Three events stand out next week: the preliminary PMI readings for many high-income countries and the policy meetings of the Federal Reserve and the Bank of Canada. The geopolitical backdrop remains elevated over the build-up of Russian troops and armament seemingly poised to invade Ukraine. No new talks between Russia and the US are scheduled (yet?).

Meanwhile, the surge in COVID-19 cases appears to be slowing in some parts of Europe and the US, while Japan imposed quasi-emergency rules in Tokyo and thirteen prefectures until mid-February. China appears to be stepping up its zero-COVID-19 efforts as the Olympics approach.

The collapse of December US retail sales (-1.9%) and the unexpected drop in industrial output gives the world's largest economy little momentum. Indications last week showed the New Year is off to a poor start. The January Empire State manufacturing survey crashed to -0.7 from almost 32 in December.

Economists understood that activity slowed. The median forecast was for 25.0 in the Bloomberg survey, warning the slowdown may be much sharper than economists have understood. The evaporation of new orders (-5.0 vs. 27.1 in December) is particularly troublesome. While the January Philadelphia Fed survey appeared better, the details were disappointing. 

The slowdown also appears to be taking place in the Eurozone. The German stats office warned that the economy contracted between 0.5% and 1.0% in Q4 21. Market rates are rising. The German 2-year yield rose by around 20 bps since end of last November to reach its highest level since April 2019 (~-0.55%), before falling in second half of last week.

The 10-year yield briefly turned positive for the first time since May 2019. The ZEW January survey found that the assessment of the current situation fell to -10.2, the lowest since last May, and worse than economists projected.

The preliminary January PMIs will be reported and weakness should be expected. However, this is not new. The Eurozone composite PMI was at 53.3, the lowest since March. It fell in four of the past five months. The trend in the UK has been similar. The composite PMI has fallen in five of the past seven months, and at 53.6 is the weakest since last February.

The US composite PMI has held in better. At 57.0 in December, it was the lowest since September. But the recent trend has been clear. December was the sixth month of slowing in the last seven months of 2021.

Japan is marching to the beat of a different drummer. It recovered from the long COVID-19 slump in September, though recall that it was below the 50 boom/bust level in Q4 19. The composite PMI rose above 50 last October, yet it pulled back slightly in December. The conditions that are leading to the imposition of new restrictions may weigh on the PMI.

Because of its July-September flare up of COVID-19, Australia's composite PMI profile looks a bit like Japan's with a recovery briefly seen before softening in December. The composite spent Q3 below 50. It bottomed in August at 43.3 and improved to 55.7 in November before easing back to 54.9 in at the end of the year. Lockdowns may weigh on activity. 

More notable are the Bank of Canada and Federal Reserve meetings. The Bank of Canada meeting concludes early in the North American session on Jan. 26 and the FOMC meeting ends later on the same day. Rather than re-hash how we got here, let's simply recognize both central banks are about to initiate a sequence of rate hikes. The markets have been pricing in an aggressive move in the months ahead.

The overnight index swaps (OIS) curve has about 160 bps of tightening priced in for the Bank of Canada this year and another 30 bps in 2023. In effect, compared with the end of last year, the market has moved to discount another rate hike this year. The two-yield has jump 30 basis points in the first three weeks of the year. At the end of 2021, the market leaned slightly in favor of a January rate hike (~55%). Now it is a little above 70%.

The Bank of Canada ended its bond buying last October. In addition to hiking rates, the Bank of Canada may also provide some forward guidance about its balance sheet strategy. Most aggressive would be to stop the recycling maturing proceeds almost immediately, say, next month. However, more likely, officials would give investors more notification.

The following meeting is March on 2. The point is that like the Bank of England and Federal Reserve, the Bank of Canada will likely allow its balance sheet to unwind considerably earlier than after the Great Financial Crisis. 

Even though most of the real sector data softened in December, the market's reaction to the FOMC minutes and official comments is to price in a more aggressive trajectory of Fed policy. Consider that on New Year's Eve, the futures market was pricing in about a 63% chance a 25 bps lift-off hike in March and nearly three hikes this year.

Now the market is pricing in the March hike and a small chance 50 bps move. Moreover, the market is 100% confident of four hikes this year. At its peak, before the equities swooned, the Fed funds futures had about a one-in-three chance of a fifth hike priced. The swaps market has 102 bps of tightening discounted for this year and around 50 bps next year. 

In his confirmation hearings, Fed Chair Powell suggested that the officials have begun discussing its balance sheet strategy. It may take two-four meetings to reach an agreement. This would also the Fed's balance sheet to begin unwinding late Q2 or Q3.

Indeed, many watchers seemed split between June and July. When the balance sheet begins to unwind is one issue, the pace is another. Last time, it began at a $10 billion pace a month, and a year later it was lifted to $50 billion a month. Atlanta Fed’s Bostic has suggested he favors a reducing the balance sheet by $100 billion a month.

Also, unlike the previous episode, Fed officials seem to be talking about unwinding the balance sheet to complement or even supplant rate hikes. The December FOMC minutes said that "some participants" argued that tightening more from the balance sheet than rate hikes "could help limit yield curve flattening." Price pressures were considerably stronger now than they were in the 2017-2018 period.

There is still a great deal of uncertainty over quantitative easing and its opposite. Bernanke once quipped to much amusement that QE works in practice but not in theory. While most discussions are around quantities and prices, we find that the signaling channel is often under-appreciated.

Consider Japan. It has reduced its asset purchases quietly and indicated there were no implications for monetary policy, which would remain highly accommodative. Sure enough, the market reaction has been muted. The ECB has also fluctuated its purchases of sovereign bonds but appears to be little perceptible market impact.

Finally, we note that the day after the FOMC meeting concludes, the US will announce its first estimate of Q4 GDP. The advanced merchandise trade balance the day of the FOMC meeting give economists fodder for last minute adjustments. Unfortunately, personal consumption expenditures (PCE), a key input for GDP, comes out at the end of the week.

However, the 1.9% drop in December retail sales has already pressured forecasts lower for PCE. The median forecast (Bloomberg) is for a 0.4% contraction. The Bloomberg median forecast for Q4 GDP has slipped in recently from 6% to 5.3%. The Atlanta Fed's GDP tracker has fallen to 5.1% from 7.3% late last year.

With inflation top of mind, the PCE deflator will attract attention. It may have stabilized in December. It may not be at the peak, but it is close. The 0.3% rise in the headline rate in January and February 2020 (0.2% and 0.1% in the core rate, respectively) may make for easy comparisons.

One implication is that in the near-term, the core may converge with the headline rather than the other way around. However, the year-over-year of inflation may begin slowing later in Q1 or Q2. Polls find that inflation is held against Biden and helps explain why the Democrats are still projected to lose both houses of Congress in November.

Politics are always bubbling near the surface of the foreign exchange market. The focus next week is on Italian presidential selection process. One possible scenario that may be best received by the market would entail the current president (Mattarella) agreeing to stay a little longer, as a caretaker like Napolitano did in 2013.

This would allow Draghi to lead his coalition government until the end of the legislative session next year. It would provide a steady hand at what is arguably an inflection point. Italian bonds would likely rally on such a development and it could lend the euro support.

Meanwhile, in the UK, Gray's internal investigation of the government parties during social restrictions is expected. It may not reveal a smoking gun, but it may do little to bolster the Prime Minister's support, while other reports talk about a handful of Tory MPs considering defecting to Labour. One increasingly gets the sense that Johnson is fighting for his political life.