, I don't expect the USD to retreat significantly.
GBP-USD managed to recover earlier losses after UK inflation exceeded expectations. UK CPI rose by 4.0% YoY in December, surpassing the consensus of 3.8%. Core inflation increased by 5.1% YoY, exceeding the consensus of 4.9%, and services inflation rose by 6.4% YoY, beating the consensus of 6.1%. Following the data release, the GBP-USD experienced a knee-jerk reaction. The unclear trend in inflation data for the last two months of 2023 is keeping markets uncertain. Swap markets, previously fully priced for a May rate cut, have now adjusted expectations to below 70%. The CPI data, combined with yesterday's mixed jobs report, presents a challenging picture for the BoE, which may need to maintain tight monetary policy for a longer duration, thereby increasing the growth challenge for the UK. Currently, the GBP is benefiting from the prospect of fewer rate cuts rather than weakening due to the rising threat to activity, but UK equity markets are sharply lower.
As for USD-JPY, it continued its upward trajectory overnight, extending its strong start to the year with a 4.5% rise year-to-date. This sharp increase contrasts with the change in US-Japan yield differentials over the same period. CFTC data suggests a 60% reduction in short JPY positions from mid-November to levels last seen in April 2023. Besides spot losses and negative carry, some of these positions may be abandoned due to low conviction ahead of the upcoming BoJ policy meeting on January 23. Market expectations for a policy shift have been pushed further into 2024. The widening of tax exemption benefits in the NISA program, effective January 1, may have encouraged retail investors to allocate cash into local and foreign stocks, contributing to the rise in USD-JPY. The base case remains a modest JPY recovery this year, contingent on factors such as a Fed rate cut, BoJ removing NIRP/YCC, and Japanese lifers adjusting FX hedge ratios.
After a challenging start to the year, I noticed that EUR-USD stabilized overnight as the market finally paid attention to ECB rhetoric. ECB President Lagarde's comment about a likely rate cut by or in the summer caught Bloomberg's attention, but her more significant observation was that the market's overly optimistic expectation for rate cuts is unhelpful. Other ECB speakers, including Villeroy, Valse, Knot, and Muller, provided their pushback within the last 24 hours. Like GBP, the FX market is grappling with how to respond when rates markets phase out rate cuts. Enhanced carry suggests EUR upside, but this needs to be balanced against Eurozone activity headwinds and the resulting "risk off" sentiment that a prolonged high monetary policy might bring. The market is currently 90% priced for an April ECB cut, totalling 140bp during 2024.
Both AUD and NZD saw declines against the USD in overnight sessions following disappointing China data. While China's economy expanded by 5.2% YoY in 2023, December retail sales fell short of market expectations, and home prices experienced the most significant drop in close to nine years. Despite arguments that the recent sell-off in AUD and NZD may appear excessive, I believe otherwise given their sensitivity to global equities and US 10Y real yields. Short-term metrics suggest a fair value range of 0.6290-0.6667 for AUD-USD and 0.6017-0.6263 for NZD-USD. Additionally, USD positioning against the AUD and NZD, as per IMM data, has swiftly shifted from net long in mid-November 2023 to net short in the most recent edition – the fastest flip from net long to net short USD speculative positions since 2017. This explains the rapid rebound of the USD. Fundamentally, I maintain a bearish stance on AUD-USD and NZD-USD in the near term, considering their significant deviation from the relationship with Chinese equities and USD-RMB. Furthermore, if expectations for Fed easing diminish, it will exert downward pressure on these currencies from both a risk sentiment and relative yield perspective.
The CHF weakened against both the EUR and USD this morning following dovish comments from SNB President Jordan. In an interview with Bloomberg TV, he emphasized that the CHF's strength in real terms, not just nominal terms, impacts the inflation outlook. He referred to the CHF's strength in the last two weeks of 2023 when EUR-CHF dropped from 0.9550 to around 0.9250, stating that "we saw real appreciation. That makes the situation for some of our firms more difficult." Although the market has toyed with the idea of a shift in the SNB's attitude towards the CHF this year, I would hesitate to chase the trend of CHF weakness too far. While the SNB may not be compelled to strengthen the CHF, it doesn't necessarily mean they'll tolerate significant CHF weakness. Swiss core and headline inflation are back below target, partly due to CHF strength throughout 2023. Policymakers are unlikely to want to relinquish this success to the FX market.
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