A report by CYS Global Remit Strategic Sales Management Team
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The Federal Reserve's attitude towards monetary policy can be said to be one of the most important factors supporting the rise of the USD for most of the year. Financial markets currently expect that Federal Reserve officials will gradually abandon their "hawkish" monetary policy stance as the labor market gradually cools. However, this expectation is far from deterministic and there are still large variables.
Last week, hawkish comments from Fed officials underscored the need for the central bank to remain vigilant about inflation, with Fed Governor Michelle Bowman saying further interest rate increases may be necessary and Chicago Fed President Austan Goolsby Goolsbee adding that policymakers did not want to "pre-commit" rate decisions. Minneapolis Fed President Neel Kashkari said last Monday local time that despite positive signs that price pressures are easing, it is too early to declare victory over inflation. Kashkari hinted that the Fed's current interest rate hike cycle is not over yet and is inclined to further raise interest rates in the future.
Fed’s Harker reiterated his view that policymakers should keep interest rates on hold because aggressive rate hikes are taking a toll on the economy. Harker said in his speech: "There is always a lag in monetary policy, and keeping interest rates stable will give these lagging factors time to catch up. Stabilizing the benchmark interest rate in the range of 5.25%-5.5% will allow us to make more prudent and informed decisions going forward. I must add that these decisions could have two outcomes, depending on the data." Harker also said he sees a "slow but steady slowdown in inflation" and expects inflation to fall below 3% in 2024 and reach the 2% target thereafter. The Fed will keep interest rates higher for longer.
Fed Chair Powell capped off last week with a hawkish tone, warning that good price data has the risk of being "misleading" and that there is "still a long way to go" for U.S. inflation to return to the 2% level. He added that the Fed is still not confident that it can achieve its goal of reducing the inflation rate to 2%. Powell further stressed that the Fed would continue to act cautiously to "deal with both the risk of being misled by several months of good data and the risk of overtightening." According to the Financial Times, this shows that the Fed is not eager to raise interest rates again immediately.
Since the July meeting, the Federal Reserve has remained on hold at two consecutive meetings, and the market expects the central bank to still not raise interest rates at the last FOMC meeting of the year next month. This is a big deal because historically, five months without a rate hike marks the end of the Fed's tightening cycle.
Expected data shows that traders in the bond market currently generally expect the Fed to cut interest rates by about 92 bp next year, while Fed officials predict a 50 bp interest rate cut in 2024 in the FOMC dot plot. A growing number of bond traders are betting that interest rate cuts from the world's major central banks will begin before the summer, challenging claims that policymakers will keep rates "higher for longer" for the foreseeable future.
For the world's major central banks such as the Fed, regardless of whether officials currently support interest rate cut expectations, the downward trend in Treasury yields is likely to ease financial conditions, thereby weakening the impact of the aggressive interest rate hike policies they have implemented.
We expect emerging market currencies to begin appreciating significantly against the USD for most of next year. After taking a beating throughout 2022 and much of 2023, most emerging market currencies have been buoyed in recent days as the Federal Reserve kept interest rates on hold last week, and October employment data suggested the U.S. economy may finally be starting to soften.
The market's expectations for the end of the Fed's interest rate hike cycle and an interest rate cut in June next year can be said to challenge policymakers' statement that they will keep interest rates "higher for longer" in the foreseeable future.
Our view is the Fed is done with its tightening cycle. We continue to hold the view that even if the Fed completes raising interest rates, it is unlikely that Fed officials will formally announce a halt to rate hikes. After all, the Fed has repeatedly surprised itself with the economy's resilience and is more willing to leave the door open to further rate hikes.
Fed officials’ hawkish remarks last week show how the “higher-for-longer” narrative and the Fed’s tightening bias remain very much in the game. It also signals to USD bears not to be complacent, as interest rate policy languages continue to pose an upside risk for USD. Last week’s calendar was packed with Fedspeaks, leading to choppy price actions. We watch the US CPI prints closely out on 14 Nov. That is a risk event for the market. A softer print will likely push the USD lower, while more entrenched CPI data will reinforce the “higher-for-longer” market narrative and pose an upside risk for the USD.
With the Fed at the end of its tightening cycle, we opine for a moderate-to-soft USD profile to play out eventually. However, for the market to support that narrative, we need to see Fed officials introduce “rate cuts” in their interest rate policy languages – which is not expected to happen until the first half of 2024.
China’s Deflationary Risk
The National Bureau of Statistics reported that the national consumer price index (CPI) in October slipped into negative territory, falling by 0.2% y/y and 0.1% m/m. The latest data underlines the deflationary risk that the world’s second-largest economy faces, as it struggles to rebound from a post-pandemic slump. In October, the national industrial producer price (PPI) fell by 2.6% y/y and remained unchanged m/m.
The fall in October’s CPI is mainly driven by a decline in food prices. In October, the price of pork fell by 30.1% y/y, causing the CPI to fall by about 0.55 percentage points. The price of eggs and fresh vegetables also fell by 5.0% and 3.8% respectively, dragging the CPI down by about 0.04 and 0.08 percentage points.
Domestic prices have been persistently low, which many blame on the aftermath of the epidemic suppressing demand. From the end of last year to the beginning of this year, after the anti-epidemic policy was gradually lifted, a common assumption is that domestic demand will rebound with a vengeance, reversing the decline during the epidemic in one fell swoop. Economic statistics in the first quarter of this year provided some comfort for this view to be realized. However, the good times did not last long, and the growth momentum failed to maintain in the second quarter. Some believe that the slump in the second quarter is just that demand has not fully recovered, corporate adjustments have not been in place, and the effect of macroeconomic control has lagged. They categorically deny that the overall economy is experiencing deflation. Latest data shows China’s exports shrank 6.4%, a much faster pace than expected, reflecting the world's second-largest economy still faces persistent external risk.
This situation of low prices and insufficient consumption appeared long before the epidemic. We can attribute them to two simple explanations: - (1) Cyclical - normal ups and downs of the economic cycle (2) China’s economy will inevitably slow down after so many years of rapid growth. These two explanations are undoubtedly too general, and both are suspected of evading and trivializing the important. We believe that there are three major reasons for the current looming deflation. Firstly, China's long-term financial burden, especially local debt, and real estate problems, has restricted the space for monetary and fiscal policy control. Secondly, the allocation of domestic economic resources is not very reasonable. Then comes the triple whammy (1) Policy uncertainty is strong (2) large enterprises lack confidence (3) small and medium-sized enterprises lack opportunities. Thirdly, the entire international environment is not conducive to the development of an export-oriented economy, and the "world factory" model faces the risk of being disintegrated.
We see mild deflation in the economic cycle as something that is not alarming. What can be alarming is when deflation becomes a chronic disease and then turns into a long-term economic depression, which is the so-called "Japanese disease." Paul Krugman, the Nobel Prize winner in economics who has always been "biased" against the Asian economy, pointed out in 2016 that the Chinese economy at that time was very similar to the Japanese economy in 1989, and warned that the Chinese economy might follow in the footsteps of the Japanese economy. Recently, he has become even more pessimistic and believes that once the economy moves towards deflation, Chinese society will face more difficult problems than Japan, not just economic depression.
We opine that the Chinese economy is a large and complex economic machine. If most economists can get the US economy wrong this year when they predicted a US recession, the Chinese economy is harder to judge. We see the Chinese economy recovering, just that the recovery is uneven in different places and industries. More importantly, we think that the Chinese government must figure out how to resolve the property bubble that is deflating and taking banks and local governments with it.
We have always maintained our take that improvement in economic fundamentals is crucial to revive investors’ risk-on sentiments, and encourage foreign fund flows back into the world’s second-largest economy. For now, a stronger USD (due to higher-for-longer Fed rhetoric) favors a near-term deprecation of the RMB against the greenback.