• U.S. yields remain under pressure as the notion of a Fed pivot continues to gain credence; Fed officials remain hawkish; we continue to believe markets are underestimating the Fed; it's hard to reconcile a risk rally with deep U.S. yield curve inversion; Brazil reports December IPCA inflation
  
• France reported firm November IP; ECB officials remain hawkish; U.K. labor market appears to be weakening significantly; BOE officials are tilting more dovish; Norway reported December CPI
  
• December Tokyo CPI ran hot; BOJ tightening expectations remain elevated; China reported mixed December money and loan data
  

The dollar has steadied as hawkish Fed officials emerged yesterday. DXY is trading higher near 103.22 after trading at a new cycle low yesterday near 102.944. Next target is the May low near 101.297. The euro is trading near $1.0730 after trading at a new cycle high yesterday near $1.0760. Next target is the May low near $1.0785 and after that is the late April high near $1.0935. GBP is trading near $1.2150 and a break above $1.2215 would set up a test of the December high near $1.2445. USD/JPY remains stuck in the middle of recent trading ranges near 132. While we believe current dollar weakness is overdone, we have to respect the price action. Until a more hawkish Fed narrative emerges, the dollar is likely to remain under pressure.

AMERICAS

U.S. yields remain under pressure as the notion of a Fed pivot continues to gain credence. The 10-year yield is trading near 3.56% and traded as low as 3.51% yesterday, while the 2-year yield is trading near 4.23% and traded as low as 4.18% yesterday. While we continue to disagree with the market’s dovish take, we have to respect the price action and acknowledge that this narrative is taking a toll on the dollar. Yet minutes released last week from the December FOMC meeting made it clear that the Fed is concerned about a premature loosening of financial conditions. According to the Chicago Fed’s measure, financial conditions have loosened steadily from mid-October through yearend. Fed speakers this week should continue to push back against this. We do not think he will be happy with how the markets have reacted to the Fed’s messaging and so we expect him to forcefully emphasize the Fed’s commitment to continue tightening.

Fed officials remain hawkish. Yesterday, Bostic said “We are just going to have to hold our resolve” and added that this stance warrants hiking rates to 5.0-5.25% range. However, he acknowledged that the case for downshifting to 25 bp moves would be boosted if CPI data Thursday showed inflation cooling. Elsewhere, Daly said she expects the Fed to hike rates somewhere above 5%, though the terminal rate is still unclear and depends on incoming inflation readings. She too acknowledged the possibility of smaller hikes, noting that “Doing it in more gradual steps does give you the ability to respond to incoming information.” Neither Bostic nor Daly vote this year.

We continue to believe markets are underestimating the Fed. WIRP suggests a 25 bp hike February 1 is fully priced in, with nearly 30% odds of a larger 50 bp move. Another 25 bp hike March 22 is fully priced in, while one last 25 bp hike in Q2 is nearly 50% priced in that would take the Fed Funds rate ceiling up to 5.25%. However, the swaps market continues to price in an easing cycle by year-end and we just don’t see that happening. November wholesale trade sales and inventories will be reported today.

It's hard to reconcile a risk rally with deep U.S. yield curve inversion. The 3-month to 10-year yield curve in the US stands at -101 bp, the most since 1981. We all know what happened back then and the recession is now only a matter of when, not if. The good news is that this will be a policy-induced recession, not due to a financial crisis or a pandemic. As such, the Fed has the levers to eventually stimulate the economy without having to resort to QE or other unconventional measures.

Brazil reports December IPCA inflation. Headline is expected at 5.60% y/y vs. 5.90% in November. If so, it would be the lowest since February 2021 and moving closer to the new target of 1.75-4.75%. At the last policy meeting December 7, COPOM left rates steady at 13.75%. However, the tone was hawkish as it reiterated that rates will be kept steady for “a sufficiently long period” and that it will not hesitate to resume hiking rates if inflation doesn’t slow as planned. The swaps market is pricing in 25 bp of tightening over the next six months to a peak near 14.0% but much will depend on Lula’s fiscal policy going forward. Markets have calmed after authorities restored order in Brasilia.

EUROPE/MIDDLE EAST/AFRICA

France reported firm November IP. France came in at 2.0% m/m vs. 0.8% expected and a revised -2.5% (was -2.6%) in October. As a result, the y/y rate moved back into positive territory. Spain reports IP tomorrow and is expected to remain at -0.4% m/m. Italy reports November retail sales tomorrow, followed by IP Friday that is expected at 0.4% m/m vs. -1.0% in October. Eurozone-wide IP will also be reported Friday and is expected at 0.5% m/m vs. -2.0% in October.

ECB officials remain hawkish. Schnabel said “Interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to our 2% medium-term target. Inflation will not subside by itself.” De Cos and Knot also speak today. WIRP suggests a 50 bp hike February 2 is almost fully priced in, followed by 75% odds of another 50 bp hike March 16. A 25 bp hike May 4 is nearly priced in, as is a last 25 bp hike in Q3 that would see the deposit rate peak near 3.5% vs. 3.75% last 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.

The U.K. labor market appears to be weakening significantly. The Recruitment & Employment Confederation said demand for permanent staff slipped for a third month in December and contracted at the sharpest pace since the early pandemic lockdowns. It also said vacancies rose at the slowest pace since February 2021 and pay growth was the slowest in nearly two years. Of note, Amazon is looking into closing three U.K. warehouses that would potentially impact 1200 jobs. The unemployment rate has risen two straight months for the 3.5% low in August and November data out next week is expected to show another increase as the labor market continues weakening.

BOE officials are tilting more dovish. Yesterday, Chief Economic Pill noted that “We are starting to see labor market indicators turn. Should economic slack emerge and unemployment rise as the latest MPC forecasts imply, that will weigh against domestic inflationary pressure and ease the threat of inflation persistence.” Governor Bailey speaks today. The peak policy rate is now seen at 4.5% vs. 4.75% at the start of this month. WIRP suggests nearly 80% odds of a 50 bp hike February 2, while a 25 bp hike March 23 is now priced in rather than 50 bp previously. After that, a 25 bp hike is nearly priced in May 11 followed by only 35% odds of another 25 bp hike in Q3.

Norway reported December CPI. Headline came in at 5.9% y/y vs. 6.1% expected and 6.5% in November, while underlying came in at 5.8% y/y vs. 5.7% expected and actual in November. Headline decelerated for the second straight month from the 7.5% peak in October but remains well above the 2% target. At the last policy meeting December 15, Norges Bank hiked rates 25 bp to 2.75% and noted that the policy rate “will most likely be raised further in the first quarter of next year.” Governor Bache stressed then that “The forecasts for the Norwegian economy are more uncertain than normal, but if the economy evolves as anticipated, the policy rate will be around 3% next year.” The expected rate path still saw the policy rate peaking near 3.0%, with gradual easing expected in H2 24. Next policy meeting is January 19 and another 25 bp hike to 3.0% is expected. This could end the tightening cycle but much will depend on how the economy evolves in H1. The swaps market is now pricing in a peak policy rate near 3.0% vs. 3.25% right after the December meeting.

ASIA

Japan December Tokyo CPI ran hot. Headline came in as expected at 4.0% y/y vs. 3.7% in November, while core (ex-fresh food) came in two ticks higher than expected at 4.0% y/y vs. 3.6% in November. Both are new cycle highs and suggests further upside in the national CPI too. The Bank of Japan will release updated forecasts at the upcoming January 17-18 meeting and reports suggest inflation forecasts will be increased significantly. November household spending was also reported and came in at -1.2% y/y vs. 0.5% expected and 1.2% in October. It’s clear that rising inflation is taking a toll on household incomes and spending.

BOJ tightening expectations remain elevated. No change is expected at the January 17-18 meeting. However, WIRP suggests nearly 30% odds of liftoff at the March 9-10 meeting and 95% at the April 27-28 meeting. We believe liftoff is likely to come earlier than we previously anticipated, with significant 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, especially as inflation continues to run hotter than previously expected.

China reported mixed December money and loan data. New loans came in at CNY1.4 trln vs. CNY1.2 trln expected and CNY1.21 trln in November, while aggregate financing came in at CNY1.31 trln vs. CNY1.85 trln expected and CNY1.99 trln in November. December CPI and PPI data will be reported Thursday. CPI is expected at 1.8% y/y vs. 1.6% in November, while PPI is expected at -0.1% y/y vs. -1.3% in November. Policymakers are totally focused on boosting growth right now and so the inflation data will have little impact. We expect further stimulus measures in Q1.