There is a battle being waged. It is not a currency war, which some observers and journalists have tried to resurrect. For years, people have asked about the bond vigilantes, the reputed defenders of hard money. They have come out of hibernation, stirred higher inflation in most places. That said, several countries in East Asia, including Japan and China do not have an inflation problem, regardless of their debt levels, size the central bank's balance sheet, or stimulus efforts.
The vigilantes are lifting swaps rates dramatically, over central bank objections (recent examples include the European Central Bank and the Reserve Bank of Australia). Rising global rates have pushed Japan's 10-year bond yield to near the limit under the Yield Curve Control. Rather than abandon it, the BOJ has offered to buy an unlimited amount of bonds at 0.25% on Monday to defend it against the vigilantes.
Of the major central banks, the Federal Reserve is perceived to be the one more tied to market expectations. That the swaps market has around a 75% chance of a 50 bp hike next month becomes a new fact in that the FOMC will take into consideration in a way that the market pricing in 67 bp of ECB tightening over the next year will not. Similarly, there is no sign that the Reserve Bank of Australia is about to capitulate to the swaps market, which sees 50 bp of tightening in the next six months and about 145 bp over the next 12 months.
In late trading before the weekend, the US warned that Putin has decided to invade Ukraine as early as next week. US bonds rallied after the European close. The dollar was bought and stocks sold-off sharply. This risk-off move will likely carry into the start of next week.
Where does this leave the dollar's exchange rate?
Dollar Index: The Dollar Index peaked in late January near 97.40. It sold off and forged a base near 95.15. The bounce with the surge in interest rates in the second half of last week and the threat of Russia's invasion of Ukraine with in days, lifted it to around 96.00 to complete the (38.2%) retracement target. The next retracement target (50%) is about 96.30 and then 96.65. The peak in late January was around 97.45. The momentum indicators are poised to turn up. The trendline connecting the October, January, and February lows begin the new week near the base (95.15) and a break could see the 94.60 area.
Euro: The widening US premium ground the euro lower and a new leg down was spurred by the fear of a Russian invasion of Ukraine. It finished with new lows for the week ahead of the weekend. Recall that it began last week with a six-session rally in tow, trying to again break out of the $1.12-$1.14 range that hard largely marked the price action for nearly three months. The euro inexplicably rallied to almost $1.15 after the US CPI surprise, but quickly retreated and finished the week below $1.1350. The roughly 30 bp increase in the US 2-year premium over Germany appeared to have accounted for about a 0.4% loss and the warnings about Russian seemed to account for the other half of the euro's loss last week. The (38.2%) retracement of the rally from the push to almost $1.1120 in late January, was around $1.1350 and was met by the pre-weekend sell-off. The 50% mark is around $1.13, and the next retracement (61.8%) is seen close to $1.1265. The momentum indicators look set to roll-over.
Japanese Yen: The jump in US rates helped lift the greenback to the multi-year high near JPY116.35 seen early last month. The dollar stalled there and sold off to almost JPY115.00 on the heightened geopolitical risk as US Treasury yields dropped sharply (10-year yield off almost nine basis points completely offset the rise on the back of the CPI increase). Support is seen in the JPY114.60-JPY114.75 area. The BOJ's offer to buy unlimited amount of 10-year bonds at 0.25% may be a sufficient signal of its commitment that it may not have to actually buy much. The MACD is gently trending up while the Slow Stochastic is nearly overextended.
British Pound: Sterling has quietly rallied in nine of the past 11 sessions. In the past week, the markets have moved to increase the likelihood of a 50 bp move by the Bank of England next month to about 75% from around 45%. In the BOE's case, four of the nine MPC members wanted a larger move earlier this month and Governor Bailey was the decider. Still, sterling entered a $1.35-$1.36 trading range. Although it frayed intrasession, sterling has not closed above the upper end since January 19 and has not closed below the lower end this month. The MACD has flatlined around the middle of the range, while the Slow Stochastic is rising but at a slower pace. UK's CPI/PPI, employment, and retail sales due in the days ahead, which could help shape expectations. On the upside, the next resistance is seen around $1.3700, where the 200-day moving average is found. It has not closed above this average since mid-September. A break of $1.35 could spur a move toward $1.34.
Canadian Dollar: The US dollar spent most of last week between CAD1.2650 and CAD1.2750. It did briefly trade below CAD1.2650 in the volatility that followed the release of the US January CPI. The low was near CAD1.2635, and the greenback jumped back to CAD1.2755. However, it was coming off before the Russian "news" broke and lifted the US dollar to CAD1.2735 by the close. The market is pricing in about 170 bp of tightening by the Bank of Canada over the next 12 months, and about a 60% chance that its first hike on March 3 is a 50 bp move. Bank of Canada Governor Macklem encouraged the market by saying that rates may have to go up more than the investors currently think to get inflation under control. The paralyzing protests against vaccine mandates will hit the economy. Several auto companies closed plants or reduced output. The cost is estimated at around C$350 mln a day. It is too new to show up in the January CPI and retail sales figures due in coming days. The broad trading range is neutralizing the momentum indicators. However, note that the Canada's two-year premium over the US peaked around 60 bp last October has steadily narrowed and swung to a discount last week, and a day before the CPI report. The discount reached a little more than eight basis points, the largest since November 2019, before the debt market rally on the Russian threat. The Canadian discount settled near four basis points.
Australian Dollar: The Aussie has risen in eight of the past 10 sessions. It slipped below the key $0.7000 level on January 30 and saw almost $0.7250 on February 10 before the being driven lower by the broad US dollar rally. It bounced off the $0.7100 area ahead of the weekend and was trading firmly near $0.7180 before the US warned that Russia could invade Ukraine in the coming days. The Aussie was sold off to about $0.7120 before stabilizing. Although the RBA Governor Lowe pushed against vigilantes, the Australian dollar led the majors higher last week with around a 0.9% gain after the Russian-inspired drop. The momentum indicators seem consistent with additional gains in the coming days. A macro challenge is possible toward the end of next week when Australia reports January employment data. A flattish report is expected.
Mexican Peso: The peso has appreciated against the dollar in nine of the past 11 weeks. Last week's nearly 1.5% gain was the largest this year. The fact that the central bank did not disappoint and delivered the 50 bp rate hike helped it recover from the setback on the jump in US rates that followed the CPI print. The swaps market is pricing in another 125 bp in hikes over the next three months. The US dollar appeared to be set to go through the week testing the 200-day moving average near MXN20.33 before the dramatic risk-off move ahead weekend. The dollar jumped to almost MXN20.58 and settled around MXN20.54. The next upside target is the trendline off late January and this month's high that begins the new week near MXN20.64. The resilience of many emerging market currencies amid the surge in US (and European) FX is notable. The JP Morgan Emerging Market Currency Index managed to hold on a 0.2% gain last week, its fifth weekly increase in the first six weeks of the year. Within the emerging market, Latam currencies are shining. Last week they accounted for five of the top seven EM performing currencies (the South African rand and Thai baht were the other two top performers). Year-to-date, Latam currencies are four of the top five EM currencies.
Chinese Yuan: The dollar traded quietly against the Chinese yuan as mainland markets re-opened from their week-long festival. It remained above CNY6.35 but could not establish a foothold above CNY6.37. The dollar rose against the offshore yuan to almost CNH6.37 from around CNH6.36 in late pre-weekend dealings. The Chinese premium over the US for 10-year borrowing was almost halved to around 75 bp from the start of the year before the late Treasury rally. The spread widened to almost 85 bp. According to ChinaBond, foreigners bought a little more Chinese bonds in January than December (CNY65.7 bln vs. CNY61.9 bln). A different market segment may be attracted to the possible capital gains rather than chasing yield given that Beijing is easing policy. Given the accommodative thrust of policy, it seems clear in word and deed that officials prefer a weaker yuan. The yuan is virtually flat this year.