USD rebounds – the beginning of a larger retracement?

USD: After a sharp sell-off some overdue recovery

Our Q1 and Q2 US dollar forecasts highlight our view of scope for the US dollar to retrace some of the sharp sell-off that took place in November and December. There is always a level of uncertainty over the extent of moves in FX around the turn of the year relative to the fundamental backdrop given the scope for position adjustment and exaggerated moves given abnormal liquidity conditions. As we have highlighted here before, the average EUR/USD performance since EUR trading began in 1999 shows the start of the year being the worst period and the end of the year the best. This didn’t play out that way last year though. After an 8% gain in Nov/Dec 2022, EUR/USD started last year retracing but then ended January a further 2.8% higher. The 2-year UST bond yield dropped as much as 35bps in January 2023 as inflation risks receded further and wage growth slowed more sharply than expected in the NFP report for December 2022. So of course the fundamentals matter here. All-else-equal might see the dollar retrace the Nov/Dec weakness but if yields moved consistent with US dollar weakness then the seasonal bias would matter little. However, the scope for yields to fall further from here seem quite small in our view. The big drop in yields is likely behind us for now given the market now is fully priced for a 25bp rate cut in March. Weak US data is now needed to validate the move in yields and if that is not forthcoming over the coming days/weeks, the scope for the US dollar to retrace the sell-off in Nov/Dec is high.

That highlights the importance of tonight’s FOMC minutes from the meeting in December – an event that added fuel to the US dollar sell-off. The FOMC members added one additional 25bp rate cut to the median dot profile for 2024 and Fed Chair Powell acknowledged that there was a discussion at the meeting about the timing and extent of rate cuts this year. This will be a key focus for the markets. What will the minutes reveal about that discussion? And in that discussion were there references to the considerable easing of financial conditions that were underway at that time (and of course has extended notably further since)? If the minutes make reference to market moves equating to Fed rate cuts that might dent market expectations of a rate cut as soon as March. We’d certainly be of the view that the minutes are more likely than not to imply rate cuts coming later than March, and hence there is a greater risk of disappointment given where market rates are now.

Such a scenario would add to the scope for a retracement of the Nov/Dec sell-off of the dollar as US yields recover further. We shouldn’t expect any big reaction either though given the flow of labour market data too – the JOLTS report today, the ADP report tomorrow and the NFP on Friday. A lack of weakness evident in those reports would certainly help extend the dollar rebound.

WEEK 2 TO WEEK 9 THE WORST PERIOD FOR EUR ON AVERAGE SINCE 1999

Source: Macrobond

GBP: Disinflation persists as sentiment remains weak

Data yesterday in the UK offered further evidence that the disinflation trend is set to continue with the BRC shop price data revealing a further notable drop in food inflation. The annual rate of food inflation fell from 7.6% to 6.6% - the eighth consecutive drop and the lowest level since June 2022. There is still a ways to go as can be seen below to get back to pre-covid levels but nonetheless this will be important in helping shape lower inflation expectations amongst households. The data correlates strongly with the ONS data and hence we should see a further easing of food inflation in the official data when released on 17^th January. What was notable in the BRC release was the fact that food promotions in the Christmas period were the strongest in four years, evidence that UK households are now becoming more price sensitive. The overall data continues to point compellingly to easing inflation risks. The 6mth annualised rate in the UK to November is now at just 0.6% while the core rate is 2.4%. It is clear that inflation rates are falling now nearly as quickly as they initially increased.

But data released today by the Institute of Directors indicate that this sharp deceleration in inflation has yet to help lift sentiment. The IoD’s Economic Confidence Index dropped from -21 in November to -28 in December with mounting fears of recession undermining confidence amongst senior business executives. The modest -0.1% contraction in Q3 real GDP growth has been followed by a -0.3% drop in October underlining the risks of technical recession. Consumer sentiment is not much better. The GfK Consumer Confidence Index did rise to -25.1 in January but remains closer to the cyclical low (-42.8) than the pre-inflation shock high of +1.0 in November 2021.

However, the BoE is unlikely to alter its rhetoric on monetary policy any time soon and a more notable decline in wage growth will be required before the BoE begins to shift its focus from possibly hiking rates to cutting rates. The pound dropped along with all G10 currencies yesterday but was much more resilient against the euro. EUR/GBP has failed to sustain levels above the 0.8700-level and policy divergence versus the ECB should help support GBP versus non-dollar currencies.

BRC DATA INDICATES MORE UK DISINFLATION ON THE WAY

Source: Macrobond & Bloomberg

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
SZ	08:30	procure.ch PMI	Dec	43.0	42.1	!!
GE	08:55	German Unemployment Change	Dec	20K	22K	!!
GE	08:55	German Unemployment Rate	Dec	5.9%	5.9%	!!
GE	10:30	German 2-Year Schatz Auction	--	--	2.640%	!
US	12:00	MBA Mortgage Applications (WoW)	--	--	-1.5%	!
US	13:30	FOMC Member Barkin Speaks	--	--	--	!
US	13:55	Redbook (YoY)	--	--	4.1%	!
US	15:00	ISM Manufacturing Employment	Dec	--	45.8	!!
US	15:00	ISM Manufacturing New Orders Index	Dec	--	48.3	!
US	15:00	ISM Manufacturing PMI	Dec	47.1	46.7	!!!
US	15:00	ISM Manufacturing Prices	Dec	48.3	49.9	!!
US	15:00	JOLTs Job Openings	Nov	8.850M	8.733M	!!
US	19:00	FOMC Meeting Minutes	--	--	--	!!!

Source: Bloomberg