A year ago, the hope was that the vaccine would help us overcome the coronavirus, whose origin remains as mysterious as deadly influenza a century ago. The hope now is that the Omicron mutations and T-cells in the body, rather than the vaccine per se, render the virus considerably less lethal. Still, it has been sufficient to disrupt some economic activity and extend the working from home or hybrid model for many.
The virus-induced deflation of 2020 morphed into its opposite in 2021 to the degree that surprised policymakers and market participants. Many countries are experiencing their highest producer and consumer inflation level in a generation. Although policymakers have shifted away from calling the pressures transitory or temporary, that still seems to be the consensus view among central banks and economists. Of course, some observers disagree in no uncertain terms. However, pricing the derivatives market showed them to be a minority, though vocal.
New Zealand and Norway hiked rates twice last year and will continue in 2022. The UK lifted rates in December, and the market expects another hike in February. This would raise the base rate to 50 bp, which is the threshold to begin letting the balance sheet run-off. With significant maturities in March, the Bank of England will likely be the first to allow its balance sheet to shrink.
Many see the next major central bank to lift rates as a close call between the Bank of Canada and the Federal Reserve. The market favors a March hike by the Bank of Canada. The accelerating tapering will allow the Federal Reserve to theoretically hike rates at the March 15-16 meeting, assuming the bond-buying is finished by then. Governor Waller and San Francisco President Daly have suggested it as a possibility.
The European Central Bank, the Swiss National Bank, and the Bank of Japan will lag behind to raise interest rates. The ECB's buying by Pandemic Emergency Purchase Program will slow and end in March. The pre-existing Asset Purchase Program will be bumped up (from 20 bln to 40 bln euros) in Q2 before being reduced to 30 bln euros in Q3 and 20 bln euros in Q4. In any event, the ECB's forward guidance remains the same. The APP purchases are open-ended and will continue until shortly before rates are raised. President Lagarde and other ECB officials have convinced the market that a rate hike in 2022 is unlikely.
With the franc near six-year highs against the euro and headline and core inflation around 1.5%, the Swiss National Bank has little direct economic need to lift rates. Still, one cannot help but wonder about the implication of having policy and bond yields below zero for such an extended period. With Swiss federal debt to GDP below 40%, its version of quantitative easing is to buy foreign bonds and equities. It may have helped slow the franc's appreciation, but it has not reversed it. Since mid-September, the franc has appreciated around 5% against the euro.
The Bank of Japan has quietly reduced the amount of stocks, corporate bonds, and government bonds that it buys. It may be nearly undetectable in the markets, which illustrates the importance of the signaling channel for this still novel form of easing. To be sure, deflationary forces have been hidden by the rise of food and energy prices. While the headline CPI in November reached its highest level (0.6%) since before the pandemic struck, consumer prices were off 0.6%, excluding fresh food and energy. The GDP deflator has averaged about -1.1% in Q2 and Q3, pointing to the strongest deflationary forces in a decade.
Fiscal policy, like monetary policy, is in flux. Japan, with its more than 200% debt of GDP, and the central bank's balance sheet more than 130% of GDP, and its deflationary pressures, is the only major country the OECD expects to report a greater budget deficit in 2022 than in 2021 (6.9% vs. 6.4%). It estimates the US budget deficit falls to 5.3% of GDP from 12.5% may need to be upgraded for the failure of Biden's Build Back Better initiative. While there may be an eventual agreement on a smaller package, the Earned Child Tax Credit is set to expire in mid-January, and the green efforts will be diluted at best.
Both sides of the scissors open, spending will be more and growth likely slower, producing a larger budget deficit relative to the economy. The OECD expected the UK's deficit to fall from 9.1% of GDP to 5.4%, but that was before the latest aid offered in the wake of the surge in Omicron and the work-from-home mandate. The eurozone's deficit is expected to fall to 3.8% of GDP from 6.7% in 2021. Still, the risk is that the spike in energy prices and the surge in COVID before the Omicron variant was sequenced will slow economic activity.
Governments will be issuing less debt, and central banks will be buying less. The ECB, BOJ, UK, and the Federal Reserve all own more than a third of the outstanding debt of their respective governments. Banks are being forced to hold more government bonds for regulators' purposes. The 100 largest US pension funds are reportedly on track to hit 100% of their funding ratio for the first time since 2008. This has fueled a shift to bonds, and some estimate it could be as much as $300 bln. The buy-and-hold market segments are critical. This, in turn, impacts the amounts available for trading and use of collateral.
Even with the dramatic drop in European benchmark (Dutch) natural gas prices ostensibly on the back of several cargoes from the US in the second half of December (~66%), it is still nearly 2.5 times more expensive than a year ago. In 2020, natural gas prices rose by more than 60%. In the US, natural gas prices are up a little less than 50% in 2021 but fell by more than a third in the past two months. Oil prices were driven lower (~20%) in November by a combination of several large consumer countries led by the US and demand concerns, in light of the surge in the virus, but recouped around 2/3 of it in December. The risk seems to be on the upside as supply appears constrained by the lack of investment in OPEC and non-OPEC countries.
Geopolitics loom large at the turn of the year. Russia has amassed large forces near Ukraine, and US officials have warned that an invasion looks likely in early 2022. After the US withdrawal from Afghanistan, Putin has chosen this time, with Europe dependent on Russian gas and the US buying Russian oil, to press hard for a sphere of influence in eastern Europe. Biden and Putin appeared to talk more in December than they have for the past year, but the key may be the January 12 meeting between Russia and NATO.
The US also warns that China's aerial harassment of Taiwan looks like a prelude to an invasion. Most experts believe it is not imminent, but some see a simultaneous move if Russia invades Ukraine as a possible scenario. Through its Belt-Road Initiative and some friendly governments, Beijing has a growing presence in the Caribbean (Barbados, Jamaica, Cuba). A third geopolitical challenge emanates from Iran. Tehran may secure sufficient fissile material to manufacture a nuclear weapon in the first part of the New Year.
There are several elections in 2022 that will capture the attention of investors and businesses and could have significant policy implications. The presidential election in Italy (January) and Austria (April) may reveal the political dynamics that could shape the next parliamentary elections (by 2023 and 2024 for Italy and Austria, respectively). The German presidential election will reflect the political dynamics that led to the new center-left governing coalition. The strong French presidential model within the parliamentary system gives the April election its significance. Macron faces a strong challenge from the right but without Le Pen's baggage.
Australia has yet to fix the date of its general election, but May 21 seems likely. The Liberal-National coalition appears on the defensive, but the polls show a tight contest. Climate change, the economy, and the policy response to the virus are the main substantive issues. In November, the US midterm elections are critical in shaping the political and economic agenda for the next two years. Polls and PredictIt.Org point to the likelihood that the Democrats lose both houses of Congress.
Commitments based on executive action, which the next administration can easily unwind, may not satisfy US allies and rivals. Moreover, it will make it more difficult for the US to pass the legislation necessary to implement the international tax reform (15% minimum for the largest businesses and revenue sharing). This would seem to undermine the authority Biden needs in negotiating to resolve the geopolitical challenges.
Among the emerging market countries, presidential contests will be held in South Korea (March), the Philippines (May), and Colombia (May). However, the Brazilian election (Oct) is the most important for investors. The contest looks likely to pit former President Lula against President Bolsonaro. The risk is for post-election drama. Lastly, China will hold its 20th National Congress in October. The notable outcome is expected to be a third term from President Xi. This is seen by many as a foregone conclusion.
Emerging markets had a difficult time in general in 2021, and the international environment will remain challenging as 2022 gets underway. The MSCI Emerging Markets ETF (NYSE:EEM) (equities) fell by around 5.3% in 2021, and the JP Morgan Emerging Market Currency Index fell by almost 9.2%. The premium over Treasuries widen. The combination of a less accommodative Federal Reserve and the slowdown in China acts as a powerful headwind. In addition, higher energy and food prices pose challenges for most.
Many emerging market countries raised interest rates in 2021. Rate hikes in Latam were spurred by price pressures, not strong growth impulses. The policy was tightened in central Europe, too, amid price pressures and better growth profiles. Some countries, like Russia and Brazil, have been particularly aggressive in raising rates, and they will likely finish in the first half of 2022. Developing Asia has faced less pressure from prices or the market to tighten, except South Korea. It doubled its key seven-day repo rate twice in 2021 to 1.0%. The market is pricing in another 50 bp of hikes in 2022. Other developing countries in East Asia will likely be withdrawing accommodation, including India, Indonesia, Malaysia, and Thailand.
Bannockburn's GDP-weighted currency index rose by about 0.50% in December to pare the year's loss to 1.3%. Position-adjusting seemed to dominate the price action of the last couple of weeks, and in this context, it meant dollar sales. The strongest in the index was the Mexican peso, with around a 4.6% gain, helped by a larger than expected 50 bp rate hike. The Australian dollar clawed back about 2% after losing 5.25% in November. Sterling advanced nearly 1.8%. Its gains were scored after the setback following the 15 bp rate hike on December 16.
For the year, only two currencies in the basket appreciated against the dollar, the Chinese yuan (~2.4%) and the Canadian dollar (~0.65%). The yen's 10.3% depreciation was the most. Brazil and South Korea battled it out for the second place. Still, the diverging performance in December gave the won the dubious honor of the second-worst performer in the Bannockburn World Currency Index. The won finished the year with an 8.6% loss, while the real lost nearly 6.8%. The euro's 6.8% loss was the most for the major currencies in the index after the yen. The Australian dollar fell by about 5.5%.
As the New Year begins, the uncertainties of the virus, the stalling of Biden's Build Back Better initiative have seen the dollar move sideways to weaker in the last couple of weeks. The 2-year interest rate differential moving into the greenback's favor also stalled. Our work shows that the US 10-year yield is more important for the yen's exchange rate. For most major currencies, this is a crucial metric to monitor.
Dollar: The US dollar trended higher for most of 2021. Who would have guessed that after trending lower in all but the first quarter of 2020, that the Dollar Index would put in its low as the rioters stormed the Capitol? The expected divergence in monetary policy sustained the greenback against the euro and yen. Also, as Fed Chair Powell noted, US yields may be low but are still attractive compared with European and Japanese yields (which have more than $12 trillion of negative-yielding bonds). The market has a great deal of good news discounted, with the Fed funds and swaps market pricing in nearly 75 bp in hikes in 2022. The market sees about a 2/3 chance of a hike at the March meeting. The other issue that will divide hawks and doves is when to stop reinvesting maturing issues. Biden is expected to nominate three new members to the Board of Governors, and it may have a women majority for the first time. The risk is on the upside for the headline and core CPI and PCE deflators in January and February, and then the comparisons may become more favorable.
The pullback of fiscal stimulus will be felt almost immediately, and the pent-up savings have largely been absorbed. The presidential extension of the moratorium on student loan repayments from February until May is worth an estimated $15 bln. While it is important to some households (about 1-in-8 people in the US have student loans), it is a small offset. Economists (Bloomberg survey median) and the Fed median forecast see 3.9% and 4.0% growth. We suspect the risk is on the downside. There is a notable divergence between the Fed and the market's inflation expectations. The median from the Fed's latest exercise sees the headline PCE deflator rising 2.6% in 2022 and the core increasing by 2.7%. The median in Bloomberg's survey projects a 3.5% increase next year in the headline and 3.3% in the core measure. Here we find ourselves in the middle. Broadly speaking, we suspect that the dollar's high is not yet in place and look for a more sustained pullback in the second half of the year as the economy (we anticipate) slows toward the trend).
Euro: The surge in the Delta variant and higher energy prices were already prompting officials and private-sector economists to push the EMU's growth prospects from Q4 21 into 2022 before the surging Omicron variation took hold. The ECB staff forecasts and the median forecast in Bloomberg's survey converge at 4.2% growth in 2022, slightly above estimates for US growth. Here, too, the risk is that growth disappoints. Still, the market is not entirely convinced by the ECB's rhetoric that the deposit rate will finish in 2022 unchanged at minus 50 bp. Aside from the economy, the EC faces challenges from the unresolved Brexit-related negotiations with the UK and trying to secure primacy of EU law in central Europe, and the threat from Russia and its ally Belarus. According to the OECD's Purchasing Power Parity calculations, the euro remains the most under-valued currency it tracks, a little more than 25% below fair value. It is slightly more under-valued than it was before the pandemic struck. The US paid nearly 220 bp more than Germany to borrow for two years at the end of 2019. It bottomed around 80 bp in mid-February 2021 and finished the year near 140 bp, the year's high. We suspect the US premium will rise further in the coming months and has the potential to push the euro to a new low of around $1.10.
(December indicative closing prices, previous in parentheses)
Spot: $1.1370 ($1.1335)
Median Bloomberg One-month Forecast $1.1325 ($1.1375)
One-month forward $1.1350 ($1.1375) One-month implied vol 5.1% (7.1%)
Japanese Yen: Japan is an exception among the high-income countries. Its budget deficit is expected to be larger in 2022 than in 2021, and the swaps market implies a slightly lower interest rate than is currently prevailing. The Bank of Japan and the median economist forecast (Bloomberg survey) project growth of 2.9% in 2022. The central bank sees core inflation (CPI, excluding fresh food) at 0.9%, while the market sees it returned to the pre-COVID pace of 0.7%. The yen was the weakest major currency in 2021, depreciating slightly more than 10% against the dollar. The combination of the yen's weakness and rising commodity prices, especially oil, saw Japan's trade balance fall back into deficit in 2021. The OECD's PPP model sees the yen roughly 13.5% below fair value, second only to the euro in terms of under-valuation. The divergence in monetary policy, in general, appeared to be the main drag on the yen. That said, the exchange rate is more sensitive to the movement of the US 10-year yield than the 2-year. The exchange rate appears to be nearly twice as sensitive (60-day rolling correlation of difference) to the 10-year Treasury yield than the S&P 500 (a proxy for risk appetites). Since around mid-October, the greenback has been chopped in a JPY112.50-JPY115.50 range. Rising US rates could help lift the dollar into a JPY117-JPY120 range.
Spot: JPY115.10 (JPY113.10)
Median Bloomberg One-month Forecast JPY114.80 (JPY113.30)
One-month forward JPY115.05 (JPY113.00) One-month implied vol 5.4% (8.2%)
British Pound: The Bank of England became the first G7 central bank to hike rates since the pandemic and is poised to do so again before another move. The swaps market has 100 bp of tightening discounted for 2022, with the first move anticipated at the February 3 BOE meeting. That move is seen raising the base rate to 50 bp, which is the threshold to stop recycling the maturing holdings purchased during quantitative easing. The UK then is poised to be pursuing the most aggressive monetary policy among major economies. Nevertheless, the US pays a premium over the UK to borrow for two years, and cable turned more sensitive to the spread in Q4 22. Some COVID-related spending increases announced at the end of the year will blunt the Office for Budget Responsibility's projections that anticipated the fiscal deficit to be more than halved in 2022 to 3.3% (from 7.9% in 2021). The UK government was battered in 2021, with "sleaze scandals," which ultimately led to an embarrassing defeat in a special election toward the end of the year, the resignation of the chief negotiator of Brexit, and the Northern Ireland protocol. The re-imposition of some COVID-related social restrictions was also unpopular. Moreover, an Opinium poll at the end of 2021 found that more than 60% of voters believe a year into Brexit, and it has gone bad or worse than they expected. More than 40% who voted to Leave in the 2016 referendum had a negative view of the exit. With Labour ahead in the polls and Starmer personally with a several percentage-point leads on the Prime Minister, it is difficult to see how Johnson recovers. Even without an election in 2022, high drama may return to UK politics.
Spot: $1.3530 ($1.3300)
Median Bloomberg One-month Forecast $1.3495 ($1.3375)
One-month forward $1.3535 ($1.3315) One-month implied vol 5.9% (7.5%)
Canadian Dollar: The Canadian dollar's nearly 1.1% gain in December was enough to push the currency higher for the year (0.65). It was the only major currency against to rise against the greenback in 2021. We often find that the near-to-medium term, the exchange rate is driven by three factors: the general risk appetite, for which we use the S&P 500 as a proxy, commodity prices (with an emphasis on oil), and monetary policy convergence/divergence, where the two-year differential serves as a guide. Monetary policy considerations appeared to dominate in Q4 21. Initially, the Canadian premium rose from around 20 bp to 60 bp, and the US dollar fell from around CAD1.28 to CAD1.23. However, the more aggressive turn by the Fed saw the Canadian premium fall back toward 20 bp, and the greenback rebounded to over CAD1.2950. Although the premium closed the year near a three-month low, the Canadian dollar continued to strengthen. How this divergence is resolved will be important. The swaps market has the Bank of Canada raising rates at 125 bp next year, and the first move is anticipated at the March 2 meeting. The OECD's estimate of Purchasing Power Parity puts fair value for the exchange rate around CAD1.26, suggesting the Canadian dollar finished the year about 1% cheap. US-Canadian trade relations remain strained a year into the Biden administration. Disputes range from potatoes and oil pipelines to lumber and the interpretation of domestic content for autos under USMCA. Canada, like Mexico, was also rattled by the "Buy American" provisions in the Build Back Better initiative, especially for electric vehicles.
Spot: CAD1.2635 (CAD 1.2775)
Median Bloomberg One-month Forecast CAD1.2625 (CAD1.2685)
One-month forward CAD1.2640 (CAD1.2770) One-month implied vol 6.4% (7.2%)
Australian Dollar: Lockdowns that covered half of Australia's population led to a contraction of the economy in Q3 21, but it appears to have snapped back strongly in Q4. The Reserve Bank of Australia is one of the few central banks anticipating more robust growth in 2022 (5% vs. ~4.0% in 2021). The IMF and OECD also expect more robust growth in the New Year but less than the central bank (4.1%). Despite projections of faster growth, the RBA forecasts CPI to fall from around 2.5% to 1.8%. The OECD sees steady prices, while the IMF projects a slight easing. The RBA has pushed hard against market expectations for rate hikes in 2022. The swaps market has about 80 bp of tightening discounted with the first hike in Q3 22. According to the IMF's Purchasing Parity model, the Australian dollar's little more than 6% decline in 2021 helped make it more competitive, which puts fair value near $0.7100. We note that Aussie's recovery in December (~2.0%) came despite a further widening of the two-year interest rate differential in favor of the US, while Australia's premium on 10-year bonds narrowed. We suspect this leaves the currency vulnerable as the NewYear gets underway. The national election, likely around the middle of Q2 22, will be fought over economic and environmental issues. The country is in scissors that is likely to get worse. Its most significant trade partner is China, and it has provoked it, leading to trade sanctions, which appear to have been offset by rising prices. At the same time, it is in a strategic alliance with the US that strengthened in 2021 (see AUKUS).
Spot: $0.7265 ($0.7125)
Median Bloomberg One-Month Forecast $0.7245 ($0.7195)
One-month forward $0.7770 ($0.7135) One-month implied vol 8.0% (9.7%)
Mexican Peso: The peso posted its biggest monthly advance in December (~4.6%) since March 2020, cutting its annual loss to about 2.9%. The larger than expected rate hike (50 bp) by the Bank of Mexico in December helped solidify the peso's recovery. It was the best performing currency in the region in 2021, and its loss was less than half of the Brazilian real ~-6.8%). The untested deputy Finance Minister takes over the central bank's helm, and with inflation above 7%, may seek to establish her anti-inflation credentials early by delivering another 50 bp hike at her first meeting (February 10). The market has aggressively priced 200 bp of tightening for 2022. The pandemic disruption helped the trade balance improve and record worker remittances. However, the widening trade deficit warns that the best may be behind it. As part of the nationalistic thrust of the Mexican government, it will halve oil exports in 2022 and stop them completely in 2023. The OECD projects the economy will slow to around 3.3% in 2022 from almost 6% in 2021. Economists (Bloomberg survey median) forecast growth to slow below 3%. The OECD and the market anticipate Mexico's inflation will moderate to around 4.4% from an average of a little more than 5.5% in 2021. The market is less constructive about the peso going forward. The median forecast (Bloomberg) has the dollar finishing 2022 near MXN21.20.
Spot: MXN20.53 (MXN21.46)
Median Bloomberg One-Month Forecast MXN20.66 (MXN21.23)
One-month forward MXN20.62 (MXN21.60) One-month implied vol 11.0% (14.9%)
Chinese Yuan: Officials have made it clear in word and deed that they prefer less upward pressure o the yuan. They have made official comments, increased the reserve requirement for foreign currency deposits, making them less attractive, and signaled displeasure in the setting of the dollar's reference rate. The divergence of PBOC and Fed monetary policy was driven home by the December decline (albeit a minor five-basis point move) in the one-year prime loan rate, the first since March 2020. The yuan rises against its other trading partners in a robust dollar environment by shadowing the dollar so tightly. The PBOC wants to loosen that link. However, its large trade surplus and portfolio inflows are making it complicated.
The zero-tolerance of COVID and the quickly and enforced lockdowns will further weigh economic activity and likely impact supply chains. Reforms in China and more activist regulator officials in the US can be expected to extend the financial decoupling that appears to already be underway. China fell short of its commitments under the "Phase 1" agreement negotiated by the Trump administration. The Biden administration does not appear ready to negotiate another deal, but it also means that the tariffs will remain in place. Since the middle of October, and with a few exceptions, the dollar has been mostly confined to a CNY6.35-CNY6.40 range. Only a move out of it is significant.
Spot: CNY6.3560 (CNY6.3645)
Median Bloomberg One-month Forecast CNY6.3680 (CNY6.38)
One-month forward CNY6.3830 (CNY6.3860) One-month implied vol 3.3% (3.5%)