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Strong US inflation reading and hawkish comments from Fed officials were the main theme in the markets last week. While much volatility was seen in the stock markets, major indexes remained rather resilient. Dollar got practically no support from expectation of three Fed hikes year this, and tumbled broadly. Euro finally broke out of range against the greenback, but it still ended as the second weakest.

On the other hand, Yen ended as the best performer on speculation that BoJ could finally start talking about rate hikes. Canadian Dollar was the second best, help by the extended rise in oil prices. Other commodity currencies ended mixed, puzzled by the lack of clear direction in risk sentiment. Sterling was also mixed as recent rally in crosses appeared to be losing momentum.

Fed officials and markets firming up expectation of three hikes this year

With US consumer inflation hitting 40-year high at 7%, Fed officials became more vocal on the need to raising interest rate. A March lift-off looks more certain than even. And, just as December's dot plot suggests, three rate hikes this year is the baseline, but some FOMC members are clearly open to more. Another question now is when the balance-sheet run-off would start, after three to four hikes, or sooner. According to Fed funds futures, three hikes to 0.75-1.00% by the end of the year is still the main scenario. There is less than 40% chance priced in for higher rates.

Stock investors refusing to give up, SPX holding above trend line

Much volatility was seen in US stocks last week. There were times when major indexes tumbled sharply at open, but reversed to close higher. Investors were refusing to give up. S&P 500 is still holding well to medium term trend line support. The up trend is still in favor to resume at a later stage through 4818.62 towards 5000 handle. Nevertheless, considering bearish divergence condition in daily MACD, break of 4531.10 support will suggest that SPX is already in correction to the rise from 3233.94. Deeper fall would then be seen to 38.2% retracement of 3233.94 to 4818.62 at 4213.27.

Dollar index in medium term correction after steep fall

Dollar was given no support from intensifying expectation of Fed rate hikes. The greenback has indeed ended as the worst performing one for the week. That's partly due to the catch up in global benchmark yields. Even Japan's 10-year JGB yield is now at 0.15 while Germany 10-year yield is on the verge of turning positive.

Dollar index dropped sharply to as low as 94.62 last week before recovering to the end. Price actions from 96.93 are currently viewed as a correction to up trend fro 89.20 only. Deeper fall could be seen but there should be strong support from 38.2% retracement of 89.20 to 96.93 at 93.97 to contain downside. However, sustained break of 93.97 will argue the trend might have reversed and deeper fall could be seen to 61.8% retracement at 92.15 and possibly below.

Yen jumped as BoJ might start to telegraph rate hike soon

Yen's rally was rather impressive last week considering that risk aversion couldn't actually take shape. Based on multiple sources, Reuters reported that BoJ policymakers are already debating whether it's time to start communicating the possibility of an eventual rate hike to the markets. While the hike itself is hardly imminent, that would involve some change in the forward guidance. Also, it's possible that the move in rates would come even before core inflation hits the 2% target.

The considerations came at a time when the higher prices are already built into the public's expectations. According the the December public opinion survey, 78.8% respondents said they expect price levels to go up one year from now. That's a notable increase from September's 68.2% and the highest level since 2019. Among them, 13.4% said prices will go up significantly, comparing to September's 8.4%.

AUD/JPY's recovered to 83.73 last week but was quickly knocked down. Fall from 84.27 resumed by breaking through 82.31 support. With the channel support broken, deeper fall is now in favor back to 80.25 support first. But overall, AUD/JPY could be unfolding a medium term corrective pattern in range of 77.88/86.24. Price actions could be rather mixed and unpredictable for a while.

WTI to test 85.92, EUR/CAD to test 1.4162

Canadian Dollar ended as the second strongest thanks to persistent rally in oil prices. WTI crude oil extended the rise from 62.90 and met target of 161.8% projection of 62.90 to 73.66 from 66.46 at 83.86. For now, such rally is still viewed as the second leg of the consolidation pattern from 85.92 only. Hence, we're not expecting a firm break of 85.92 yet. Instead, another fall should be seen before the consolidation completes. Break of 77.97 support will indicate rejection by 85.92 and target 73.66 resistance turned support first. However, firm break of 85.92 could pave the way to 90 handle.

While EUR/CAD's rebound from 1.4162 was slightly stronger than expected, it appeared that it's complete at 1.4644 already. Deeper fall will remain in favor as long as 55 day EMA (now at 1.4426), to retest 1.4162 low. Whether EUR/CAD could break through 1.4162 low to resume larger down trend might depend on WTI's reaction to the above mentioned 85.92 resistance. Rejection by 85.92 could help floor EUR/CAD at or above 1.4162, and bring rebound to extend the corrective pattern with another rising leg.

USD/JPY Weekly Outlook

USD/JPY's steeper and deeper than expected decline last week suggests that rise from 112.52 has completed at 116.34 already. But as a temporary low was formed at 113.47, initial bias is turned neutral this week for some consolidations. Risk will stay on the downside as long as 116.34 resistance holds. Below 113.47 will target 112.52 structural support. Considering bearish divergence condition in in daily MACD, break of 112.52 will confirm that it's already in correction to the up trend from 102.58. Deeper decline would be seen to 38.2% retracement of 102.58 to 116.34 at 111.08.

In the bigger picture, no change in the view that rise from 102.58 is the third leg of the up trend from 101.18 (2020 low). Such rally should target a test on 118.65 (2016 high). Sustained break there will pave the way to 120.85 (2015 high) and raise the chance of long term up trend resumption. However, firm break of 112.52 support will dampen this bullish case and we'll assess the outlook based on subsequent price actions later.

In the long term picture, the rise from 75.56 (2011 low) long term bottom to 125.85 (2015 high) is viewed as an impulsive move, no change in this view. Price actions from 125.85 are seen as a corrective pattern which could still extend. In case of deeper fall, downside should be contained by 61.8% retracement of 75.56 to 125.85 at 94.77. Up trend from 75.56 is expected to resume at a later stage for above 135.20/147.68 resistance zone.

Monday, Jan 17, 2022

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Tuesday, Jan 18, 2022

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Wednesday, Jan 19, 2022

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Thursday, Jan 20, 2022

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Friday, Jan 21, 2022

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Summary

United States: Not Through with 2021 Just Yet

• Inflation is intensifying and consumer activity is cooling, data covering the month of December reveal. The Consumer Price Index (CPI) rose 7.0% year-over-year, the fastest increase in nearly 40 years. Similarly, the Producer Price Index (PPI) was up 9.7% over the year. Meanwhile, retail sales unexpectedly declined 1.9% in the final month of the year.
• Elsewhere, the NFIB Small Business Optimism Index edged up to 98.9. Industrial production slipped 0.1%, as supply constraints held down manufacturing production. Consumer sentiment fell to 68.8 in January, the first solid sign that the Omicron surge is weighing on economic activity.
• Next week: Housing Starts (Wednesday), Existing Home Sales (Thursday), Leading Index (Friday)

International: U.K. GDP Advances While Australian Retail Sales Surge

• In the G10, U.K. November GDP rose an encouraging 0.9%, while Australia retail sales rose by 7.3% month-over-month in November, the largest gain since May 2020. In emerging markets, price pressures remain present in Brazil, as December CPI came in higher than expected at 10.06% year-over-year, still well above the Central Bank of Brazil's 3.5% target for 2022.
• Next week: China GDP (Monday), U.K. CPI (Wednesday), Japan CPI (Friday)

Interest Rate Watch: When Will the Federal Reserve Shrink Its Balance Sheet, and by How Much?

• The outlook for U.S. monetary policy has shifted significantly in recent months. With tighter monetary policy on the horizon, market attention has turned to possible reductions in the Fed's asset holdings, which total nearly $9 trillion at present, up from $4.2 trillion before the pandemic.

Credit Market Insights: Mortgage Rates Are on the Rise

• According to Freddie Mac, the average rate on a 30-year fixed-rate mortgage jumped almost a quarter of a percent this week, rising to 3.45% from 3.22%—the highest level since the pandemic's onset in March 2020.

Topic of the Week: U.S. Dollar Stumbles to Start the Year

• A hawkish shift from the Fed has not been enough to prevent the U.S. dollar from tumbling to start 2022. Following a year where the broad dollar index (DXY) rose close to 6.5%, in the first few weeks of this year the same index has dropped a little over 1%.

Full report here.

U.S. Highlights

• Equity markets saw further losses this week, following more hawkish messaging from the Fed. Between Powell and Brainard’s confirmation hearings and other Fed speakers, the signals for a March rate hike are flashing loud and clear.
• December’s inflation data supported the case for a rate hike, with headline inflation reaching 7% year-on-year (y/y). Core inflation also surprised to the upside, and is now up 5.5% y/y – the highest reading in 30 years.
• Retail sales showed a loss of momentum to end the year, as inflation erodes consumer purchasing power. Consumer spending is looking weaker in both the fourth quarter of 2021 and the first quarter of 2022 relative to our latest forecast.

Canadian Highlights

• The economic calendar was unusually empty this week, but the next week will be anything but. Inflation numbers, the Bank of Canada Business Outlook Survey and Survey of Consumer Expectations will be in focus ahead of the Bank of Canada meeting in two week’s time.
• Inflation has been running hot in Canada, well above the Bank of Canada 2% target. The recent Omicron wave is expected to exacerbate existing supply chain issues, restraining growth and pushing prices higher in the near-term.
• The housing market is another area where prices have been rising rapidly. Monday’s report on home sales and prices is likely to echo this, showing another month of gains in both sales and prices amid low inventory.

U.S. - Eyeing Inflation Like a Hawk

Equity markets experienced further losses this week, following more hawkish language from Fed officials that signaled rate hikes could kickoff as early as March. The S&P500 has fallen just over 3% from the beginning of the year. Treasury yields continue to march higher as markets adjust their expectation for monetary policy.

Looking at the recent inflation data, the case for rate hikes is clear. Headline CPI ended the year up 7% year-on-year (y/y), the fastest pace since 1982. In December, the month-on-month pace of inflation cooled slightly to 0.5%, as energy prices were a drag on the headline for the first time since April. But, core inflation was even hotter, up 0.6% m/m, driven by strong increases in shelter inflation and another jump up in used vehicle prices. While those items were the biggest contributors, prices were up strongly for a host of goods and services, continuing a trend of broadening price pressures that has been evident since October – the same month that Fed Chair Powell changed his tune on whether the run up in inflation is transitory.

Accelerating goods prices take much of the blame for inflation’s 40-year record high (Chart 1). You have to go back to 1980 to see goods prices rising 12% in one year. Goods prices should cool over the coming year as production, inhibited by the pandemic and global input shortages, begins to normalize. But, just as it does, service price growth looks to accelerate. Services prices were up 4% year-on-year in 2021, an acceleration from a 3% pace immediately prior to the pandemic, but not out of line with past periods of economic strength. This is likely to move even higher in 2022, keeping pressure on the Fed to tighten policy.

The impact of elevated inflation is already evident in retail sales. Retail sales surged in the spring as a third round of stimulus payments from Washington hit Americans’ bank accounts. Nominal sales have plateaued, in part as consumption shifts away from goods, which dominate retail sales, and towards services. However, when you compare to sales adjusted for overall inflation, you see how price growth has increasingly eroded consumer purchasing power (Chart 2). Given that goods prices are up more than services, the picture is even more dire.

Any way you slice it, December’s retail sales data showed that consumer spending lost momentum towards the end of the year. Our December forecast projected real personal consumption expenditure growth around 6% in the fourth quarter. The data released since suggests that it is going to be closer to 4%. It also provides a soft starting point for the first quarter, where spending is likely to slow to 2% as consumer caution on Omicron weighs on close-contact services.

Inflation is also cutting into wage growth, something that has not gone unnoticed by Fed officials. At his Senate confirmation hearing, Fed Chair Jay Powell delivered his most hawkish messaging on inflation yet. Fed Governor Lael Brainard, who is the nominee for Vice Chair of the FOMC to succeed Richard Clarida, echoed his remarks, mentioning that workers are worried about how far their paychecks would stretch. Other Fed officials who spoke this week similarly signaled that interest rates are forthcoming, likely beginning as early as March.

Canada - All Eyes on Inflation

The economic calendar was unusually empty this week, but the next week will be anything but quiet, with a number key data releases on the docket. With this week's news of inflation south of the border hitting a 7% mark, all eyes will be on inflation numbers in Canada next Wednesday. Fanned by the similar flames of rising goods prices amid supply-chain bottlenecks and strong consumer demand, inflation has been running hot in Canada as well, though reassuringly more than two points below its U.S. counterpart (Chart 1).

Even while below its U.S. counterpart, inflation is well above the Bank of Canada 2% target. Rising prices have been felt acutely by producers and consumers alike. Indeed, just as important as actual inflation for the central bank, is consumers and businesses expectations for its future evolution. This puts the focus on the Bank of Canada Business Outlook Survey and Survey of Consumer Expectations. Those surveys will shed light on inflation expectations among businesses and consumers at the time when the Omicron wave was taking hold. These will take an added importance ahead of the Bank of Canada meeting in less than two weeks.

While those surveys won't capture Omicron's full impact, they will likely still show an increase in the businesses' near-term inflation expectations and pricing plans. In December's CFIB survey, small businesses' intentions to raise prices over the next 12 months reached a survey's high at 4.6%. At the same time, small businesses' concerns about shortage of inputs and distributional challenges continued to mount, weighing on their ability to ramp up production. Labour shortages, already acute before the Omicron hit, will be made worse in the near-term as workers become sick or are required to isolate. All in all, while Omicron's impact is expected to be relatively short-lived, supply-chain issues may take a turn for the worse in the near-term, restraining growth and pushing prices higher.

The housing market is another area where prices have been rising rapidly, leading to a significant deterioration in housing affordability. Monday's report on home sales and prices is likely to echo this, showing another month of gains in both home sales and prices amid low inventory.

This week's Bank of Canada research showed that first-time buyers are increasingly unable to get their foot in the housing market's door, facing high prices and intense competition from investors and repeat buyers. The share of home purchases by the first-time buyers fell by 3 percentage points since the start of the pandemic, reaching a new low in the mid-2021 at 46.8%, down from 49.8% at the start of the pandemic (Chart 2). Low variable rates on mortgages are boosting demand for real estate. More than 50% of new mortgages borrowers in recent months opted out for a variable rate mortgage. This could be another reason for the Bank of Canada to expedite rate liftoff.

Can earnings season soothe investors’ nerves?

It’s been a turbulent start to the year in the markets and that’s unlikely to change as we move into earnings season. Fear of high inflation and accelerated monetary tightening is driving much of the volatility that we’re seeing in financial markets over the last couple of weeks and that’s unlikely to abate any time soon, with peak inflation still probably ahead of us.

Earnings season could go some way to easing the nerves in the coming weeks as we get a reminder that the economy is still in a strong position despite the challenges it’s facing. But even this comes with an element of uncertainty given that omicron hit in late November which will undoubtedly have had an impact. Of course, as we’ve seen the last two years, there are also winners when consumers stay at home and restrictions are imposed.

Ultimately though, central banks remain at the top of the list for investors right now and next week offers a selection of meetings, minutes, and speakers that will surely attract a lot of attention. It’s hard to look past the CBRT on Thursday as being one of the highlights next week. After an aggressive easing cycle that’s come at a huge cost, will the central bank finally slam on the breaks?

US

The upcoming week is busy with economic data and earnings results.  Goldman Sachs, Bank of America, and Morgan Stanley will close out earnings for the big banks, while Procter & Gamble may give a better look at how much further price increases the consumer may have to expect.  On Tuesday, the Empire Manufacturing Index should show activity cooled in January.  Wednesday is all about housing activity that might show both building permits and housing starts edged down.  On Thursday, initial jobless claims are expected to resume declining, while the Philadelphia business outlook is anticipated to improve, and Existing home sales may show a small decline.

The blackout dates are in effect for the Fed, so it will be quiet until the January 26th FOMC meeting. With financial markets pricing in over a 90% chance that the Fed will raise rates in March, Treasury yields appear to be forming a range just below the 1.80% level.

EU 

With the ECB being among the minority of central banks still singing from the transitory hymn sheet, the focus next week will be on the ECB accounts from December, comments from policymakers including President Christine Lagarde on Monday, and the final inflation numbers for December. At 5%, inflation is uncomfortably high and the central bank may soon finally buckle like the rest if pressures don’t soon ease.

UK

The data dump week for the UK, with labour market, inflation, and retail sales all being released. But Wednesday is undoubtedly the standout, with Governor Bailey due to speak hours after the CPI release which could make for some interesting comments. Three or four rate hikes are expected this year so expectations are quite hawkish but as we’ve seen recently, there is a growing fear that more will be warranted.

Russia

No major data or economic events next week so the focus will remain on the various geopolitical risks that Russia has found itself at the centre of. A possible invasion of Ukraine is very much top of the list, with the week of intense talks between the US and Russia seemingly failing to lead to any breakthrough.

Russia is also intrinsically linked to the energy crisis in Europe which is intensifying as more outages in French reactors put further pressure on limited reserves.

South Africa

Inflation data next week is expected to show price pressures increasing, with the CPI rising to 5.7% which will increase calls for more rate hikes from the SARB.

Turkey

A rare period of relative stability for the lira which is unlikely to last, as the CBRT meets next week. Can the central bank resist the urge to cut again or are more sharp losses on the horizon? Not cutting could provide some support for the lira as it may signal an end, for now, of the easing cycle. 

China

China releases fourth-quarter GDP and Retail Sales on Monday. The markets are braced for a downturn in growth, with a consensus of 3.5%, down from the gain of 4.9% in Q3. This would mark the weakest GDP report since Q2 2020.

Retail Sales are forecast at 3.8% y/y in December, down from 3.9% beforehand. The government has enacted a zero-Covid strategy, which has restricted travel and dining out. Slow income growth is also hurting consumers and has put a dampener on consumer spending.

China’s property sector remains in deep crisis, with no signs of any improvement on the horizon. Evergrande and other developers owe billions and investment growth and household loans have decreased. The government has eased restrictions on real estate funding but these measures have so far proven ineffective.

China house price index is released on Saturday which could put a dampener on the open if it’s particularly bad news. The previous release showed 3% growth though and it’s widely regarded as low impact data.

Also on Monday, ahead of the GDP release, the PBOC will decide whether to maintain the MLF rate at 2.95%.

India

No major economic data or events next week.

Australia 

Australia releases key employment data for December next week. Employment change is expected to slow to 60,000, down from 366,100 in November. The unemployment rate is forecast to ease to 3.5%, down from 3.6%.

Iron ore prices rose to their highest level in three months, as heavy rains engulfed Brazil’s mining region, which has sparked supply concerns.

New Zealand

It’s a quiet economic calendar next week. On Thursday, New Zealand releases the BusinessNZ Manufacturing PMI for December. The PMI was stagnant in November, with a reading of 50.6 points.

Japan

Inflationary pressures in Japan are much lower than those in the UK or the US, but inflation is nonetheless moving higher after years of deflation. The Bank of Japan is expected to maintain its ultra-loose policy at its meeting on Tuesday, but will likely revise up its view of inflation risks for the first time since 2014.

Inflation remains well below the bank’s target of 2%, but the BoJ could look to raise interest rates before it achieves it.

Economic Calendar

Saturday, Jan. 15

Economic Data/Events

• China new home prices

Sunday, Jan. 16

• The US’ National Retail Federation opens its annual Retail’s Big Show expo at Javits Center, New York

Monday, Jan. 17

Economic Data/Events

• US equity and bond markets are closed for Martin Luther King Jr. holiday
• China GDP, retail sales, industrial production, surveyed jobless, property investment, medium-term lending
• Handelsblatt Energy Summit with German Economy Minister Habeck
• Finance ministers of the Euro region meet in Brussels
• Japan PM Kishida speaks to parliament
• Canada existing home sales
• Poland CPI
• Japan industrial production, core machine orders, tertiary industry index
• Singapore electronic exports
• Russia Trade
• Norway Trade
• Philippines overseas remittances
• UK Rightmove house prices
• Switzerland sight deposits, Bloomberg January economic survey
• Turkey central government budget balance

Tuesday, Jan. 18

Economic Data/Events

• US cross-border investment, empire manufacturing, NAHB Housing Market Index
• BOJ Rate Decision: No change to monetary policy, may adjust its view of inflation risks
• Japan industrial production, capacity utilization
• EU finance ministers meet in Brussels and hold a policy debate on global minimum taxation for multinational companies.
• Australia consumer confidence
• Canada housing starts
• Eurozone new car registrations
• Germany ZEW survey expectations
• New Zealand house sales
• Russia Trade
• Mexico international reserves
• UK jobless claims, unemployment
• Poland CPI
• Switzerland producer and import prices
• South Africa mining, gold, and platinum production
• Turkey house price index
• Sweden Riksbank Gov Ingves speaks on a panel at a blockchain and stablecoin conference

Wednesday, Jan. 19

Economic Data/Events

• US housing starts
• UK CPI, house price index
• French President Macron addresses European Parliament
• BOE Gov Bailey speaks to UK Parliament Treasury Committee
• Canada CPI
• Germany CPI
• South Africa CPI
• Eurozone construction output
• Australia Westpac consumer confidence
• New Zealand card spending
• South Africa retail sales
• Russia current account
• Bank Earnings from BoA and Morgan Stanley

Thursday, Jan. 20

Economic Data/Events

• US existing home sales, initial jobless claims
• ECB Minutes to December policy meeting
• BOJ Minutes of December meeting
• UK RICS house prices
• Norway Rate decision: Expected to keep rates steady
• Turkey Rate decision: Expected to keep rates steady
• Hungary Rate decision: Expected may keep rates steady
• Eurozone CPI
• Hong Kong CPI
• Russia CPI
• Japan Trade
• China loan prime rates, swift global payments
• Australia unemployment, consumer inflation expectations, RBA FX transactions
• New Zealand food prices, ANZ Truckometer heavy traffic
• Germany PPI
• Taiwan export orders
• Mexico unemployment
• Spain house transactions, trade
• France business and manufacturing confidence
• Netherlands unemployment, consumer spending
• Poland consumer confidence
• EIA Crude Oil Inventory Report
• Netflix reports earnings after the bell

Friday, Jan. 21

Economic Data/Events

• US Conf. Board leading index
• Japan CPI
• UK Retail sales
• BOE Mann speaks at the Official Monetary and Financial Institutions Forum
• Canada Retail
• Eurozone Consumer confidence
• Bank of Italy releases the Quarterly Economic Bulletin
• Turkey Consumer Confidence
• New Zealand performance of manufacturing index, net migration
• Singapore home prices
• Switzerland Money supply
• Russia Money supply
• Thailand trade, forward contracts, foreign reserves
• China FX net settlement
• Poland sold industrial output, construction output, employment, PPI

Sovereign Rating Updates

• EFSF (DBRS)
• ESM (DBRS)

The Bank of Japan will conclude its first monetary policy meeting of 2022 on Tuesday and publish an updated set of economic forecasts. So far, the BoJ has been excluded from the global central bank race to normalize policy amid skyrocketing inflation in many parts of the world. However, with price pressures swelling in Japan too, the January meeting might see the Bank take a baby step towards the hawkish side. The question is, would a slightly less dovish stance do much for the yen’s prospects in the short term?

BoJ may soon get its wish of untaming inflation

Policymakers in Japan have been striving for decades to boost inflation in the country but to no avail. Things may be about to change, however, as the pandemic and the ensuing health and economic policy responses have created a price shock that no one could have predicted at the onset. While Japan’s consumer price index currently stands at a paltry 0.6% year-on-year versus a staggering 7.0% in the United States, the inflation picture isn’t quite so subdued under the surface.

Businesses are facing mounting cost pressures as the global supply-chain bottlenecks and the surge in commodity prices is pushing up prices. Japan relies heavily on imports for its raw materials as well as for its energy needs so there is no escape from the changing global inflation landscape. Making matters worse is the yen’s depreciation against the US dollar; a weaker exchange rate makes imports more expensive.

In the past, Japanese firms have found it difficult to pass higher costs onto price-conscious consumers, but they may have no choice this time given the scale of the squeeze on their profit margins.  Wholesale prices have already shot up to a record high of 9.0%. Inflation expectations among businesses and households are also on the rise, although they remain at low levels for now.

Will the BoJ sound the inflation alarm?

It shouldn’t come as much of a surprise therefore if the Bank of Japan ups its inflation projections in its latest outlook report on Tuesday. The bigger question for investors, though, is just how much more worried policymakers have become about inflation. Governor Haruhiko Kuroda has suggested that inflation could soon reach 2%. Yet, unless wage growth catches up, the comparatively modest spike in consumer prices won’t be seen as a risk to an economy that’s been mired in deflation since the 1990s.

Money markets aren’t flagging a rate hike over the next year, although the odds are inching higher for 2023. However, a rate increase isn’t the BoJ’s only option. It might first decide to tweak its yield curve control policy by widening the target band on the 10-year Japanese government bond yield (currently 20 basis points above or below zero). Sovereign bond yields have been rallying lately as the major central banks pivot towards tighter policy so it’s quite probable the BoJ’s yield target could be tested should speculation heat up about higher rates in Japan too.

It may be too early to get less bearish about the yen

But such a shift in market expectations could be months away and, in the meantime, it’s still all about yield differentials due to other central banks’ actions as far as the yen is concerned. The Fed’s increasingly hawkish tone pushed the greenback to a five-year high of 116.14 yen earlier this month.

A correction is now in process, dragging the pair down to the 38.2% Fibonacci retracement of the November-December down leg at 113.66. A deepening of the correction could see the December trough of 112.28 yen being revisited. However, should the dollar perk up again, the next major target for the yen bears will be the 161.8% Fibonacci extension of 117.36.

To sum up, tighter policy seems some way off still in Japan. But with Japanese exports enjoying strong demand and the BoJ’s own surveys pointing to improved economic conditions, policymakers may not be so hesitant to respond to the rising threat of inflation. Reports suggest that discussions have already started on how the forward guidance on rates should be updated once inflation starts to approach 2%. The danger for the markets is that after such a long period of monetary easing in Japan, the timing of any change in the policy direction may catch them off guard.

Part II: Are Stablecoins Really "Stable"?

Summary

• Stablecoins, which are a category of digital currency, have many favorable characteristics. Payments can be settled essentially instantaneously, and "unbanked" individuals can easily use them. Their supplies are not limited, so potential problems with deflation do not arise with stablecoins as they potentially could with limited forms of digital currencies.
• Unlike other cryptocurrencies, such as Bitcoin and Ether that exhibit extreme levels of price volatility, the values of stablecoins tend to be stable. Many stablecoin issuers claim that their tokens are fully "backed" by reserves.
• However, assets that can experience their own periods of illiquidity and price dislocation represent a significant proportion of the reserves of some stablecoin issuers. If the confidence of investors in the value of their holdings is shaken, then stablecoin issuers can experience "runs," much like commercial banks before the advent of deposit insurance and the creation of a robust supervisory and regulatory framework.
• If the explosive growth that stablecoins have enjoyed in recent years continues in coming years, then periods of financial market volatility could potentially become extreme.
• Stablecoin issuers have largely operated in a regulatory vacuum until now. But regulators have become acutely aware of the potential risks that stablecoins present, and they are scrambling to catch up. Some federal agencies have recommended that Congress pass legislation that would require stablecoin issuers to become insured depository institutions, which would be subject to supervision and regulation by the appropriate regulatory bodies.
• Furthermore, private stablecoin issuers may soon face competition from central banks that are gearing up to issue their own digital currencies. We will discuss central bank digital currencies (CBDCs) in Part III of this series.

NOT A DEPOSIT. NOT PROTECTED BY SIPC. NOT FDIC INSURED. NOT GUARANTEED. MAY LOSE VALUE. NOT INSURED BY ANY FEDERAL GOVERNMENTAL AGENCY

This commentary is provided for information purposes only and does not contain any recommendations or investment advice. The Firm makes no recommendation as to the suitability of investing in digital assets, including cryptocurrencies. Investments in digital assets carry significant risks, including the possible loss of the principal amount invested. It is only for individuals with a high risk tolerance who can withstand the volatility of the digital asset market. Investors should obtain advice from their own tax, financial, legal and other advisors, and only make investment decisions on the basis of the investor's own objectives, experience and resources.

Stablecoins: Benefits of Digitization Without Price Volatility

In the first report of our series on cryptocurrencies (a.k.a. digital currencies), we discussed their ability to perform the three basic functions of money as well as some of their benefits and drawbacks. In terms of the functions of money, their use as a unit of account is limited at present. That is, prices of most goods and services continue to be expressed in terms of national currencies (e.g., U.S. dollars, euros, etc.) rather than in cryptocurrencies per se. Digital currencies are being used as mediums of exchange, albeit still well short of the volume of transactions that are being processed via national currencies at present. They can provide good stores of value, at least when held over long periods of time. But the high degree of price volatility that is inherent in digital currencies can limit their ability to serve as a store of value for individuals and businesses in the short term. Furthermore, the investment options of cryptocurrencies are limited at present, because there has been no issuance of crypto-denominated securities, to the best of our knowledge.

But there is a class of cryptocurrencies, which are known as "stablecoins," that possess the benefits of digitization without the extreme price volatility of some other digital currencies, such as Bitcoin and Ether. As the first half of their name implies, prices of stablecoins tend to be stable, because their values are essentially pegged to another asset, such as a national currency. For example, Tether, which is the most widely used stablecoin, is convertible to U.S. dollars at a ratio of 1:1 and the issuers of Tether claim that every token is fully backed by $1 worth of dollar-denominated assets.1 Since it started trading in 2015, the day-to-day price fluctuation of Tether has generally been less than one-hundredth of a cent. That said, there have been episodes when the price has moved by significantly more, a topic to which we will subsequently return. Other widely used stablecoins include USD Coin and Binance USD, which also have very low price volatility.

Stablecoins have a number of benefits, some of which are inherent to all digital currencies and some of which are specific to stablecoins. Similar to all cryptocurrencies, payments made in stablecoins can be settled essentially instantaneously. This is especially important for payments that are made across national borders, which historically have been time-consuming and characterized by high transactions costs. In addition, stablecoins could be used to make costless payments for "unbanked" individuals, which we discussed in more detail in Part I. But what sets stablecoins apart from other digital currencies is that the former do not have wild swings in value, thereby enhancing their property as a short-term store of value. Furthermore, the supply of stablecoins is not limited. Consequently, the potential deflation issue associated with a limited money supply that we discussed in our first report does not arise with stablecoins.

But stablecoins do not overcome some notable drawbacks of digital currencies. Similar to other cryptocurrencies, there has been no issuance to date, to the best of our knowledge, of securities that are denominated in stablecoins. Therefore, individuals who own stablecoins earn a rate of return of 0%, unless they place those tokens in a crypto savings account, which we briefly noted in Part 1. But because stablecoins do not have wild swings in value, corporate treasurers in coming years could potentially start to issue securities that are denominated in stablecoins, which would enhance their quality as a store of value. In addition, stablecoins could be used increasingly by individuals and businesses to make payments due to their stable values.

Stablecoins Are Potentially Vulnerable to "Runs"

But there is a more significant drawback to stablecoins that was highlighted in a recent speech by Federal Reserve Governor Christopher Waller. Specifically, stablecoins are issued by the private sector and, in essence, stablecoin issuers resemble 19th century commercial banks. As long as depositors in that bygone era were confident that they could withdraw all of their money from their bank, the system was sound. But as soon as that confidence was shaken, a "run" on the bank could ensue that could lead to the collapse of the bank. In a full-blown panic, such as what occurred in 1893 and again in 1907, the entire banking system was potentially at risk. The Federal Deposit Insurance Corporation (FDIC) estimates that about 9,000 American banks failed between 1930 and 1933, which contributed to the depth and the severity of the Great Depression.

In response, Congress created the FDIC in 1933 to guarantee the value of banking accounts. Today, the FDIC guarantees checking and savings accounts up to $250,000 per depositor, per insured bank. Furthermore, deposit-taking institutions are regulated and supervised by federal and state agencies. The existence of deposit insurance in conjunction with a robust supervisory and regulatory framework gives individuals confidence in the safety of their deposits. Bank runs, which were commonplace prior to the establishment of the FDIC and federal regulatory bodies, have been exceedingly rare since 1933.

In contrast, the value of stablecoins are not guaranteed and stablecoin issuers are not currently regulated. Many stablecoin issuers claim that their coins are "backed" by some other asset(s). For example, the issuers of Tether state that "every Tether token is always 100% backed by our reserves," which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties." In that regard, the most recent independent accountant's report, which was published in September 2021, showed that "commercial paper and certificates of deposit" accounted for more than 40% of Tether's assets. Normally, the commercial paper (CP) market is deep and liquid with interest rates on high-quality CP only a few basis points above rates paid on Treasury bills (Figure 1).

However, the CP market can become illiquid during times of financial stress. As Figure 1 makes clear, CP spreads spiked during the 2008 financial crisis and again in March 2020 when the global economy was going into free fall amid the onset of COVID-19. This sharp rise in CP interest rates relative to T-bill rates implies that prices of CP nosedived. In other words, the value of the assets that, at least in part, "back" stablecoins fell sharply, and owners of stablecoins no longer had assurance that each token they owned was fully convertible into one U.S. dollar. Selling of stablecoins ensued, causing their prices to fall. As shown in Figure 2, the price of Tether dipped to $0.97 in March 2020. The price of USD Coin also fell during that period.

Periods of market dislocations, as occurred in March 2020, can potentially initiate negative feedback loops. That is, marked declines in CP prices can lead to weakness in stablecoin prices. Selling of CP by stablecoin issuers to finance redemptions puts added downward pressure on CP prices, which can then lead to further price declines of stablecoin prices, etc. Furthermore, dislocations in one asset market, such as the CP market, can quickly spill over to other asset markets. The Federal Reserve moved quickly to pump liquidity into financial markets in March 2020, but the price dislocations experienced in the CP and stablecoin markets during that period could have been more extreme and long-lasting had officials not acted so nimbly and adeptly. Stablecoins had not yet been created in 2008, but the sharp price declines experienced in the CP market during the global financial crisis undoubtedly would have put significant downward pressure on prices of stablecoins, had they existed at that time. Because the size of the stablecoin market has grown exponentially—the market capitalization of Tether, which is just one stablecoin among many, has shot up from about $4 billion at the beginning of 2020 to roughly $78 billion at present—stablecoins represent a potential risk to the financial system.

There is also the issue of market power. There are numerous issuers of stablecoins at present, but as demonstrated by other tech platforms over the past few decades, one company can become dominant due to network effects. For example, there initially were many "word processing" software programs available when the technology was first developed. But Microsoft Word eventually emerged as the program that essentially all individuals wanted to adopt, because a "critical mass" of other individuals were using it. The same winnowing process could eventually occur with stablecoins, which could lead to an undue amount of market power for that issuer. Is it good public policy to allow the payment system of an economy to be controlled by a small handful of private companies without public sector oversight?

Regulators Are Increasing Their Focus on Stablecoin Issuers

As noted previously, stablecoin issuers are not regulated at present. But regulators are attuned to the risks that stablecoins potentially pose, and they are increasing their focus on them. The Federal Reserve, the FDIC and the Office of the Comptroller of the Currency (OCC) recently conducted a series of "policy sprints" and, as highlighted in a recent joint statement, they plan to begin issuing guidance "on whether certain activities related to crypto-assets conducted by banking organizations are legally permissible." As these agencies note, this guidance will apply only to the activities of banks, not to other platforms. But the use of the word "sprint" reflects the sense of urgency that the explosive growth in digital currencies, and its associated implications for the financial system, has imparted on regulators.

Regarding regulation that is specific to stablecoins, the President's Working Group on Financial Markets (PWG) recently issued a report in November 2021 that asks Congress to pass legislation requiring stablecoin issuers to become insured depository institutions.2 These institutions would have access to the liquidity facilities of the Federal Reserve, and the value of the tokens that are issued by these institutions would be guaranteed, up to a limit, much as bank deposits are guaranteed up to $250,000 by the FDIC. These institutions would also be subject to supervision and regulation by the appropriate regulatory bodies and to liquidity and capital requirements, much as "traditional" depository institutions (i.e., commercial banks and credit unions) are currently subjected. Furthermore, the PWG report recommends that stablecoin issuers be restricted from affiliating with commercial entities, much as commercial banks are generally prohibited from owning or being owned by a non-bank enterprise.

It is an open question whether Congress will ultimately choose to follow the PWG's recommendations. Congress could enact its own set of guidelines or choose to ignore the issue entirely. But even in the event that Congress does not authorize a broad and comprehensive regulatory framework, there may be some limited steps, which were highlighted in a recent speech by Treasury Undersecretary Liang, that agencies can take under current authorization to provide some regulatory oversight of stablecoin issuers. In short, the days of laissez-faire in the stablecoin market are probably numbered. Not only are regulators poised to undertake some degree of oversight, but some central banks are gearing up to issue their own digital currencies, which could create competition for privately-issued stablecoins. We will turn to central bank digital currencies (CBDCs) and their implications for the financial system in Part III of this series.

Conclusion

Similar to all digital currencies, there are some significant benefits associated with stablecoins. They allow payments to be made essentially instantaneously, and "unbanked" individuals could use stablecoins provided they have a mobile phone. Issuance of stablecoins can be unlimited, so the potential deflationary risk that arises with digital currencies with limited issuance does not arise. Their attractiveness as a short-term store of value is enhanced by their generally stable values.

But there is a notable drawback to stablecoins at this time. Specifically, their values are not insured, as commercial bank deposits are, and stablecoin issuers are not regulated at present. Consequently, in periods of heightened financial stress, such as autumn 2008 and March 2020, stablecoin issuers could potentially experience destabilizing "runs." If the explosive growth that stablecoins have enjoyed in recent years continues in coming years, then periods of financial market volatility could potentially become extreme.

Government regulation usually lags developments that occur in the private sector, and stablecoin issuers have largely operated in a regulatory vacuum. But regulators are becoming attuned to the risks that stablecoins potentially present, and they are scrambling to catch up. Although it is not clear what sort of legislation Congress may eventually enact, the days of laissez-faire in the stablecoin market are probably numbered. Furthermore, private stablecoins issuers may soon face competition from digital currencies that are issued by central banks, which is the topic of our next report in this series.

Endnotes

1 tether-assurance-sept-30-2021.pdf. (Return)

2 The PWG was created in 1988, and it is chaired by the secretary of the Treasury. Other members include the chair of the Board of Governors of the Federal Reserve System, the chair of the Securities and Exchange Commission, and the chair of the Commodity Futures Trading Commission. (Return)

In a crowded week for Canadian data releases, we expect the headline CPI inflation rate to stand out. The measure will likely accelerate to 4.9% year-over-year from 4.7% in November. Omicron-related weakness in energy products is expected to have been offset by persistent strength in expenses tied to home and car purchases. Indeed, this is largely what we saw in U.S. CPI releases last week. Combined, homes and cars explain roughly half of the inflation in Canadian core CPI (excluding food and energy products) relative to pre-pandemic (February 2020) levels. As weaker prices early in the pandemic—especially for energy products—drop out of the year over year calculation, we expect the headline inflation rate to plateau before dialing lower in coming months. But even as those distortions fade, price pressures from ongoing supply chain challenges, higher input prices, and strong consumer demand will continue to broaden. Almost 60% of the consumer price basket has already been growing at a more than a 2% annual rate compared to pre-crisis levels.

Next week’s Q4 Bank of Canada Business Outlook Survey (BOS) will be carefully scrutinized for further evidence of those price pressures. Capacity limits—including difficulties in sourcing and retaining both capital and labour—already topped business concerns in prior editions of the survey. There were tentative signs that supply chain pressures were easing late last year as the surveys suggested supplier delivery times had edged lower and Canadian auto production bounced back from disruptions tied to the global semiconductor shortage. But labour shortfalls are expected to remain a key obstacle for business growth. The latest BOS survey period (mid-November to early December) came too early to capture the full impact of Omicron, but the rapid spread of the variant and large numbers of workers required to self-isolate are likely adding to labour shortages in the near-term. The tone of the Bank of Canada commentary will be watched closely for hints at how worried the bank has grown over the latest COVID wave. However, with the economic impact of Omicron expected to be relatively short-lived and inflation and capacity pressures persisting, we don’t expect a delay in rate hikes. Central bank communications in January will likely be used to signal the first increase in March or April.

Week ahead data watch:

We see no reason to deviate from StatCan’s early estimates of a 3.1% increase in manufacturing sales for November. The increase was driven in part by higher auto production as supply chain issues eased, at least temporarily, and came despite significant transportation disruptions due to severe flooding in B.C. late in the month.

Our forecast for retail sales is in line with the advance estimate from StatCan of 1.2% for November. Our latest tracking of consumer spending suggests sales of merchandise dipped lower in December. Spending on services is not captured in the monthly retail sale data, but there was a much larger pullback in travel spending in December.

Canadian housing starts are expected to have remained solid at 270k in December after a larger 301k add in November, in line with still-strong levels of building permit issuance in recent months.

The Bank of Japan will be in the spotlight next week. It will likely reaffirm that rates won’t rise for a long time, leaving the yen at the mercy of foreign central bank moves and risk appetite. The People’s Bank of China will also meet and could loosen policy to empower economic growth, although its actions are usually more important for stock markets rather than FX. 

BoJ - A hint of optimism

The Japanese economy is turning a corner. A weaker yen has helped boost exports, businesses are becoming more confident according to the latest Tankan survey, the unemployment rate stands at just 2.2%, and the nation has finally escaped deflation.

All that sounds good, but the economy is not out of the woods yet. Consumption remains weak, wage growth is anemic despite the tight labor market, and the Omicron wave that is sweeping through the country is a major threat to the recovery.

The inflation rate speaks for itself. It is barely positive despite massive supply disruptions and soaring energy prices, so ‘organic’ inflationary pressures remain subdued.

This means that while the central bank might strike a slightly more optimistic tone next week, any tightening moves are still far away. Recent media reports suggest the BoJ is debating when it can start telegraphing an eventual rate hike, but that’s unlikely to happen until next year.

As for the yen, relative monetary policy suggests the outlook remains negative, especially against the currencies that will be enjoying higher rates, like the dollar or sterling. That said, there are a couple of factors that could prevent deep losses in the yen.

The first is the massive spending package the new Prime Minister is about to unleash to power up the recovery. Beyond that, with liquidity being withdrawn from the global financial system, volatility episodes in the markets could become more frequent, allowing the defensive yen to enjoy brief periods of strength.

The trend seems negative, but it could be a stormy ride.

Chinese GDP in focus

Over in China, the show will get going on Monday with GDP numbers for the last quarter. Retail sales, industrial production, and fixed asset investment for December will also be released. All these indicators are expected to have lost steam, with annual GDP growth slowing to 3.6% from 4.9% previously.

That’s no surprise considering the crisis in the property sector and the energy shock during that quarter, not to mention the recent lockdowns in many cities as the government sticks to its zero-covid policy.

But it could be a case of ‘bad news is good news’ if GDP numbers are weak, since that would give the People’s Bank of China the perfect excuse to loosen policy again to counter the economic slowdown.

Liquidity measures from the PBoC typically impact the local stock market the most, but if traders sense this could stabilize the economy, there could be some effect on China-sensitive currencies like the Australian dollar too.

Speaking of Australia, the nation’s employment report for December will be released on Thursday. The aussie has recovered substantially lately as iron ore prices jumped, yet the outlook is still clouded.

Markets are pricing in four rate hikes by the Reserve Bank this year, which seems over-optimistic and allows room for disappointment. The Australian economy is not that strong and could suffer spillover effects from China, its largest trading partner by far.

Data dump from UK 

There is also a heavy barrage of data releases from the United Kingdom. The ball will get rolling with jobs numbers for November on Tuesday, ahead of inflation stats for December on Wednesday and retail sales on Friday.

Sterling enjoyed a very strong start to the year, drawing fuel from intensifying speculation that the Bank of England will raise interest rates again next month. The implied probability of a hike at that meeting currently stands at 78%.

The pound’s ability to stage such a powerful rally despite weak risk sentiment in the markets is quite impressive and suggests monetary policy expectations are really what’s driving FX markets right now.

Markets get excited about Canada

Meanwhile, the Canadian economy is improving at such a dramatic pace that markets now assign an 80% chance for a rate increase this month, in contrast to the Bank of Canada’s latest guidance that April is the earliest possible date. As such, the upcoming inflation stats on Tuesday and retail sales on Friday could be crucial.

All in all, a rate increase this month seems like a bridge too far. While the labor market is booming and inflation is hot, wage growth remains below pre-pandemic levels and Omicron is rampaging through the country, with many provinces imposing tougher restrictions lately. This could keep the BoC hesitant to take any risks for now.

The loonie has bounced back with force lately thanks to this speculation and the rebound in oil prices, and although the big picture remains favorable, it may be in for a disappointment by the central bank later this month.

Financial markets saw a shake-out early this week on the back of the more hawkish Fed, now signalling a rate hike already in March when tapering of asset purchases is done. US 10-year bond yields continued to rise to 1.8% and stock markets took a dive. Money markets now price close to 100% probability of four hikes from the Fed this year, which seems fair. However, calm was restored in the middle of the week after Fed governor Jerome Powell argued that the Fed would be able to tame inflation and that it could happen without too much damage to the economy. But yesterday stocks took a dive again in response to hawkish comments from more Fed members.

Another new high in US inflation in December at 7.0% y/y, the highest level since June 1982, was digested fairly well by markets. The increase was in line with consensus but core inflation surprised slightly to the upside rising to 5.5% y/y (consensus 5.4% y/y) from 4.9% y/y. The muted market reaction to the number would suggest that high inflation is to a wide extent already expected by the market. We look for inflation to stay high in the short term as for example the latest increase in used car prices in the US is not yet fully factored into CPI. The same goes for the CPI shelter component. But from Q2 22 we expect price increases to gradually taper off. Inflation is set to be high for all of 2022, though, and with the tightest US labour market in decades the Fed needs to act to rein in inflation.

Despite the hawkish turn of the Fed, EUR/USD moved higher this week. It has been looking technically oversold for a while and with investors still being long USD, there seems to be some profit taking on this trade. However, we see scope for USD turning stronger again as the Fed departs on its hiking journey in a few months.

In China inflation pressures are easing as producer prices (PPI) saw the biggest monthly drop (-1.2% m/m) since April 2020. The decline is due to lower commodity price inflation; we believe this will soon lead to a peak in PPI and headline CPI in US and Europe as well. Falling inflation pressure leaves room for PBOC to ease policy further in coming months.

Omicron continues to drive big waves of Covid around the world. But there are also signs of a peak in some European countries and the Northeastern US states that have been hit the worst. It adds to hope that Omicron will not overwhelm hospitals and could mark the end of the pandemic as we know it. Of course, the risk of new mutations also still looms.

Talks between Russia and US/NATO this week did not change much. Russia stated yesterday that they regarded the talks as unsuccessful but had the will to continue talks. In the paper Research Russia - Expect serious market disruptions if a war breaks out, 14 January, we look at different scenarios for the conflict.

The coming week looks to be fairly uneventful. China kicks off the week with GDP for Q4 on Monday as well as industrial production and retail sales. They will likely confirm that Q4 was weak. We look for a cut in China's policy rate. In the US we get regional business surveys (Philadelphia and Empire) and in Europe, we expect to see the German ZEW and Euro consumer confidence to decline due to the triple headwinds of Covid outbreaks, supply bottle necks and an erosion of household income from the high inflation, see Euro Macro Monitor - Tripple headwinds, 10 January 2022. On Thursday, the Turkish central bank may cut rates.

Full release here.