• Fed expectations are drifting sideways given that there are no Fed speakers this week; we get some key January survey readings; we are skeptical regarding reports of a currency union in South America; Brazil reports mid-January IPCA inflation; Mexico reports mid-January CPI data
  
• The eurozone reported firm preliminary January PMIs; Germany reported February GfK consumer confidence; U.K. reported soft preliminary January PMIs and December public sector net borrowing; Hungary is expected to keep the base rate steady at 13.0%
  
• Tokyo Electric Power is seeking government approval to raise household power rates by about 30%; Japan reported preliminary January PMIs and December department store sales; Australia reported preliminary January PMIs
  

The dollar remains under modest pressure. DXY is trading lower just below 102. After making a new cycle low last week near 101.528, DXY is on track to test the May low near 101.297. The euro is trading flat near $1.0870 after making a new cycle high yesterday near $1.0925, just shy of the April high near $1.0935. Break above that would set up a test of the March high near $1.1185. Sterling is trading lower near $1.2315 after weak economic data were reported. Sterling is likely to continue underperforming due to the negative fundamental backdrop. Key retracement objectives from this year’s rally come in near $1.2215, $1.2145, and $1.2075. USD/JPY is trading lower near 130.25 as last week’s high near 131.60 remains out of reach for now. China is closed all week for the Lunar New Year holiday. While we believe that the current dollar weakness is overdone, we continue to respect the price action. Until a more hawkish Fed narrative emerges, the dollar is likely to remain vulnerable.

AMERICAS

Fed expectations are drifting sideways given that there are no Fed speakers this week. WIRP suggests a 25 bp hike February 1 is fully priced in, with less than 5% odds of a larger 50 bp move. Another 25 bp hike March 22 is nearly 90% priced in, while one last 25 bp hike in Q2 is only about 33% priced in. We think these odds are too low. Furthermore, the swaps market continues to price in an easing cycle by year-end and we just don’t see that happening. Until this Fed narrative changes, however, the dollar is likely to remain vulnerable.

We get some key January survey readings. Philly Fed non-manufacturing index, S&P Global preliminary January PMIs, and Richmond Fed manufacturing index will all be reported today. Headline manufacturing PMI is expected at 46.0 vs. 46.2 in December, services PMI is expected at 45.0 vs. 44.7 in December, and the composite is expected at 47.0 vs. 45.0 in December. Richmond Fed is expected at -5 vs. 1 in December. Kansas City Fed manufacturing index will be reported Thursday and is expected at -8 vs. -9 in December, followed by its services index Friday.

We are skeptical regarding reports of a currency union in South America. Such talk has been heard off and on since Mercosur was established as a common market back in 1991. That common market was initially made up of Argentina, Brazil, Paraguay, and Uruguay. Venezuela later became a member but was suspended in 2016. Brazil Finance Minister Haddad pushed back on the reports, stressing that the discussions are about creating a common unit of account to conduct and promote bilateral trade, not a common currency. The notion of a currency union is reportedly coming up again at Argentina’s behest, most likely because Lula has more in common politically with Fernandez (both leftists) than Bolsonaro did. Lula and Fernandez wrote an op-ed focusing on a common currency before they met yesterday.

The region’s two largest economies are simply too far apart to contemplate a currency union. Brazil’s inflation is slightly below 6% while Argentina’s is around 95%. Argentina has basically been a basket case since the peg was broken back in 2002, while Brazil has mostly thrived as even leftist Lula adopted market-friendly policies. Lastly, Brazil’s institutional framework is much stronger than Argentina’s and risks losing market confidence if it is linked with a less reliable partner such as Argentina. No economist has come out in support of a common currency and so it’s no surprise that Haddad has walked it back. Creating a simple unit of account for bilateral trade is obviously meant to reduce the reliance on the dollar but to us, it would be nothing but an accounting gimmick. Why bother?

For those keeping score at home, economic integration can take many forms. A free trade area eliminates all trade barriers amongst its members while all members maintain their own trade policies against non-members. A customs union builds on a free trade area by creating a common trade policy for members vis-à-vis non-members. A common market typically builds on a customs union by adding free movement of labor between members. An economic union builds on a common market by adding a common set of economic policies (like the EU), while a currency union builds on an economic union by adding a common currency (like the eurozone). The countries in Mercosur are much farther apart in terms of economic development than even the eurozone members were up its creation.

Brazil reports mid-January IPCA inflation. Headline is expected at 5.83% y/y vs. 5.90% in mid-December. If so, it would continue to disinflation process but would remain above the 1.75-4.75% target range. The swaps market is pricing in the possibility of one final 25 bp hike to 14.0% but much will depend on President Lula’s fiscal policy stance. His recent comments criticizing high interest rates are not helpful. Next COPOM meeting is February 1 and rates are expected to remain steady at 13.75%.

Mexico reports mid-January CPI data. Headline is expected at 7.85% y/y vs. 7.77% in mid-December and core is expected at 8.32% y/y vs. 8.34% in mid-December. At the last policy meeting December 15, Banco de Mexico hiked rates 50 bp to 10.5% and signaled another hike at the next meeting February 9 by noting “The Board considers it will still be necessary to raise the reference rate in its next monetary policy meeting. 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.” The swaps market is pricing in a peak policy rate between 10.75-11.0%.

EUROPE/MIDDLE EAST/AFRICA

The eurozone reported firm preliminary January PMIs. Headline manufacturing PMI came in at 48.8 vs. 48.5 expected and 47.8 in December, services PMI came in at 50.7 vs. 50.1 expected and 49.8 in December, and the composite came in at 50.2 vs. 49.8 expected and 49.3 in December. The composite rose for the third straight month from the 47.3 trough in October and is the highest since June. Looking at the country breakdown, the German composite came in at 49.7 vs. 49.6 expected and 49.0 in December and the French composite came in at 49.0 vs. 49.5 expected and 49.1 in December. Italy and Spain will be reported with the final PMI readings in early February.

Germany reported February GfK consumer confidence. It came in at -33.9 vs. -33.3 expected and a revised -37.6 (was -37.8) in January. January IFO business climate will be reported tomorrow. Headline is expected at 90.3 vs. 88.6 in December, driven by gains in both current assessment and expectations to 94.9 and 85.3, respectively. The improved sentiment readings and a warm winter so far have helped feed notions that Germany and the eurozone can avoid recession. We believe this is too optimistic, especially since the full impact of the 250 bp of tightening so far has yet to be felt, along with the 150 bp that’s still expected in 2023.

ECB tightening expectations are little changed. WIRP suggests a 50 bp hike February 2 is almost fully priced in, followed by nearly 70% odds of another 50 bp hike March 16. A 25 bp hike May 4 is about 75% priced in, while a last 25 bp hike in Q3 is about 70% priced in that would see the deposit rate peak near 3.5%. If inflation continues to slow, we think the expected peak rate is likely to move back down to 3.25% as it did last week and perhaps even down to 3.0%, which is where it stood back in mid-December. December M3 data will be reported Friday and is expected at 4.6% y/y vs. 4.8% in November.

The U.K. reported preliminary soft January PMIs. Headline manufacturing PMI came in at 46.7 vs. 45.5 expected and 45.3 in December, services PMI came in at 48.0 vs. 49.5 expected and 49.9 in December, and the composite came in at 47.8 vs. 48.8 expected and 49.0 in December. The composite reading is the lowest since January 2021 and is likely to fall further in the coming months. The CBI also released the results of its January industrial trends survey. Total orders came in at -17 vs. -8 expected and -6 in December, selling prices came in at 41 vs. 52 in December, and business optimism came in at -5 vs. -48 in December. The CBI distributive trades will be reported Thursday.

The U.K. also reported December public sector net borrowing. PSNB ex-banking groups came in at a record GBP27.4 bln vs. GBP17.3 bln expected and a revised GBP19.6 bln (was GBP22.0 bln) in November. The bulk of the monthly deficit came from GBP17.3 bln in debt servicing costs, the second biggest monthly number on record, with another GBP7 bln due to energy subsidies. For the first nine months of FY22, the total deficit came in at GBP128.1 bln. With rates headed higher and the economy slipping into recession, the PSNB numbers will only get worse in 2023. This leaves no room for Chancellor Hunt to use fiscal policy in any meaningful manner that would boost growth.

BOE tightening expectations remain steady. WIRP suggest 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 in June is priced in that would see the bank rate peak near 4.5%. Last week, Governor Bailey said inflation has peaked and will fall “quite rapidly” in late spring due to largely energy prices. The swaps market is pricing in the start of an easing cycle in H2 but we think this is unlikely.

National Bank of Hungary is expected to keep the base rate steady at 13.0%. The bank has kept this rate steady since it last hiked September 27, though it introduced the 1-day deposit rate in October at 18.0% to help support the forint. Inflation continues to accelerate, however, and so the markets may test the bank’s resolve to end the tightening cycle. As it is, the market is pricing in the start of an easing cycle in the next three months, which is highly unlikely given inflation close to 25%.

ASIA

Tokyo Electric Power is seeking government approval to raise household power rates by about 30%. The utility applied to hike regulated power rates starting in June and also announced a JPY300 bln ($2.3 bln) capital injection into its retail unit Tepco Energy Partner, which is getting squeezed by rising fuel costs and the weak yen. Such an increase would be politically damaging to Prime Minister Kishida. As it is, his popularity remain low even though the government in October announced a JPY29.1 trln plan to offer subsidies to utilities in order to help lower household electricity and gas costs. Both headline and core (ex-fresh food) inflation are the highest in nearly four decades and has spread to broader price pressures as core ex-energy is also at multi-decade highs. The Bank of Japan is forecasting that core inflation will move back below the 2% target in both FY23 and FY24 but it’s hard to see how this happens without tightening policy soon.

Japan reported preliminary January PMIs and December department store sales. Manufacturing PMI came in steady at 48.9, services PMI came in at 52.4 vs. 51.1 in December, and the composite came in at 50.8 vs. 49.7 in December. This is the highest composite reading since October and is the second straight increase from the 48.9 trough in November. Department store sales came in at 4.0% y/y vs. 4.5% in November, the slowest since February 2022. The 2023 outlook remains cloudy, especially if the BOJ starts to withdraw accommodation.

Australia reported preliminary January PMIs. Manufacturing PMI came in at 49.8 vs. 50.2 in December, services PMI came in at 48.3 vs. 47.3 in December, and the composite came in at 48.2 vs. 47.5 in December. This is the highest composite reading since October and is the first increase since September. China reopening is likely to have ongoing positive impact on Australia as 2023 progresses but it will likely be uneven.