• FOMC minutes contained a strong message to the markets; we believe Fed tightening expectations still need to adjust higher; ADP private sector job estimate will be the data highlight; JOLTs data suggest the labor market remains strong; December ISM manufacturing PMI was reported; Banco de Mexico releases its minutes
  
• Eurozone inflation continues to ease; ECB tightening expectations have fallen; Germany reported weak November trade data; U.K. reported final December services and composite PMIs; BOE tightening expectations have also fallen; Egypt devalued for the third time in less than a year
  
• JGB yields continue to rise; BOJ tightening expectations remain elevated; Caixin reported firm December services and composite PMIs
  

The dollar is flat ahead of ADP. DXY is trading near 104.271 after support near 104 held. A break above 104.893 is needed to set up a test of the December 7 high near 105.822. The euro is having trouble sustaining a move above $1.06 and a break below $1.0460 is needed to set up test of the November 30 low near $1.0290. Sterling is likely to continue underperforming as it struggles to make much headway above $1.20. USD/JPY traded at the highest level since December 30 near 132.90 today. Further upside may be limited near-term as charts suggest the pair will eventually test the May low near 126.35. We continue to believe that dollar weakness in late 2022 was overdone and we expect the greenback to claw back much of those losses in the coming weeks and months. Of note, ECB and BOE tightening expectations have fallen in recent days (see below) and we see room for Fed tightening expectations to move higher, especially after the strong message contained in the FOMC minutes (see below).

AMERICAS

FOMC minutes contained a strong message to the markets. There were quite a few passages referring to balancing two-way risks and keeping the policy outlook flexible. However, we believe the key takeaways come from the following: “A number of participants emphasized that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price-stability goal or a judgment that inflation was already on a persistent downward path.” That is, the Fed was concerned that markets would misunderstand and take the decision to downshift to 50 bp as a pivot away from its inflation fight. Clearly, it wasn’t. Furthermore: “Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability.” That is, the Fed does not want looser financial conditions due to any such misunderstanding. Since that December 13-14 meeting, financial conditions have tightened a bit. The 10-year yield has risen over 20 bp, high yields spreads have widened nearly 30 bp, and the S&P 500 has fallen around 5%. We believe that the Fed minutes serve notice that markets would do well not to underestimate the Fed’s resolve.

We believe Fed tightening expectations still need to adjust higher. WIRP suggests a 25 bp hike February 1 is fully priced in, with nearly 40% odds of a larger 50 bp move. If financial conditions loosen significantly ahead of that meeting, we believe the Fed would likely send a strong message to the markets with another 50 bp hike. Another 25 bp hike March 22 is fully priced in, with nearly 65% odds of one last 25 bp hike in Q2 that would take the Fed Funds rate ceiling up to 5.25%. However, the market continues to price in an easing cycle starting in H2 and we just don’t see that happening.

ADP private sector job estimate will be the data highlight. It is expected at 150k vs. 127k in November but it’s still unclear whether the recent update to its model has made it more accurate in terms of predicting NFP. Looking ahead to the December jobs report tomorrow, consensus for NFP stands at 200k vs. 263k in November, while the unemployment rate is seen steady at 3.7% and average hourly earnings are seen down a tick to 5.0% y/y. Annual revisions to the household survey will be seen. Of note, the unemployment rate is derived from the household survey and it will be interesting to see if its -328k reading last month was an outlier or a harbinger of things to come for the establishment survey’s NFP. December Challenger job cuts, November trade (-$63.0 bln expected), and weekly jobless claims will also be reported today.

JOLTs data suggest the labor market remains strong. Job openings came in at 10.458 mln vs. 10.005 mln expected and a revised 10.512 mln (was 10.334 mln) in October. If the labor market remains tight, the Fed will be forced to tighten even more to get the desired fall in wage and price pressures. The Atlanta Fed’s GDPNow model is tracking 3.9% SAAR growth in Q4, up from 3.7% previously. The next model update will come later today. Of note, Bloomberg consensus sees SAAR growth slowing from 3.2% in Q3 to 1.1% in Q4 and 0.1% in Q1, which seems too low in light of recent data.

December ISM manufacturing PMI was reported. Headline came in a tick lower than expected at 48.4 vs. 49.0 in November. Details were mostly good, with employment rising to 51.4 vs. 48.4 in November and priced paid falling to 39.4 vs. 42.9 expected and 43.0 in November, the lowest since April 2020. Supplier deliveries fell to 45.1 vs. 47.2 in November and is the lowest since March 2009. Backlog of orders rose slightly to 41.4 vs. the cycle low of 40.0 in November. The lower these numbers are, the lower the strains in the supply chains. If these measures remain low, this is obviously a good sign for inflation going forward. ISM services PMI will be reported Friday and headline is expected at 55.0 vs. 56.5 in November.

Banco de Mexico releases its minutes. At that policy meeting December 15, the bank hiked rates 50 bp to 10.50% and said “The Board considers it will still be necessary to raise the reference rate in its next monetary policy meeting” February 9. It added that “Subsequently, it will assess if the reference rate needs to be further adjusted as well as the pace of adjustments based on the prevailing conditions.” While the market is pricing in 25 bp, we expect another 50 bp hike to 11.0% next month. The swaps market is pricing in a peak policy rate near 11.0% but much will depend on how inflation develops and also on Fed policy.

EUROPE/MIDDLE EAST/AFRICA

Eurozone inflation continues to ease. After a string of lower than expected December CPI readings from Spain, Germany, and France, Italy reported today. Its EU Harmonized measure came in as expected at 12.3% y/y vs. 12.6% in November and was the lowest since September. Eurozone reports tomorrow, with headline expected at 9.5% y/y vs. 10.1% in November, which would be the lowest since August, while core is expected at a new cycle high of 5.1% y/y vs. 5.0% in November. Of note, November PPI was reported today and came in at 27.1% y/y vs. 27.5% expected and 30.8% in October. This was the third straight month of deceleration from the 43.5% peak in August to the lowest since December 2021, and points to further disinflation ahead.

ECB tightening expectations have fallen. WIRP suggests a 50 bp hike February 2 is over 90% priced in, followed by 70% odds of another 50 bp hike March 16. However, the peak deposit rate is now seen between 3.25-3.50% vs. 3.5% at the start of this week. If inflation continues to slow, the expected peak rate is likely to move closer to 3.25% and perhaps even to 3.0%, which is where it stood back in mid-December.

Germany reported weak November trade data. Exports came in at -0.3% m/m vs. flat expected and a revised 0.8% (was -0.6%), while imports came in at -3.3% m/m vs. -0.9% expected and a revised -2.4% (was -3.7%) in October. The y/y rates, while still positive, continue to slow sharply. November retail sales and factory orders will be reported tomorrow. Sales are expected at 1.5% m/m vs. -2.7% in October, while orders are expected at -0.5% m/m vs. 0.8% in October. IP will be reported next Monday. With Germany’s second largest trading partner China struggling with the pandemic, we do no think this recent bounce in the data can be sustained and our view is supported by the trade data.

U.K. reported final December services and composite PMIs. Services PMI was revised down a tick to 49.9 while the composite PMI remained steady at 49.0. Construction PMI will be reported tomorrow. Similar to the eurozone, we also downplay the recent modest improvement in the U.K. sentiment indicators, especially as the ongoing rail, air, and border control strikes all but guarantee weaker January PMI readings. With both fiscal and monetary tightening in the pipeline, it’s hard to see where growth would come from.

BOE tightening expectations have also fallen. WIRP suggests 75% odds of a 50 bp hike February 2, while a 25 bp hike March 23 is priced in rather than 50 bp previously. After that, a 25 bp hike is priced in for Q2, with only low odds of final 25 bp hike in Q3 and so the peak bank rate remains close to 4.5% vs.4.75% at the start of the week. Sterling remains heavy and remains stuck near $1.20 after trading as high as $1.2445 in mid-December. We expect sterling to continue underperforming this year and note that the major retracement objectives from the September-December rally come in near $1.1645 (38%), $1.14 (50%), and $1.1150 (62%).

Egypt devalued the pound for the third time in less than a year. EGP is now trading near 27 per USD vs. 24.80 at the start of this week and is moving closer to the parallel rate between 29-30 per USD. The move is not surprising as increased FX flexibility was a key pledge under its recently agreed $3 bln 46-month Extended Fund Facility from the IMF. The last thing the IMF wants is for its aid to be spent defending an unsustainable peg. Other key parts of the agreement call for “monetary policy aimed at gradually reducing inflation [and] fiscal consolidation to ensure downward public debt trajectory.” This means continued monetary and fiscal tightening ahead and while painful, the reforms should help put Egypt on a more sustainable economic trajectory.

ASIA

JGB yields continue to rise. Overnight, the government sold a total of JPY2.7 trln ($20.4 bln) of 10-year JGBs at an average yield of 0.5%, the highest since 2015 and right at the BOJ’s new ceiling under YCC. Demand weakened as the bid to cover ratio fell to 4.76 vs. 6.03 previously, as investors appear less willing to hold JGBs at current yields due to expectations that Yield Curve Control will likely be dropped this year. The market should continue to test the BOJ’s commitment to YCC. Of note, the 10-year swap rate is nearly double the new YCC ceiling. As an aside, the rise in JGB yields has left the stock of negative yielding global bonds at zero, something not seen since 2014, when the ECB embarked on Quantitative Easing.

Furthermore, BOJ tightening expectations remain elevated. WIRP suggests nearly 30% odds of liftoff at the March 9-10 meeting and is fully priced in at the April 27-28 meeting. Liftoff is likely to come earlier than we previously anticipated, with risks of a move in Q2 vs. H2 seen previously. Given Kuroda’s penchant for surprises, we cannot rule anything out right now and even Q1 is possible.

Caixin reported firm December services and composite PMIs. Services came in at 48.0 vs. 46.8 expected and 46.7 in November, which helped drag the composite up to 48.3 vs. 47.0 in November. The improvement was especially surprising after official PMI readings came in much weaker than expected. Last week, manufacturing came in at 47.0 vs. 47.8 expected and 48.0 in November, while non-manufacturing came in at 41.6 vs. 45.0 expected and 46.7 in November and dragged the composite lower to 42.6 vs. 47.1 in November. Of note, China Beige Book International warned of potential contraction in Q4 GDP and added that full-year growth likely slowed to a mere 2%. While more stimulus is expected this year, growth is likely to remain uneven and subpar due to ongoing viral outbreaks.