USD upside potential as growth outperforms

USD: Strong GDP growth but FX market moves muted by deflator

The Q4 real GDP report was a mixed bag from a rates and FX perspective with the rates market ultimately giving more focus to the weak deflator rather than the strong GDP growth print. The 3.3% Q/Q SAAR gain was well above the 2.0% consensus with inventories and net trade providing a larger lift to overall GDP growth than was expected. The consumer spending component was only marginally stronger than expected (2.8% vs 2.5%) but the strong end to the year must surely place further doubt on the scope for the Fed to commence its easing cycle by March.

But March still remains feasible primarily due to the very favourable inflation data within the GDP report. The 2-year UST note yield fell 9bps with the probability of a March cut drifting a little higher due to the headline deflator falling from 3.3% in Q3 to 1.5% in Q4 – the weakest reading excluding the initial covid hit since Q4 2019. The core PCE deflator was in line with the consensus but remained at the 2.0% target for the second consecutive quarter – further evidence that the Fed has already or is very close to achieving its goal of price stability.  

Hence, market participants are still left to deliberate the potential for the Fed to cut rates based on falling inflation but without that favourable inflation backdrop coinciding with any clear evidence of a downturn in economic activity. At some point the answer to that question must be that they would cut indeed on the evidence of inflation returning to the price stability goal but whether that would be required by March remains questionable. There remains two labour market reports prior to the March meeting and certainly if those reveal a further weakening of the jobs market and slower wage growth the argument for a cut in March will be strong.

As we have highlighted to clients in our G10 FX 2024 Outlook (here) falling inflation this year is going to result in a considerable tightening of monetary policy when measured in real policy terms. Even with rate cuts being delivered as priced in the OIS market, real policy rates will be higher across much of G10. For the Fed that is less the case given the real fed funds rate is already the highest across G10 but keeping rates higher for longer would leave policy very restrictive. Based on the quarterly GDP core deflator, the real fed funds rate stands at 3.4%. The long-term average for the real fed funds is around 1.0%.

We now go into next week’s FOMC meeting on the back of a much stronger GDP print but still compelling evidence of disinflation. The tone from Powell is likely to remain cautious on near-term rate cuts being delivered but just like with the ECB yesterday (here), a more favourable tone on inflation could be enough to keep alive expectations of a cut in March. The near-term US dollar bias remains to the upside though and we look set to test and breach the year-to-date high in DXY recorded on Tuesday at 103.82.

US CORE PCE DEFLATOR BACK AT 2.0% AND SLIGHTLY BELOW THE AVERAGE SINCE 1990 (2.1%)

Source: Macrobond & Bloomberg

JPY: BoJ minutes contrast with weak inflation

The yen is roughly unchanged today reflecting the broader limited moves in the FX markets today but there may be a slight bias for yen weakness although the range so far today in USD/JPY is just 30 pips. The yen did weaken modestly in response to the weaker than expected inflation data from Tokyo but this then reversed after the minutes from the BoJ meeting in December were released. There was a surprisingly large drop in the Tokyo inflation data with the headline YoY rate falling from 2.4% in December to 1.6% in January. The core-core rate fell from 3.5% to 3.1%. The declines were 0.4ppt and 0.3ppt more than expected and could raise doubts over the BoJ’s potential plans to hike the key policy rate in April. Still, the base effects should be more supportive for inflation remaining higher over the coming months given the gas and electricity subsidies were introduced in Q1 2023 which helped depress inflation.

The BoJ minutes were certainly consistent with the continued gradual process toward the point of raising the key policy rate. The reference to it being important to “deepen discussions on issues such as the timing of the exit from the current monetary policy and the appropriate pace of raising policy interest rates thereafter” highlighted a clear intent to get to the point in which rates can be raised, and possibly raised in the context of further increases ahead.

There was also a reference from “some members” on it not being too late to make a rate decision after the spring wage negotiation round. That would certainly imply later but could still include April. By then the information on the ‘shunto’ wage round for larger companies will be known but the overall national figure including SMEs will not be formally published. The BoJ though should be in a position to know a lot more through BoJ branch contacts across the country.

Given our near-term bias for the US dollar to strengthen and given the larger than expected drop in the inflation data, we may in turn see some increased appetite for yen funded carry positions that helps fuel a further rise in USD/JPY. April seems too far ahead to discourage yen selling although the threat of intervention will slowly increase if spot continues to drift higher to the 150-level.

G10/JPY VS G10-JAPAN EQUALLY-WEIGHTED RATE SPREAD

Source: Macrobond & Bloomberg

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
EC	09:00	M3 Money Supply (YoY)	Dec	-0.7%	-0.9%	!
EC	09:00	Loans to Non-Financial Corporations	Dec	--	0.0%	!!
EC	09:00	Private Sector Loans (YoY)	--	0.6%	0.5%	!
US	13:30	Core PCE Price Index (YoY)	Dec	3.0%	3.2%	!!!
US	13:30	Core PCE Price Index (MoM)	Dec	0.2%	0.1%	!!!
US	13:30	PCE price index (MoM)	Dec	0.2%	-0.1%	!!
US	13:30	PCE Price index (YoY)	Dec	2.6%	2.6%	!!
US	13:30	Personal Income (MoM)	Dec	0.3%	0.4%	!
US	13:30	Personal Spending (MoM)	Dec	0.4%	0.2%	!!
US	13:30	Real Personal Consumption (MoM)	Dec	--	0.3%	!
CA	13:30	Wholesale Sales (MoM)	--	--	0.9%	!!
US	14:00	Dallas Fed PCE	Dec	--	1.50%	!
US	15:00	Pending Home Sales (MoM)	Dec	1.5%	0.0%	!!

 

Source: Bloomberg