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USD Bears Cheer | CN PMI Fell Short

A report by CYS Global Remit Strategic Sales Management Team

USD Bears Anticipating Fed Rate Cut | skip to SGD/CNY

Expectations for the Federal Reserve to cut interest rates have been rising in recent weeks, and the market has priced in a 100bp interest rate cut next year. Two weeks ago, the United States released CPI, PPI, and retail sales data one after another. All three data showed signs of further easing of inflationary pressures.

Among them, the latest CPI in October ended its rebound in the past three months and fell back to 3.2%. The core CPI fell back to 4% y/y, which was worse than the expected 4.1%. However, the Michigan Consumer Confidence Report showed that U.S. short-term inflation expectations rose to a seven-month high in November, and inflation expectations for the next 5 to 10 years rose to 3.2%, the highest level since 2011.

Fed Governor Christopher Waller’s comments last week solidified expectations for an interest rate cut. He believed that the current interest rate level is enough to return inflation to the 2% target level, and said that if the data continues to decline in the next 3 to 5 months, he will consider an interest rate cut. And this has nothing to do with whether the economy is in recession. Therefore, the current focus falls on the timetable for interest rate cuts. The FOMC is scheduled to meet again on December 12-13, which will be the Fed’s last meeting this year.

At present, the market is highly enthusiastic about interest rate cuts expected to begin in June next year. We watch for the December dot plot, which will show the Fed's determination and prediction of interest rate cuts.

U.S. Treasury Secretary Yellen gave a pretty dovish stance last Thursday. She believes the U.S. economy does not need to further tighten monetary policy significantly to eliminate inflation expectations and is expected to achieve a "soft landing" due to strong employment. Yellen mentioned that in the past, the Fed sometimes has had to tighten monetary policy significantly to prevent inflation from becoming entrenched in the economy, leading to recessions.

Some analysts also believe that although the interest rate hike cycle is likely to end, oil prices, geopolitical tensions, economic growth, etc. have made future inflation full of uncertainty. It seems difficult for the Federal Reserve to explicitly cut interest rates, as the Fed refuses to get complacent in its fight against inflation. This suggests that the current market pricing is too advanced i.e., the Fed will be the first to cut rates.

Last Wednesday night, data showed that the revised annualized quarterly rate of real GDP in the United States in the third quarter was 5.2%, higher than the initial estimate of 4.9% and the forecast of 5%, the fastest growth rate in the past two years. GDP grew faster in the third quarter than initially estimated, reflecting upward revisions to business investment and government spending, which appeared to disrupt expectations for a rate cut.

Data released on Thursday showed that the U.S. personal consumption expenditures (PCE) price index rose 3% y/y in October, still higher than the Federal Reserve's 2% target. The number of Americans filing for unemployment benefits increased last week.

After U.S. inflation reached a 40-year high of 9.1% in June 2022, the Federal Reserve began aggressive interest rate increases, pushing interest rates to the highest level in 20 years. Although inflation fell to 3.2% as of October, it is still well above the Fed's forecast level and its 2% target.

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.

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.

With the Fed at the end of its tightening cycle, we are beginning to see the moderate-to-soft USD profile playing out, as the FX market is forward-looking. We still think that for the market to fully 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. For now, we expect emerging currencies to start recovery against the greenback, with the higher-for-longer narrative fading in favor of a dovish Fed pivot.

China’s PMI a Let Down

China’s factory activity contracted further in November, as the world’s second-largest economy continues to battle a fragile economic recovery. China's official manufacturing Purchasing Managers Index (PMI) released last Thursday fell to 49.4 from 49.5 in October, lower than the expected 49.71. The official non-manufacturing PMI in November also slipped to 50.2, down 0.4 percentage points from the previous month, falling for two consecutive months, and hit a new low for the year, but still maintained above the 50-mark which separates expansion and contraction.

The decline in PMI is not only affected by factors such as some industries entering the traditional off-season in November and insufficient market demand, but also shows that the momentum of economic recovery still needs to be strengthened. The focus in the next step is on expanding domestic demand, giving priority to the restoration and expansion of private enterprise investment and household consumption while strengthening employment security and taking multiple measures to further consolidate the foundation for economic recovery.

China's official manufacturing and service PMIs have not met expectations, further raising expectations for policy support. The overall policy tone will be disclosed at the upcoming Central Economic Work Conference, and fiscal policy is expected to be the focus.

The reaction from China and China-related markets after the PMI data was released was almost negligible, further reinforcing expectations that more stimulus measures are on the way. The USD/CNY exchange rate has almost no fluctuations in response to PMI, and the market seems to be more concerned about changes in U.S. bond yields.

The market should be prepared for further RMB appreciation and more short squeezes are expected, especially if driven by seasonal factors. Starting from 2017, November to January are the traditional months for foreign exchange settlement. The RMB has appreciated significantly. But over time, the marginal effect will gradually weaken. In particular, the current interest rate gap between China and the United States is still wide, and the sharp short-term rebound of the RMB may attract carry traders to enter the market, that is, go long the USD again to earn more interest rate differentials. Therefore, subsequent changes in the Fed's monetary policy remain crucial.

We believe that the USD index is the pricing anchor for the central parity of the RMB. We also note that the USD index is greatly affected by the strength of European currencies. If the euro turns softer, the USD will "passively strengthen". In the short term, the RMB exchange rate is expected to enter a two-way fluctuation range at the 7.1 mark.

In terms of interest rate differentials between China and the United States, after rapidly trading in expectations of the end of the Fed’s interest rate hike cycle and US economic cooling, the short-term downward trend in U.S. bond yields will slow down marginally. From the perspective of the domestic economy, the Central Economic Work Conference is expected to further increase efforts to stabilize growth, which will provide support to the RMB exchange rate.

China's Monetary Policy Execution Report for the third quarter of 2023 released by the PBoC stated that it will adhere to a managed floating exchange rate system based on market supply and demand and adjusted with regards to a basket of currencies. China’s central bank reinforced its commitment to focus on the long term and pledge to resolutely correct procyclical market behavior, deal with behavior that disrupts market order, and prevent the risk of exchange rate overshooting. It aims to maintain the basic stability of the RMB exchange rate at a reasonable and balanced level.

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 weaker USD (due to softer US CPI prints) contributed to the continued strengthening of the RMB. A further decline toward the psychological key 7 level before year-end remains on the cards. The recent RMB exchange rate has returned to the appreciation channel, mainly due to the continuous decline of the USD index and changes in market expectations. Even though China's latest PMI in November fell short of expectations, it did not affect the trend of the Chinese yuan at all.

At present, the Federal Reserve has announced the suspension of interest rate hikes twice in a row, and U.S. inflation has fallen back to a moderate range. The market has judged that the U.S. interest rate hike cycle is over and will choose a looser policy to support the U.S. economy. The USD index has continued to fall, and the yields on 10-year treasury bonds in China and the U.S. interest rate spreads continue to narrow. Additionally, year-end is typically the seasonal peak of foreign exchange settlement. As the demand for RMB exchange settlement increases, the RMB exchange rate is expected to rebound strongly.

Looking forward, as the unilateral strong trend of the USD index against non-U.S. currencies comes to an end, and with strong support from the steady recovery of domestic economic fundamentals, the RMB exchange rate will gradually rise back to a reasonable price range consistent with the currency value.

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