Three events stand out next week. Preliminary readings of the PMI for many high-income countries and policy meetings of and . The geopolitical backdrop remains high against the buildup of Russian troops and armaments seemingly poised to invade Ukraine. No new discussions between Russia and the United States are planned (yet?). Meanwhile, the surge in COVID cases appears to be slowing in parts of Europe and the United States, while Japan has imposed near-emergency rules in Tokyo and thirteen prefectures through mid-February. . China appears to be stepping up its zero-COVID efforts ahead of the Olympics.
The collapse of December in the United States (-1.9%) and the unexpected drop in the stock give the world’s largest economy little momentum. Last week’s indications showed that the new year was off to a bad start. January crashed to -0.7 from nearly 32 in December. Economists have understood that activity is slowing down. The median forecast was 25.0 in the Bloomberg survey, warning that the slowdown could be much steeper than economists understood. The evaporation of new orders (-5.0 against 27.1 in December) is particularly troublesome. While the January survey showed better results, the details were disappointing.
The slowdown also seems to be happening in the Eurozone. The German statistics office warned that the economy contracted between 0.5% and 1.0% in Q4-21. Market rates are rising. The German yield rose by around 20 bps since the end of last November to reach its highest level since April 2019 (~-0.55%), before falling in the second part of last week. The yield briefly turned positive for the first time since May 2019. The January survey found that the Current Situation Assessment fell to -10.2, the lowest since last May, and worse than expected by investors. economists.
Preliminary January PMIs will be out next week and expect some weakness. However, this is not new. The eurozone was at 53.3, the lowest since March. It has fallen in four of the past five months. The trend in the UK has been similar. The has fallen in five of the past seven months and, at 53.6, is the weakest since last February.
The United States fared better. At 57.0 in December, it was the lowest since September. But here too the recent trend is clear. December was the sixth month of slowdown in the last seven months of 2021.
Japan parades to the rhythm of a different drummer. It recovered from the long COVID crisis in September, but remember it was below the 50 boom/bust level in Q4-19. The composite PMI rose above 50 last October, although it retreated slightly in December. The conditions that lead to the imposition of new restrictions can weigh on the .
Due to its July-September COVID surge, Australia’s composite PMI profile looks a bit like Japan’s with a rally before softening in December. The composite spent the third quarter below 50. It bottomed in August at 43.3 and improved to 55.7 in November before falling back to 54.9 by year-end. Confinements can weigh on activity.
Most notable are the meetings of the Bank of Canada and the Federal Reserve. The Bank of Canada meeting ends at the start of the January 26 North American session and the FOMC meeting ends later the same day. Rather than rehash how we got here, let’s just acknowledge that both central banks are about to launch a series of rate hikes. The markets have anticipated an aggressive move in the coming months.
The overnight index swap (OIS) curve has about 160 basis points of tightening for the Bank of Canada this year and another 30 basis points in 2023. Indeed, compared to the end of last year, the market has decided to discount another rate hike this year. Yield jumped 30 basis points in the first three weeks of the year. At the end of 2021, the market was tilting slightly in favor of a rate hike in January (~55%). It is now a little above 70%.
The Bank of Canada ended its bond purchases last October. In addition to raising rates, the Bank of Canada can also provide forward guidance on its balance sheet strategy. The most aggressive would be to stop the product from recycling maturation almost immediately, say next month. However, officials are more likely to inform investors more. The next meeting is March 2. The fact is that, like the Bank of England and the Federal Reserve, the Bank of Canada will likely allow its balance sheet to unwind much sooner than after the Great Financial Crisis.
Even though most real sector data softened in December, the market’s reaction function to official comments is to price in a more aggressive Fed policy trajectory. Consider that on New Year’s Eve, the futures market was pricing in about a 63% chance of a 25 basis point hike in March and nearly three hikes this year. Now the market is fully pricing in the March rally and a small chance of a 50 basis point move. Moreover, the market is 100% confident on four bulls this year. At its peak, before stocks slumped, fed funds futures had about a one-in-three chance of a fifth price increase. The swap market has 102 bps of discounted tightening for this year and around 50 bps next year.
During his confirmation hearings, Fed Chairman Powell suggested officials had begun discussing his balance sheet strategy. It may take two to four meetings to reach an agreement. It would also allow the Fed’s balance sheet to start unwinding at the end of Q2 or Q3. Indeed, many observers seemed split between June and July. When the balance sheet starts to unravel is one problem, the pace is another. Last time it started at a rate of $10 billion per month and a year later it reached $50 billion per month. The Atlanta Fed’s Bostic has hinted that he favors a balance sheet reduction of $100 billion a month.
Also, unlike the previous episode, Fed officials seem to be talking about balance sheet unwinding to complement or even supplant rate hikes. The December FOMC minutes said “some participants” argued that balance sheet tightening more than rate hikes “could help limit yield curve flattening.” Price pressures were considerably stronger today than they were during the 2017-2018 period.
There is still a lot of uncertainty about quantitative easing and its opposite. Bernanke once joked with great amusement that EQ works in practice but not in theory. While most of the discussion is about quantities and prices, we find that the signaling channel is often underestimated. Consider Japan. It discreetly reduced its asset purchases and indicated that there was no impact on monetary policy, which would remain very accommodating. Indeed, the market reaction was muted. The ECB has also fluctuated its purchases of sovereign bonds but seems to have little perceptible impact on the markets.
Finally, note that the day after the close of the FOMC meeting, the United States will announce its first estimate of . The day ahead of the FOMC meeting gives economists fodder for last-minute adjustments. Unfortunately, (PCE), a key data for the GDP comes out at the end of the week. However, the 1.9% decline in retail sales in December has already weighed on the outlook for PCE. The median forecast (Bloomberg) is for a contraction of 0.4%. Bloomberg’s median forecast for fourth-quarter GDP recently fell 6% to 5.3%. The Atlanta Fed’s GDP tracker fell to 5.1% from 7.3% at the end of last year.
With inflation in mind, the PCE deflator will attract attention. It may have stabilized in December. It may not be the top, but it’s close. The 0.3% rise in the headline rate in January and February 2020 (0.2% and 0.1% as of , respectively) may facilitate comparisons. One implication is that in the short run, the core may converge with the title rather than the other way around. However, the year-over-year trend may start to slow later in the first or second quarter. Polls show inflation being held against Biden and help explain why Democrats are still expected to lose both houses of Congress in November.
Politics is still boiling near the surface of the forex market. Next week the focus will be on the Italian presidential selection process. A possible scenario that might be best received by the market would involve the current president (Mattarella) agreeing to stay on for a bit longer, as an interim like Napolitano did in 2013. This would allow Draghi to lead his coalition government until the end of the legislative. session next year. This would provide a steady hand at what is arguably an inflection point. Italian bonds would likely rally to such a move and could provide support. Meanwhile, in the UK, Gray’s internal inquiry into government parties during social restrictions is awaited. It may not reveal hard evidence, but it may do little to bolster the PM’s backing, while other reports speak of a handful of Tory MPs considering defecting to the party labor. There is a growing sense that Johnson is fighting for his political life.