Due an extended business trip, this weekend’s commentary has been consolidated into one note.

There are a few main themes in the foreign exchange market that may be useful noting as we begin the second half of Q1. The two overarching considerations are US warnings of a pending Russian invasion of Ukraine and adjustment of interest rate expectations amid rising inflation in many countries, even if not in China and Japan, the world’s second- and third-largest economies.

One can despise the authoritarian regime in Moscow, but one needs to recognize the perverse incentives. NATO will not accept a member whose borders are disputed. Moscow does not want Ukraine to join NATO. It follows like night from day that by threatening Ukraine’s border, Russia effectively keeps Ukraine out of NATO.

In addition, many observers insist on linking the type of regime that rules Moscow with its geographic national interest. Yet surely with even a casual understanding of history, one can grasp the strategic importance of the Ukrainian plains to Russia’s security. 

Heightened inflation and the easing of the pandemic restrictions have turned the monetary cycle. There is little doubt that the US and Canada are going to join the UK and Norway who have already begun their adjustment process. The Reserve Bank of New Zealand is likely to deliver its third hike in the cycle in the week ahead.

Despite a series of stronger-than-expected US data (January CPI, retail sales, and industrial production), the swaps market has cut the odds of a 50 bps hike by more than half to less than 40%. Formal and informal surveys show than many expect the US inflation is likely to ease, perhaps starting in March or April. An acceleration of the pace of Fed hikes seems more likely if CPI does not begin rolling over.

As Vice-Chair of the FOMC, the NY Fed President has a permanent vote on the FOMC. Williams seemed to speak for the leadership when he said before the weekend that there was no compelling case for a “big step” in March.

Moreover, for a Federal Reserve that recognizes the significance of the disparity of wealth and income and seemed to put an emphasis on the “maximum and inclusive employment,” it will be raising rates while real earnings are falling. 

Japan’s Q4 deflator and January's CPI show that even at this stage deflationary forces persist. They are being masked by higher energy and commodity prices, which are sparking a negative term of trade shock. 

This puts the Bank of Japan in a difficult position. It does not think tightening financial conditions is appropriate so it will have to defend the 0.25% cap on the 10-year bond yield. The yield is rising as the price of capital is rising across world. 

The European Central Bank and the Reserve Bank of Australia continue to push against market expectations for early rate hikes. The ECB holds an informal meeting on Feb. 24. It appears that a consensus is emerging to modify the asset purchase plans to allow for an earlier rate hike if necessary. The March 10 meeting will have updated forecasts and new forward guidance.

The 2-10-year yield curve in the Anglo-American economies (US, UK, Canada, and Australia) flattened so far this year. Australia’s has flattened the most—around 45 bps. The curve has flattened by 31 bps in the US, and a little less than 20 bps in the UK. Canada’s 2-10-year curve has flattened by nearly 10 bps.

On the other hand, the Germany curve has steepened by about 20 bps, while Italy’s curve is almost 50 bps steeper than when it began the year. The difference between the two and 10-year yield in Japan edged wider (less than 10 bps). China’s 2-year yield has fallen by almost 20 bps, while the 10-year yield has risen by three basis points this year.

China may have removed its supportive efforts too early, and it has again returned the punchbowl. Its yield on 10-year borrowing over the US has narrowed, which may deter foreign investors, especially those segments that saw it as a relative-valued trade.

Earlier in the year, Chinese officials seemed to caution against pressing the yuan higher, and it even raised the reserve requirements for foreign deposits. However, in recent sessions, the PBOC’s dollar reference rate was lower than the market expected.

Emerging markets more broadly are faring better than one might have expected, given the rise in US market rates, anticipated Fed hikes, and the slowing of China. EM is not a homogenous group and Latam is outperforming. Year-to-date, the three strongest emerging market currencies are from the region. The Brazil real, Peruvian sol, and Chilean peso are each up more than 7% this year.

The MSCI Emerging Market Equity Index is slightly positive for the year, up almost 0.9%, while the MSCI World Index of developed markets is off nearly 7%. Let's turn to the currencies themselves.

Dollar Index

A range of roughly 95.65-96.50 was carved last week. It was essentially flat on the week, which in itself is impressive given the swing away from a 50 bps hike in March and a 10 bps decline in the implied yield of the December Fed funds futures. It was the first weekly decline since the end of last November.

The high for the week (and month, so far) was set at early and in last three sessions chopped up to around the middle of the range. It closed slightly above 96.00 on the week. The range could be extended by 0.50 in either direction without being a strong signal. The MACD has flatlined, while the Slow Stochastic is trending higher.

Euro

The euro bottomed on Feb. 14 near $1.1280 and recovered to almost $1.1400 by the middle of the week. The euro closed the week at a four-day low, a little above $1.1320. The long-holiday weekend in the US, within the context of the heightened tensions in Eastern Europe, may have weighed on the euro and risk appetites more broadly.

The MACD looks to have turned lower, and the Slow Stochastic has been trending down. It takes a break of the $1.1260 area to warn of a possible test on last month's low near $1.1120. The economic data highlight is the preliminary February PMI. It will be released on Monday when the US is on holiday.

The easing of the virus may have helped services rebound, while manufacturing likely remained at elevated levels (58.7 in January). That may be sufficient for the composite to rise for the first time since November and only the second time since last July.

Japanese Yen

The geopolitical tension and sharp losses in US stocks sent the greenback to two-week lows slightly below JPY114.80 before the weekend. While the settlement was just above JPY115.00, it was below the 20-day moving average (~JPY115.10) for the second consecutive session.

The trendline that connects the Jan. 24 low (~JPY113.45), the Feb. 2 low (~JPY114.15), and the Feb. 14 low (~JPY115.00) was violated on a closing basis on Feb. 17 and was unable to resurface it ahead of the weekend. It looks to begin the new week a little below JPY115.50.

The exchange rate continues to be more correlated with the S&P 500 than the 10-year yield. Over the past 30 sessions, the correlation of the changes is about 0.55 for the S&P 500 and the exchange rate compared with practically zero for the 10-year Treasury yield and the exchange rate. The momentum indicators are trending lower. Initial support is seen around JPY114.60.

Below there, the band of support in the JPY114.00-JPY114.15 may be more formidable. The economic data highlight in the week ahead is the preliminary PMI reading. Recall in January, as new COVID-19 measures were taken, the composite slipped below the 50 boom/bust level. After growing at an annualized rate of 5.4% in Q4 21, the Japanese economy may be fortunate to grow 1% in Q1 22. 

British Pound

Sterling may be added to the list of false breaks seen in the foreign exchange market so far this year. It managed to settle above $1.36 on Feb. 17 for the first time in nearly a month, but no follow-through buying materialized, and it settled a little below there the following day.

Despite a string of strong data, including CPI, retail sales, and employment, the swaps market saw a sharp decline in the perceived likelihood of a 50 bps hike when the BOE meets again in mid-March. The odds have fallen from a 75% chance to a little more than 35%. The pullback ahead of the weekend pared the week's gains, but still managed to extend its advance for the third consecutive week.

Still, the cable still appears to remain range-bound, and most activity continues on the $1.35-handle. Sterling continues to trend higher against the euro. Through last week, it has risen in nine of the past 11 weeks. Year-to-date, sterling is the strongest of the major currencies, rising by about 0.5%. The euro has fallen by about the same amount.

Initial euro support is seen in the GBP0.8285-GBP0.8300 area. As COVID-19 restrictions were relaxed, the UK services sector is likely to improve, and this is expected to be picked up by the PMI. 

Canadian Dollar

The US dollar has been confined to a fairly clear range against the Canadian dollar this month. The CAD1.2650-CAD1.2660 band marks the lower end, and the cap is CAD1.2800. The correlation between the exchange rate and the risk-environment (S&P 500 proxy) has fallen sharply in recent weeks. The 30-day rolling correlation is a little more than 0.25, down from nearly 0.75 at the end of last year.

On the other hand, the correlation with the two-year yield differential has risen to about 0.4 from around 0.05 at the end of 2021. The Slow Stochastic is trending lower, but the MACD has flatlined. The economic calendar is light next week. The efforts by the Canadian government to quash the protests, using financial institutions and the expanded police powers, may eventually prevail - but at a significant cost for the minority Liberal government.

Nevertheless, the domestic political developments appear to be having minimal impact on the exchange rate. Meanwhile, unlike the US and UK, the swaps market did not change much for Canada much last week. The odds of a 50 bps rate hike were steady at a little below 50%.

Australian Dollar

The Antipodean currencies led the majors higher last week (New Zealand dollar ~0.75% and Australian dollar ~0.55%). The Aussie's high for the week was set ahead of the weekend a little below $0.7230, but the risk-off that prevailed saw it settle at a three-day low slightly above $0.7175. The MACD is rising gradually and is near the year's high. The Slow Stochastic appears to have begun rolling over.

This month's high was set near $0.7250, but the market shows little inclination to challenge it. Initial support is seen around $0.7140, and a break could spur losses toward $0.7100. The Australian dollar rose to eight-month highs against the New Zealand in the middle of last week near NZD1.08. It fell back to nearly NZD1.07 before the weekend.

A top of some import appears to be in place. While some support may be seen around NZD1.0660, the first significant test could be closer to NZD1.0575, the low from mid-January. The flash composite PMI may rebound from the collapse in January (to 46.7 from 54.9).

Given the importance the Reserve Bank of Australia has attached to wage growth, the Q4 21 in the middle of next week will likely draw attention. Recall that the four-quarter moving average rose by 2.2% in 2018 and 2019. It fell back to 1.7% in 2020 and that is where it was in Q3 21.

With the anticipated 0.7%, the year-over-year rate will increase to 2.4%, but the four-quarter average will still below 2%. The swaps market shifted away from a June hike. The first hike is fully discounted for July, and for 140 bps of tightening over the near 12-months.

Mexican Peso

The US dollar fell for the third consecutive week against the Mexican peso. The 1.20% decline was the largest in two months. Since the end of last November, the greenback has risen in only two weeks against the peso. Consider that the four-week US T-bill pays an annualized rate of one basis point while the one-month cetes pays a little more than 6%. The carry attracts.

Also, the peso is a liquid proxy for emerging market currencies more broadly. The JP Morgan Emerging Market Currency Index is up about 2% so far this year, while the peso has gained 1.2%. The swaps market has nearly 200 bps of tightening priced in for Mexico over the next 12 months.

After flirting with it at least half a dozen times this year, the dollar finally was sold through the 200-day moving average (~MXN20.34) in the middle of last week and has now closed below it for three consecutive sessions. The MACD has rolled down, and the Slow Stochastic has entered overextended territory. There is little chart support ahead of the MXN20.12.

On the upside, a move back above MXN20.50 would suggest a low is in place. Although Mexico-'s bi-weekly CPI (year-over-year) has remained above 7% since mid-November, it has decelerated from 7.7% to almost 7% at the end of January. There is some risk that it picked up again in the first half of this month. Nevertheless, less likely a 50 bps hike is in the US, the more likely a 25 bps hike by Banxico is when it meets on March 24, a week after the Fed.

Chinese Yuan

For the last four sessions, the PBOC's dollar fixing has been weaker than the median the Bloomberg survey projected. Is it significant? At most, one can say that it is a reversal of the recent relationship and it may not be consistent with the comments seemingly meant to cap the yuan earlier this year. The dollar fell by about 0.45% against the yuan last week, the most in about three and a half months.

The dollar is approaching CNY6.32 low of Jan. 26, which was the lowest since 2018, when it bottomed a little below CNY6.2450. Technically, the gap from late January (CNY6.3235-CNY6.3363) was nearly completed with the dollar's pre-weekend loss. A break could spur a move toward CNY6.30.

China's premium over the US on 10-year rates has stabilized after hitting a three-year low of almost 70 bps on Feb. 10. It finished last week closer to 85 bps, owing almost exclusively to the pullback in the US yield. It is a light week for Chinese economic data. More economic stimulus appears to be expected.