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Monthly Foreign Exchange Outlook

DEREK HALPENNY
Head of Research, Global Markets EMEA and International Securities

Global Markets Research
Global Markets Division for EMEA
E: derek.halpenny@uk.mufg.jp

LEE HARDMAN
Senior Currency Analyst

Global Markets Research
Global Markets Division for EMEA
E: lee.hardman@uk.mufg.jp

LIN LI
Head of Global Markets Research Asia

Global Markets Research
Global Markets Division for Asia
E: lin_li@hk.mufg.jp

MICHAEL WAN
Senior Currency Analyst

Global Markets Research
Global Markets Division for Asia
E: ｍichael_wan@sg.mufg.jp

LLOYD CHAN
Senior Currency Analyst

Global Markets Research
Global Markets Division for Asia
E: lloyd_chan@sg.mufg.jp

EHSAN KHOMAN
Head of Commodities, ESG and Emerging Markets Research – EMEA

DIFC Branch – Dubai
E: ehsan.khoman@ae.mufg.jp

CARLOS PEDROSO
Chief Economist

Banco MUFG Brasil S.A.
E: cpedroso@br.mufg.jp

MAURICIO NAKAHODO
Senior Economist

Banco MUFG Brasil S.A.
E: mnakahodo@br.mufg.jp

_{MUFG Bank, Ltd.
A member of MUFG, a global financial group}

March 2024

KEY EVENTS IN THE MONTH AHEAD

1) CAN FED EVENTS SPARK FX VOLATILITY?

The level of FX volatility hit multi-year lows with our G10 FX Volatility Index (3mth implied) dropping below one standard deviation from the long-term average and to a level not seen since January 2022 – the entire spike in volatility related to the global inflation shock has now fully reversed. EUR/GBP 3mth implied volatility dropped to 4%, the lowest since before the Global Financial Crisis. So the question for the month ahead is – what can trigger an upturn in extremely low levels of volatility? Every G10 central bank will meet in March apart from the RBNZ so there is certainly a greater prospect of some upturn in volatility. The key event of course will the FOMC meeting on 20th March when the policy rate will be left on hold but the focus will be on the guidance and whether the dots profile changes from the three 25bp rate cuts signalled in December. We think the dots will remain unchanged, similar to current market pricing. Ahead of the meeting, Fed Chair Powell will deliver his semi-annual testimony to Congress on 6th March and will be key for shaping expectations going into the FOMC meeting. Most central banks will keep policy rates unchanged but the SNB is where pricing indicates the greatest probability of a cut after much weaker than expected inflation data in February.

2) BOJ TO FINALLY ACT?

The other central bank that could act is the BoJ – the other way of course with expectations building that the BoJ has enough confidence in inflation becoming sustainable to lift its key policy rate from the current -0.10%. We have brought forward our forecast for the first hike from April to March but lowered the size of that first rate hike from 20bps to 10bps. The uncollateralised overnight call rate has been drifting higher and is trading just below zero and hence a 10bp hike would be enough to move away from both NIRP and ZIRP. We acknowledge it remains a very close call between March and April but the majority of comments from Governor Ueda and other BoJ officials suggest to us that a level of confidence on sustainable wage and inflation growth has reached a high enough level to prompt action. The prior GDP contractions and the recent declines in inflation do not undermine that belief in our view. Japan’s working age population is shrinking (1mn in 5yrs) for the first time on a sustained basis and will mark an important turning point for wage growth in Japan.

3) CHINA’S ANNUAL TWO SESSIONS AND NATIONAL PEOPLE’S CONGRESS (NPC) MEETING

China’s “Two Sessions” will commence on 5th March. The Government Work Report will give out the GDP growth target and the fiscal deficit budget, and potentially more policies on the property market, LGFV debt, attracting investment, demand-side stimulus to boost consumption, and etc. The degree of policy intensity signalled by the NPC work report is key to watch. We expect a similar “around 5%” GDP target and a modestly larger fiscal deficit. “Big-bang” stimulus is unlikely given the focus on high-quality development.

Forecast rates against the US dollar - End-Q1 to End-Q4 2024

Notes: All FX rates are expressed as units of currency per US dollar bar EUR, GBP, AUD and NZD which are expressed as dollars per unit of currency. Data source spot close; Bloomberg closing rate as of 4:30pm London time, except VND which is local onshore closing rate.

US dollar

MARKET UPDATE

In February the US dollar strengthened very modestly against the euro in terms of London closing rates, from 1.0846 to 1.0808. In addition, the dollar strengthened versus the yen, from 146.28 to 149.82. The FOMC did not meet in February and hence the fed funds rate remained at 5.25% and 5.50%. The FOMC continued with its policy of reducing its securities holdings with QT ongoing at a pace of USD 95bn worth of UST bonds (USD 60bn) and MBS (USD 35bn) of balance sheet reduction each month, although the pace of QT looks set to be tapered possibly starting over the coming months with a deeper discussion expected at the March FOMC meeting.

OUTLOOK

The US dollar was close to unchanged in February despite some substantial moves in rates markets. The 2-year UST note yield jumped 41bps to close at 4.62% with a strong US employment report and a strong CPI report fuelling a considerable paring of rate cut expectations. At the end of January, market pricing indicated 148bps of rate cuts this year but this has now dropped to 82bps. While the extent of rate cuts at the end of January was excessive, the extent of rate cuts now looks a little too cautious. The Fed could well now hold off from cutting until June, but weakening growth and inflation moving closer to target would easily see the FOMC cut at each remaining meeting implying a total of 125bps. The Dots profile at the March meeting may not change (75bps of cuts) but if the economy weakens and the disinflation trend is maintained cuts can commence in June. Rents and core services ex-housing remain the sticky components but moderating wage growth should still alleviate upward pressure in underlying inflation.   

Optimism over continued US economic resilience is high but we remain sceptical and suspect that certain key tailwinds have been key to the strength of the economy that are about to fade. Large fiscal stimulus support (CHIPS, IRA) and excess consumer savings will no longer be supports for growth while the transmission of tighter policy is ongoing. The Commercial Real Estate concerns that hit regional banks in February will only reinforce the weakness in bank lending. The start to the year also revealed weakness with retail sales and manufacturing production declining. Retail sales fell 0.8% m/m in January while manufacturing production fell 0.5%. The consensus real GDP estimate for Q1 of 2.0% Q/Q SAAR appears optimistic. Consumer confidence declined and the NFIB Small Business Optimism index fell to 89.9 and remains well below the long-term average of 98.0 with hiring plans dropping to the lowest level since the pandemic struck. We would place greater importance of forward looking indicators rather than lagging indicators like GDP and NFP.

Hence, we are maintaining our USD forecast profile that sees the dollar holding up around current levels before weakening more notably in H2 as the Fed cutting cycle takes holds. There are limits to dollar selling however with the US election and the prospect of a Trump victory likely curtailing the extent of dollar selling

INTEREST RATE OUTLOOK

* Interest rate assumptions incorporated into MUFG foreign exchange forecasts.

For the first two months of 2024 we had kept our UST rate forecasts the same as we had embedded a few outcomes into our path in our original outcome, where we were averaging out the possibility of a.) Fed starting later with cuts, and b.) the market had priced in too much of a decline in rates into late 2023 so we were expecting a retracement in Q1 (which has largely happened). However, we now lift our general forecast up anywhere between 25-38bps to consider the risk the Fed cuts later (June vs our May call). We live in a highly fluid environment and a lot can change from week to week, let alone month to month. And as we said before, once markets have already priced out a certain scenario and the Fed does not deliver, as we approach the May meeting, if there aren’t conditions or a tail risk events warranting a rate cut in May, we will likely push back our cut expectation to June. Why not just change it to June? Well we like the optionality of keeping the view adjustment one meeting at a time because we think the backdrop in markets is ripe for a major u-turn in risk assets and we remain concerned around banks and liquidity dynamics in Q2-Q3. 

(George Goncalves)

FEDERAL RESERVE TOTAL ASSETS

US TREASURY BOND YIELDS

Japanese yen

MARKET UPDATE

In February the yen weakened versus the US dollar in terms of London closing rates from 146.28 to 149.82. In addition, the yen weakened versus the euro, from 158.66 to 161.93. The BoJ did not meet in February and hence the YCC framework was unchanged with the +100bps range maintained with an upper-end reference rate of 1.00%. The BoJ has still committed to “large-scale” JGB buying when required but the general sense in the market continues to be that YCC will soon be brought to an end. The key policy rate also remained unchanged at -0.10%.

OUTLOOK

The yen weakened sharply in February and is once again the worst performing G10 currency. The low level of FX volatility, high yields abroad and strong risk appetite have all served to weaken the yen. IMM positioning data shows a sharp increase in yen selling while OTC retail FX margin flows indicate yen selling from this sector as well. The Japan equity markets reached a very significant milestone in February with the Nikkei 225 breaking above the previous record high that was recorded in December 1989. Policies first instigated under PM Abe have begun to bear fruit with reform of corporate Japan resulting in companies focusing more on greater efficiency of excess capital. 2023 saw another record year of share buybacks in Japan with 50% of net profits now returned to investors through dividends and buybacks. This all reflects the response to pressure from the TSE to focus on ROE and price-to-book ratios. The Nikkei 225 is 17% higher this year and 50% higher since the end of 2022. This is hugely significant and could result in greater capital outflows as domestic equity market performance encourages an increase in risk taking. Japan households still hold 52.5% of total household wealth in cash deposits. The expansion of NISAs (Nippon Individual Savings Accounts) are helping encourage riskier investments.

Higher inflation in Japan, if sustained, could certainly help increase riskier investments as households seek higher returns to protect savings in real terms. The YoY core nationwide CPI rate fell from 2.3% to 2.0% in January, but this was less than expected (1.8%). BoJ Governor Ueda spoke in the Diet in February and was much more confident in his assessment that the wage-price spiral was strengthening and confidence was growing that price stability can be achieved. This view was echoed by other policy board members (Hajime Takata; 29^th Feb). We now see grounds for the BoJ moving more quickly than we originally believed (April) and a March rate hike is looking more likely. Contracting GDP last year is unlikely to last and a rebound in growth this year as inflation subsides gradually will support consumer spending. With Japan’s working age population shrinking, stronger wage growth than has been seen in recent decades is a much higher prospect.

A BoJ rate hike and importantly a signal of potentially more hikes to come will help the yen to recover. For a large sustained move stronger, G10 central banks will also need to embark on rate cutting cycles.

INTEREST RATE OUTLOOK

* Interest rate assumptions incorporated into MUFG foreign exchange forecasts.

The 2-year JGB yield jumped in January, by 10bps to close at 0.18%. This was a much more modest move than in other markets with weak real GDP and falling inflation helping to curtail a jump in yields. With YCC still in place as well, it may be helping to deter to some degree JGB selling. Still, the time looks to be approaching for a change in policy. Governor Ueda was much more explicit in signalling increased confidence in rising wages when he spoke in the Diet, stating that “companies in Japan will be more aggressive than ever” in raising wages. The BoJ may well be receiving anecdotal information on wage hike plans and have already been highlighting the change labour supply backdrop that points to higher wages as well. In the last five years Japan’s working age population has declined by 1mn, the first such decline in data going back to 1972. Inflation is also lower due to subsidies that will expire while the weak yen is fuelling strong tourism which is lifting inflation in the hotel and accommodation sector. The surge in Japan equities and concerns over excessive yen weakness should encourage BoJ to hike, we now think in March.

JAPANESE INVESTMENT TRUST PURCHASES OF FOREIGN EQUITIES

BOJ PURCHASES OF JGBS

Euro

MARKET UPDATE

In February the euro weakened very modestly versus the US dollar in terms of London closing rates, moving from 1.0846 to 1.0808. The ECB did not meet in February and hence the key policy rate was unchanged at 4.00%, following 450bps of rate hikes through to September last year. The ECB is running down APP securities and will commence PEPP run-off in H2 with an estimated EUR 380bn of securities rolling off the balance sheet from both programs combined in 2024

OUTLOOK

The euro weakened marginally versus the US dollar but was still the third best performing G10 currency after the US dollar and the Swedish krona. But moves were modest across the FX markets and EUR/USD 3mth implied volatility fell to the lowest level since January 2022. At the start of this year we highlighted a broadly neutral US dollar view with a bias favouring US dollar strength and that is what has unfolded but with Fed and other central bank rate cut expectations now pared back to more reasonable levels, it is difficult to hold strong conviction over EUR/USD direction from here. Incoming economic data over the short-term will likely dictate rates and FX moves and on that front there is some reason for moderate optimism that we can see some pick-up in growth in Europe going forward. Industrial production jumped 2.6% in December with the November data revised higher and was the biggest increase since August 2022. The advance Services PMI also increased to 50.0 in February, the highest level since July. A modest pick-up in growth will make for a pleasant change given the zero growth through the Q2-Q4 period of last year. The global PMIs for new orders and inventories also suggest the global inventory downswing has bottomed – good news for Germany’s manufacturing sector.

A moderate pick-up in growth won’t really have much impact on rate cut timing with the speed of inflation decline of paramount importance. We see the disinflation trend continuing. The drop in inflation is clearly unfolding faster than the ECB expected and the minutes from the January meeting included a reference to a cut to the 2024 inflation forecast (2.7%). With the 2025 forecast at 2.1% and the 2026 forecast at 1.9% the ECB is now close to achieving its price stability goal. We would argue that the ECB should cut in April assuming no upside inflation surprises but this is looking less likely given the communications tend to suggest a larger consensus willing to only consider a cut in June. The first ECB cut is now only nearly fully priced by June which suggests some big macro surprises would be required to shift that view.

Plunging FX volatility highlights the continued general synchronised pricing in the forward market of rate cuts to come. The Fed/ECB pricing of total cuts this year remains within 10bps and that is limiting EUR/USD volatility. While actual rate cuts delivered will likely be similar, we see some slight improvement in growth in Europe in contrast to slower growth in the US as allowing for some EUR appreciation. However, US election risks could start to see a EUR move higher peak out in Q4

INTEREST RATE OUTLOOK

* Interest rate assumptions incorporated into MUFG foreign exchange forecasts.

The removal of most of the rate cut priced in for April has helped to lift yields in general and the move higher in February was beyond expectations that has seen the 10-year German bund yield increase 24bps to close at 2.41%. Some rates volatility may emerge when the ECB meeting takes place in early March. The ECB is likely to lower its inflation forecast for 2024 from the current 2.7% level. The GDP forecast of 0.8% for this year looks reasonable but could be cut slightly. While the forecast changes would suggest scope for an April cut, we assume now that the ECB will continue to push back on that timing which if clearly communicated by Lagarde will limit the scope for a big drop in yields. But risks are skewed to the downside initially. After the jump in yields in February we would assume levels through the rest of the year will be lower based on the key view that inflation trends will remain favourable. The growth picture will likely remain unclear with falling inflation and some pick up in global trade volumes offset by the transmission of tighter monetary policy that is curtailing demand for credit. Hence, we expect to see some moderate declines in yields going forward as inflation falls back to target.   

APP AND PEPP REDEMPTIONS (ESTIMATED)

EURUSD 3MTH IMPLIED VOLATILITY

Pound Sterling

MARKET UPDATE

In February the pound weakened modestly against the US dollar in terms of London closing rates from 1.2718 to 1.2634. In addition, the pound weakened against the euro, from 0.8528 to 0.8555. The MPC at its meeting in February left the key policy rate unchanged at 5.25%, following 14 consecutive rate increases through to August before commencing a pause from September.

OUTLOOK

The pound weakened in February against the dollar and euro but still outperformed most other G10 currencies, and on a year-to-date basis is the second best performing G10 currency with only the dollar outperforming. The BoE at its meeting in February published updated forecasts which revealed a sharp revision lower of inflation, which is now expected to reach its target in Q2. However, the profile then rises back above target to 2.75% by year-end and only falls back below target three years later. This profile underlined the continued caution of the BoE despite much sharper than expected declines in inflation. Indeed, two MPC members maintained their votes to hike in a 6-2-1 vote (Dhingra voting to cut). Rhetoric from BoE officials throughout February maintained a cautious tone with Deputy Governor Ramsden suggesting that the BoE could continue with QT beyond reaching an equilibrium level with the BoE able to manage liquidity with other available tools. 

The hawks on the MPC continue to fret about services inflation and argue this means continued caution on easing policy is warranted. Megan Greene took the BoE’s underlying services CPI measure (excluding non-private rents, accommodation and airfares) and also excluded energy-intensive services and arrived at an underlying level of services inflation of, a still high, 4.0%. The latest PMI Services Output Price index shows that the disinflation process has stalled over recent months and from April we will see a 10% increase in the National Living Wage. Catherine Mann cites high-income households as causing the stickiness in services inflation due to the limited impact on those households from higher mortgage rates. The upcoming budget is also likely to include tax cuts and ahead of an election there are risks of some surprise giveaways that could complicate the disinflation process. The economy also looks to have bottomed with business and consumer sentiment improving as the inflation shock eases.

The GBP forecast profile and levels are unchanged and we see scope for GBP strength over the initial period of the forecast profile but assume the pound will then underperform in the second half of the year that results in EUR/GBP drifting higher. The grounds for BoE caution on cutting rates remain in place despite the large drop in BoE inflation forecasts. Higher wages and sticky services CPI while growth moderately improves should be supportive for the GBP over the coming months.  Volatility remains very low but a breakout looks more likely to the upside initially before GBP weakness (vs EUR) emerges later in the year.

INTEREST RATE OUTLOOK

* Interest rate assumptions incorporated into MUFG foreign exchange forecasts.

The 10-year Gilt yield jumped notably in February, by 33bps to close at 4.12%. The move reflected the general move higher in global long-term yields as inflation data came in more mixed in major economies and central bank officials continued to push back on the idea of earlier rate cuts. As outlined above, underlying inflation pressures remain problematic and coupled with the potential for a moderate pick-up in growth and with the budget in March likely to add further fiscal stimulus, we now see a greater risk of a further delay to the BoE cutting rates. We mentioned May or June as most likely last month here but added August was feasible and now assume August as being the start date for the BoE’s first cut. That implies Gilt yields could be a little higher than we originally assumed but we still maintain that yields should decline gradually reflecting the disinflation trend. While the BoE sees inflation drifting back above target in 2H of this year after a brief drop below 2.0% in Q2, the levels will still be consistent with there being scope to remove some tightening especially given the real policy rate would be at levels by mid-year that look excessively high.                 

BOE GILT HOLDINGS

UK CPI YOY, % VS. WEEKLY EARNINGS 3M YOY, %

Chinese renminbi

MARKET UPDATE

In February, USD/CNY increased from 7.1680 to 7.1877. The PBOC kept the 1-year MLF stable at 2.50% on 18^th February and held its 1-year LPR rate unchanged at 3.45% but cut the 5-year LPR rate by 25bps on 20^th February to 3.95%.

OUTLOOK

Against the background of adjustments in expectations on the Fed's interest rate cuts, the PBOC’s action of keeping the MLF policy rate unchanged in the short term will help maintain the stability of the CNY exchange rates. During the Spring Festival, the January CPI, core CPI, and PPI inflation rates released in the US were all stronger than expected. The stickiness of service prices and the rebound in production costs have reminded markets that there is still risk in being too assertive in the fall of "supply-driven" inflation. Whether U.S. inflation can fall back smoothly, and the pace and extent of the Fed's easing remain uncertain. Interest rate futures signal that market participants have dialled back the Federal Reserve’s rate cuts this year. The external developments have increased downward pressure on the CNY against the dollar.

The stable performance of USD/CNY was largely helped by various domestic policy initiatives, amid the poor housing sales number during the Spring Festival period. On 23^rd February, President Xi Jinping presided over the fourth meeting of the Central Financial and Economic Commission and emphasized that a new round of large-scale equipment updates and the replacement of old consumer goods with new ones will be promoted to effectively, he also stated to reduce the logistics costs of the whole society. The large-scale equipment updates could potentially stimulate demand and production. Also, on 23^rd February, the meeting of the State Council confirmed it would study policies to attract and utilize foreign investment with greater intensity and deploy further efforts to prevent and resolve local debt risks. Also, for the purpose to improve the sentiment in the domestic stock market, on 23^rd February, China Securities Regulatory Commission clarified that there is currently no 10-year IPO backward investigation arrangement, and the proportion of on-site inspections of companies to be listed will be greatly increased to help increase the quality of listed companies. A "penetrating" clue-screening system will be built to accurately identify and severely crack down on market manipulation and insider trading. It will actively work with the National Development and Reform Commission Promote the implementation of qualified consumer infrastructure REITs projects.

Such tense policy initiatives show the government’s strong intention in stabilizing growth. The NPC meeting on 5^th March is likely to be along the line in giving positive signals. We expect a similar “around 5%” GDP growth target and a modestly larger budgeted fiscal deficit as percentage of GDP for 2024 as well. Recent improvement in Northbound portfolio shows that market still is willing to buy into the government’s positive policies. Shall the NPC meeting deliver, we expect the CNY to stage a modest rally in March. 

INTEREST RATE OUTLOOK

* Interest rate assumptions incorporated into MUFG foreign exchange forecasts.

Real interest rates actually rose in recent months, despite nominal interest rates on general loans and personal mortgage loans falling to historical lows in Q4 2023. Real interest rates adjusted for inflation are relatively high, compared with China’s growth potential. The year-on-year CPI growth rate in January 2024 was -0.8%yoy, down 0.5ppts from the proir month. The 3.95% nominal LPR and -0.8%yoy CPI inflation mean a 4.75% real rate - which is not conducive to full release of endogenous financing needs. On 20^th February, the PBOC cut the 5-year LPR rate by 25bps, the largest single time policy rate cut ever, while keeping the 1-year LPR unchanged, after keeping 1-year and 5-year MLF rates unchanged. The 25bps rate cut for the 5-year LPR came as a positive surprise as the market was expecting a 10bps cut. We can see the government’s intention to stabilize the economy, but the decline in the NIM of Chinese commerial banks to 1.69% in Q4 2023, could constrain the room for further PBOC rate cuts. Net, we expect a further 20bps cut on LPRs and a 30-40bps cut on MLFs to reduce the cost and NIM pressure for commercial banks.

DAILY PROPERTY SALES DURING THE SPRING FESTIVAL FELL FURTHER

Source: CEIC, MUFG GMR

NET NORTHBOUND INFLOWS SEEN RECENTLY

Source: CEIC, MUFG GMR

For other currencies outlooks, please download the PDF version attached at the top of this page.