Dollar Mixed as Markets Digest Red Sea Tensions

January 12, 2024

Win Thin

Risk sentiment is holding up after the U.S. and U.K. launched airstrikes against Houthi rebels in Yemen; December inflation data remain in the spotlight; Fed officials remain cautious; underlying strength in the economy is likely to persist as weekly jobless claims suggest the labor market remains robust
ECB President Lagarde was cautiously optimistic; the monthly U.K. data dump began
BOJ may cut its growth and inflation forecasts at the upcoming meeting; Japan reported November current account data; China reported December CPI, PPI, trade, and new loan data; Taiwan elections will be held Saturday

The dollar is mixed as markets shrug off rising Red Sea tensions. DXY is trading slightly higher near 102.42 after two straight down days. The euro is trading lower near $1.0950 while sterling is trading lower near $1.2735. USD/JPY is trading lower near 145.20 while CHF is underperforming near .8535 despite the overnight air strikes on Houthi rebels in Yemen (see below). NOK and CAD are outperforming as oil prices spike. While U.S. economic data have mostly come in on the firm side, current market easing expectations for the Fed still need to adjust significantly. Until that happens, the dollar remains vulnerable. We thought the upside miss in U.S. CPI data yesterday would provide some impetus for a market reset but the impact was fleeting.

AMERICAS

Risk sentiment is holding up after the U.S. and U.K. launched airstrikes against Houthi rebels in Yemen. U.S. officials have been warning of consequences if the Houthi attacks on commercial shipping in the Red Sea continued. The attacks continued and so the consequences are being seen now. However, the Houthis said their attacks would continue and promised a response to the air strikes “very soon.” Oil prices are up sharply, with Brent crude trading above $80 per barrel for the first time since December 27. Other than oil however, markets do not appear to be that concerned about escalation as safe haven CHF is underperforming, UST yields are higher, and global equity markets are mostly higher. These could all reverse if tensions ratchet up so stay tuned.

December inflation data remain in the spotlight. PPI will be reported today. Headline is expected to rise four ticks to 1.3% y/y while core is expected to remain steady at 2.0% y/y. Yesterday, CPI ran hot. Headline came in two ticks higher than expected at 3.4% y/y vs. 3.1% in November, while core came in a tick higher than expected at 3.9% y/y vs. 4.0% in November. This was the first acceleration in headline since August. Looking ahead, the Cleveland Fed’s inflation Nowcast model estimates January headline and core CPI at 3.0% and 3.8%, respectively.

Fed officials remain cautious. Mester said “I think March is probably too early in my estimate for a rate decline because I think we need to see some more evidence. I think the December CPI report just shows there’s more work to do, and that work is going to take restrictive monetary policy.” Mester also said that the Fed should begin discussions about slowing the pace of QT this year. Despite the upside miss for CPI, Fed easing expectations remain elevated. WIRP suggests 5% odds of a cut January 31 and rising to 75% March 20. More importantly, six rate cuts are now priced in vs. five at the start of last week and there are nearly 15% odds of a seventh cut. Kashkari speaks today.

Underlying strength in the economy is likely to persist. The New York Fed’s Nowcast model has Q4 growth at 2.5% SAAR and Q1 growth at 2.7% SAAR and will be updated later today. The Atlanta Fed’s GDPNow model has Q4 growth at 2.2% SAAR vs. 2.5% previously and will be updated next Wednesday after the retail sales data. Bottom line: the US economy is still growing above trend in Q4 and quite possibly Q1.

Weekly jobless claims suggest the labor market remains robust. Initial claims came in at 202k vs. a revised 203k (was 202k) last week while the 4-week moving average was steady at 208k. Both are the lowest since mid-October. Of note, next week's initial claims data are for the BLS survey week containing the 12th of the month. If these claims stay low, then that sets us up for another solid NFP. There is no Bloomberg consensus yet for January NFP, but its whisper number stands at 156k vs. 216k in December. Elsewhere, continuing claims fell to 1.834 mln vs. 1.870 mln expected and a revised 1.868 mln (was 1.855 mln) last week. This was the lowest since the last week of October.

EUROPE/MIDDLE EAST/AFRICA

European Central Bank President Lagarde was cautiously optimistic. She would not get pinned down on the timing of rate cuts, stressing “I cannot give you a date.” However, she added “But I can say that if we win this battle, if we get to 2% as we estimate in 2025, and if it’s confirmed by the data we will have” then “I’m very confident, then rates will start to decline as soon as we have this certainty.” EUR/USD continues to trade within a range around 1.0975. Today, ECB Chief Economist Lane speaks on Post-Pandemic Economic Governance and Next Generation EU. WIRP suggests the first cut will come April 11, while a total of six cuts are priced in for 2024.

The monthly U.K. data dump began. November GDP, IP, services, construction, and trade were all reported. GDP came in a tick higher than expected 0.3% m/m vs. -0.3% in October, IP came in as expected at 0.3% m/m vs. a revised -1.3% (was -0.8%) in October, services came in two ticks higher than expected at 0.4% m/m vs. a revised -0.1% (was -0.2%) in October, and construction came in at -0.2% m/m vs. 0.2% expected and a revised -0.4% (was -0.5%) in October. The y/y rates all worsened from October but overall, U.K. economic activity is tracking the BOE’s forecast of a 0.1% rise in real GDP in Q4. As such, we doubt the November GDP print will shift the dial on BOE interest rate expectations. Indeed, interest rate futures still imply 125 bp of rate cuts this year (starting in Q2).

ASIA

The Bank of Japan may cut its growth and inflation forecasts at the upcoming meeting. The bank will release its quarterly outlook report at the January 22-23 meeting and reports suggest the FY24 forecast for core inflation will be cut to around 2.5% vs. 2.8% forecast in October while the FY25 forecast will remain slightly below the 2% target. The FY23 growth forecast may be cut slightly after weaker than expected Q3 GDP data. While the forecast changes are likely to be modest, the underlying message will be that the BOJ is in no hurry to remove accommodation. Indeed, liftoff expectations have been pushed out to either July (90% odds of liftoff) or September (95% odds).

Japan reported November current account data. The adjusted surplus came in at JPY1.89 trln vs. JPY2.18 trln expected and JPY2.62 trln in October. However, the investment flows will be of more interest. The November data showed that Japan investors turned net sellers of U.S. bonds (-JPY8 bn) after three straight months of net buying. Japan investors turned net sellers (-JPY223 bln) of Australian bonds again and remained net sellers of Canadian bonds (-JPY31 bln) for the fifth straight month and for ten of the past eleven months. Investors turned net sellers of Italian bonds (-JPY229 bln) again. Overall, Japan investors turned total net sellers of foreign bonds (-JPY1.17 trln) after three straight months of net buying. With Japan yields likely to move higher in 2024, it’s possible that Japan investors will stop chasing higher yields abroad. November data supports this thesis but it’s still too early to say for sure.

China reported December CPI and PPI data. CPI came in at -0.3% y/y vs. -0.4% expected and -0.5% in November, while PPI came in at -2.7% y/y vs. -2.6% expected and -3.0% in November. Deflationary risks remain high and so we expect further easing in the coming weeks. Of note, central banks around the world should send a thank you note to China, as the world’s second largest economy has been exporting deflation to the rest of the world. We believe this is one of the big reasons why inflation has come down so quickly in recent months.

China reported soft new loan data. New loans came in at CNY1.17 trln vs. CNY1.35 trln expected and CNY1.09 trln in November, while aggregate financing came in at CNY1.94 trln vs. CNY2.15 trln expected and CNY2.45 trln in November. Credit growth remains lackluster, which is to be expected as policymakers have so far refrained from taking aggressive stimulus measures. Economists surveyed by Bloomberg expect the PBOC to lower the lending rate on its 1-year medium-term lending facility by 10 bp to 2.40% this Monday.

China also reported firm December trade data. Exports came in at 2.3% y/y vs. 1.5% expected and 0.5% in November, while imports came in at 0.2% y/y vs. -0.5% expected and -0.6% in November. This was the strongest y/y gain in exports since April but was due in large part to low base effects. However, exports fell -4.6% in 2023 vs. 2022 and was the first full year decline since 2016.

Taiwan elections will be held Saturday. The most recent polls before the blackout period showed the ruling Democratic Progressive Party candidate Lai Ching-te narrowly leading the KMT candidate Hou Yu-ih. A DPP victory would likely mean tensions with mainland China would persist as Lai has promised to continue current President Tsai’s stance. Of note, Taiwan People’s Party candidate Ko Wen-je is running a distant third as the anti-establishment choice.

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