The trends were already entrenched before the US election and continued through most of last month. The trend toward higher rates and higher equities stalled, while the dollar remained strong. Investors and business continue to wrestle with the implications of the Republican sweep in the US elections.There are two broad issues that are the source of uncertainty. The first is the broad tariff Trump has advocated on the campaign trail: 60% on China and 10-20% on rest of the world. Several people who will have senior economic posts in the new administration downplayed a literal interpretation. Still a global tariff regime would hurt those that enjoy the closest trade ties with the US, outside of China; namely, Mexico, Canada, and parts of Europe, and Vietnam. It is as Henry Kissinger quipped once, “It may be dangerous to be America’s enemy, but to be America’s friend is fatal.” We suspect that many investors and policymakers underestimate the extent of global integration. Consider that two months before the US election, the CEO of RTX (Raytheon) acknowledged that the US-defense behemoth had 6000 suppliers in China. Ostensibly, tariffs could provide inventive to grow a domestic alternative. Yet, the raw, and especially refined critical metals and mineral are needed in various military and civilian products. China has secured a comparative advantage. Around 99% of the US rare earth imports come from China, as does 95% of magnesium anode, 90% of several pharmaceutical products, and about 70% of lithium batteries.Perhaps, most telling is that the Census Department estimates that last year nearly half of US imports (49.3% or $1.51 trillion of $3.07 trillion) came from branches companies headquartered in the US. Mexico has made a similar argument. The deputy trade minister recently argued that about 70% of Mexico’s imports from Asia are brought into the country by about 50 foreign companies, of which half of them are headquartered in the US (e.g., automotive, semiconductor, and aerospace.The dollar trended lower in Q3, and part of the narrative was that the Republican nominee and vice-president candidate argued for a weaker dollar. It was an integral part of its call to re-shore manufacturing and boost the US economic competitiveness. At the same time, price pressures were moderating faster than expected while the unemployment rate had risen for four consecutive months through July. The Federal Reserve signaled its intent to begin removing some of the restrictiveness of monetary policy. It began the easing cycle with a 50 bp rate cut.US rates and the dollar bottomed shortly after the cut, helped by the strongest rise nonfarm payrolls in six months. The narrative that emerged in Q3 was that regardless of the election outcome, the US deficit and debt would grow. It would be inflationary and deter the Federal Reserve from easing as much as it had projected in the September Summary of Economic Projections.The median view was for 150 bp of cuts between Q4 24 and the end of 2025. The market, as is often its wont, ran ahead of the Fed, and in late September was discounted 200 bp of cuts by the end of 2025. A combination of stronger US data and the strength of the Republican victory helped fuel the dramatic reassessment. By the end of November, the market was pricing in 65 bp of cuts between next month’s meeting and the end of next year.The US two-year yield rose from about 3.60% in mid-September to almost 4.40% by the eve of the November 5 US election. The Federal Reserve delivered a quarter-point cut a couple days after the election, but the two-year note yield consolidated mostly between 4.35% and 4.50%. The 10-year Treasury yield performed similarly–bottomed near 3.60% in mid-September and approached 4.40% in the run-up to the election. It reached 4.50% in mid-November.About half of the increase in the US 10-year yield since mid-September reflects an increase in inflation expectations as reflected by the difference between the 10-year inflation-protected security and the conventional yield. The bulk of the other half of the backing up of the 10-year yield can be accounted for the change expectations for the Fed funds rate. That suggests there is little additional risk premium due to supply concerns or other political concerns. The tariffs and tax cuts delivered in Trump’s first term were not inflationary. Leaving aside the 2020 pandemic distortions, in the first three years of Trump’s first term, CPI averaged an annual rate of about 2.1%. The US CPI also rose by 2.1% in 2016. Growth was a little stronger. It averaged about 2.65% a year in 2017-2019 after averaging about 2.25% in the previous three years.The annual federal government budget deficit averaged 2.8% in the three years through 2016 and nearly 4.1% in the three years through 2019. Targeting tariffs on intermediate goods and impacting consumer goods with readily available alternatives minimizes the impact on CPI. Nor must one subscribe to modern monetary theory to recognize that budget deficits are not always inflationary. Indeed, there is good reason to suspect that the somewhat firmer US inflation readings in Q4 will be unwound in early 2025. With the exception of the growth scare in Q1 24 (1.6% annualized), the US economy has been posting above trend growth in since mid-22. Most other high-income countries are struggling. The ECB’s forecast for 0.8% eurozone growth this year is at risk, and the early winter weather without the wind has seen natural gas supplies are draw down, is pushing up energy costs. The eurozone had not recovered from the pandemic before the Russia’s invasion of Ukraine posed a new shock. The de-risking of exposure to China, and the challenge from ICE to EV is wreaking havoc to Western Europe’s auto and parts sector. If Europe grows in crisis, as the old saw claims, then we should take seriously the possibility of new bold initiatives. However, the risk is that the domestic political considerations in Germany and France argue against it. The German government has collapsed, and it will lose this month’s vote of confidence, which will set the stage for an election around the middle of Q1 25. The CDU will most likely lead the next government and has little interest in implementing the proposal’s sketched in Draghi’s recent report, including joint bond issuance. French President Macron felt compelled to call a snap election over the summer, but the results have produced a stable government. It too will likely face a confidence vote. France’s 10-year benchmark yield trades at a premium to Spain and Portugal. The yield is closer to Italy’s than Germany’s.Like the French election, the Japan’s election did not result in a stronger government. The governing coalition lost its mandate. The Liberal Democrat Prime Minister Ishiba remains in office owing to the inability of the opposition parties to find common ground, but he heads up Japan’s first minority government. One of its first initiatives will be supplemental budget and the like increase in the tax-free income threshold to secure the support of the Democratic People’s Party. Geopolitical tensions are elevated. The outcoming Biden administration and the UK have granted Ukraine permission to use their missiles and guidance system to attack Russian territory. Russia responded by firing an intercontinental ballistic missile at Ukraine, changed it nuclear doctrine (to lower the threshold of first use), and a threatening the UK. Moreover, Russian troops have reportedly been joined by a 100k North Korean force. Two undersea communication cables appear to have been purposely sabotaged as the asymmetrical warfare continues. China’s assistance to Russia is causing great consternation in Europe and the US. At the same time, it continues to harass Taiwan, the Philippines, and Japan. Its repeated displays of force and intimidation have become so commonplace that there is risk that the exercises can morph into a genuine attack and would still secure an element of surprise. The Bannockburn World Currency Index, a GDP-weighted basket of the currencies of the 12 largest economies, fell by nearly 1.5% in November after it declined by nearly 2.1% in October. That means that these past two months accounted for more than half of this year’s decline, which reflects the strength of the US dollar. Indeed, all the currencies in the index fell against the dollar but the Japanese yen, which surged by 3% in the last week in November. Among the G10 components of the BWCI, the euro fared the worst falling more than 3% in November. Its weighing in the basket is slightly more than 18.5%. The yen, which posted a net gain of about 1.2%, has a 5% weighting. The Russian rouble was the poorest performer the Bannockburn World Currency Index. It got clocked for 8.2%, which is a little more than half of the year-to-date loss (15.6%). Fiscal issues took a toll on Brazilian real during the last week of November. It had been nearly flat coming into that last week and finished the month off almost 4.8%. BWCI was near a six-month high at the end of Q3 near 92.40. It fell to almost 89.00 before stabilizing. The pull back in US rates may allow for a consolidative phase, but we are concerned that a firm employment report (December 6) and another small rise in the US CPI (December 11), contrasts with most of the other high-income countries. U.S. Dollar: The Republican sweep in the November election helped the dollar and equities extend this year’s outperformance. Although some of Trump’s appointments are controversial, his economic team is not, and this was greeted enthusiastically by the capital markets. Several senior nominations have suggested that the tariffs threatened in the campaign were negotiating positions, and that the emphasis will be on spending and tax cuts. Given the firmness of recent inflation readings, the general resilience of the labor market (November nonfarm payrolls are expected to rise by about 180k, slightly more than this year’s average), and expectation for fiscal stimulus, the derivatives market anticipates few rates cuts than the Fed signaled in September. The odds of a December cut have been scaled back to about 55% from a little more than 80% shortly after the November 7 quarter-point cut. The market now sees the Fed funds effective rate near 3.85% at the end of next year. That is about 100 bp higher than in late Q3. An updated Summary of Economic Projections will be made available at the conclusion of the December 17-18 FOMC meeting. In the past year, the market deviated and then converged with the Fed. This time, the central bank may converge with the market and scale back the easing it anticipated it would deliver in 2025. The Dollar Index surged by about 6% since the end of September, its best two-month performance in a couple of years. It traded above 108.00 for the first time in nearly two years. The next technical target is near 109.00. Still, the momentum indicators are stretched, and a consolidative phase could bring it back toward 105.50. Euro: The eurozone is in poor shape. The economy is weak. Its largest member has not been able to string together two quarters of back-to-back growth in two years. The eurozone looks poorly positioned to compete with the US, defend itself against Russia, and come to terms China, an aggressive competitor. The early winter weather and less wind has seen gas inventories drawn down and prices rise sharply. They are now more than double the level from late February. The ECB meets on December 12. Although the market flirted with the idea of a 50 bp cut, especially after the dismal preliminary November PMI, on balance, the uptick in the November CPI and the depreciation of the euro seems to favor sticking with the quarter-point pace. The swaps market anticipates slightly more than 100 bp of easing in H1 25. Meanwhile, the broad tariffs threatened in the US campaign would hit Germany and Italy the hardest. Among the EMU members, they enjoy the largest trade surplus with the US. The economic stress proved too much for the German and French governments. The improbable German coalition government collapses. Formally, the government will lose a confidence vote in mid-December, paving the way for national elections in mid-February. The conservative CDU is most likely lead the next government. In France, a constitutional path to bypass parliament to pass the 2025 budget may trigger a confidence motion, which the beleaguered government is unlikely to survive, or the budget which the EU has already approved, is at risk. The euro fell to $1.0335 in late November, its lowest level since late 2022. It set a two-decade-low that year near $0.9535. (As of November 29, indicative closing prices, previous in parentheses) Spot: $1.0575 ($1.0835) Median Bloomberg One-month forecast: $1.0600 ($1.0925) One-month forward: $1.0590 ($1.0850) One-month implied vol: 8.0% (6.9%) Japanese Yen: Rising US rates helped lift the US dollar to JPY156.75 in the middle of November, a four-month high. After the intervention and the dramatic unwinding of the carry trade, the dollar briefly traded below JPY140 in mid-September. US rates bottomed shortly the Federal Reserve delivered a 50 bp rate cut and the dollar gradually recovered. It reached almost JPY154 in October. The rise in US rates post-election and the reluctance BOJ Governor Ueda to prepare the markets for another hike saw the dollar extend its gain. Prime Minister Ishida gambit of calling a snap election failed in that the coalition lost its majority. On the other hand, Ishida is still prime minister, but now he heads up Japan’s first minority government. With the support of the Democratic Party for the People (DPP), ta JPY13.9 trillion (or about $92 bln) supplemental budget will be delivered. It contains new household subsides of electricity, gas, and gasoline. The DPP also insist on raising the tax-free threshold on income. The Japanese economy is strengthening, price pressures are firm, and the Bank of Japan is committed to normalizing monetary policy. The swaps market has 15 bp of tightening discounted at the conclusion of the meeting on December 19. As goes the US 10-year yield, so goes the yen. Since the middle of November peak near 4.50%, the 10-year Treasury yield has pulled back by 30 bp. Both the exchange rate and the 10-year US yield fell below their respective 200-day moving averages in late November. A break of The JPY149 area could spur a move toward JPY147.40 area.Spot: JPY149.75 (JPY153.00) Median Bloomberg One-month forecast: JPY152.00 (JPY148.60) One-month forward: JPY149.05 (JPY152.45) One-month implied vol: 12.2% (11.8%) British Pound: Sterling recovered after trading below $1.25 for the first time in six months. The leg down began with the US election when sterling was trading above $1.30. It was stabilizing near $1.26 when it was jolted with a sharper than expected drop in October retail sales (-0.9% vs. -0.4% expected) and a dreadful flash November PMI, which saw the composite drop back into contraction territory from 51.8 in October. It traded slightly below $1.2490 but recovered to about $1.2750 at the end of the month, helped by the broader dollar pullback. The roughly two-and-a-half-cent rally off the lows may have exhausted the corrective pressures. The Bank of England meets on December 19, the day after the November CPI is reported. The base effect (CPI fell by 0.2% in November 2023) warns of the risk of the second consecutive year-over-year increase, which will likely be the highest since the end of Q1. There is little chance of the BOE rate cut in December, but price pressures will ease again, after January, and a rate cut at the first meeting in of 2025 (February 6) looks reasonable. The dramatic sell-off in Gilts continued and the 10-year yield reached almost 4.60% in early November, but with the help of a recovery in US Treasuries and weaker data, the yield finished the month near 4.25%. Lastly, there is hope in some quarters that a special relationship between the UK and the US is rekindled during the next US administration. The focus may be on a trade deal. Spot: $1.2735 ($1.2925) Median Bloomberg One-month forecast: $1.2800 ($1.2965) One-month forward: $1.2730 ($1.2930) One-month implied vol: 7.5% (7.8%) Canadian Dollar: The US dollar was paring its post-election gains that carried it from around CAD1.38 to CAD1.41, after peaking on November 15. However, late on November 25, Trump threatened a 25% tariff on all imports from Canada (and Mexico, and 10% on China) in an apparent attempt to force greater control of the border for drugs and migrants. The US dollar shot up to almost CAD1.4180, its highest level since the pandemic. Canada’s exported nearly a fifth of its GDP to the US in 2023. Such a tariff would crush the Canadian economy, with some projections that the US dollar could rise above the record near CAD1.62 seen in early 2002. Still, the tariff threat is widely understood as a negotiation tactic and given the continental organization of production in several sectors, and the extensive energy ties, the US economy would be adversely impacted. Canada has shown a strong willingness to comply with US restrictions on trade with China and can be expected to strike a deal with the new US administration. Yet, it has injected a note of uncertainty, and this could point to a higher volatility profile going forward. Meanwhile, the US two-year premium over Canada widened to near 118 bp in November, a new 27-year high. It has retreated to below 100 bp but finished the month near 107 bp. The Bank of Canada meets on December 11 and the swaps market is discounting almost a 50% chance of another 50 bp cut. Spot: CAD1.4005 (CAD 1.3950) Median Bloomberg One-month forecast: CAD1.4000 (CAD1.3765) One-month forward: CAD1.3990 (CAD1.3935) One-month implied vol: 5.5% (5.4%) Australian Dollar: After dropping 4.8% in October, the Australian dollar’s largest monthly decline in two years, it stabilized in early November. Despite some volatility around the US election, the Australian dollar was up about 2.2% in the first week of November. It peaked on November 7 (the Fed cut a quarter-point) near $0.6700. It was around $0.6440 in the middle of the month and made a marginal new low in reaction to Trump’s tariff threat. The Reserve Bank of Australia was among the last of the G10 central banks to tighten and its overnight rate peak was lower than most. Under Governor Bullock, the central bank has emerged as among the most hawkish. It took some time, but the RBA persuaded the market to give up hopes of a rate cut this year. In fact, the derivatives market has pushed the first cut into Q2 25. The economy expanded by 0.2% (quarter-over-quarter) in Q1 and Q2 24. It may be strengthening slightly in H2. The Reserve Bank of New Zealand is a different kettle of fish. It raised rates aggressively and had among the highest overnight rates in the G10 at 5.50% from May 2023 through July 2024. It has been aggressive in cutting interest rates and in three meetings has slashed the overnight rate to 4.25%. The RBNZ holds out the likelihood of another half-point cut (third in a row) when it meets next in February, assuming the economy evolves as expected. The New Zealand dollar performed slightly better than the Australian dollar in November (-1.1% vs. -1.25%), but year to date, the Aussie has outperformed by nearly 2%. Spot: $0.6510 ($0.6560) Median Bloomberg One-month forecast: $0.6600 ($0.6590) One-month forward: $0.6515 ($0.6565) One-month implied vol: 9.2% (10.0%) Mexican Peso: The Mexican peso fell by about 1.75% against the US dollar for the second consecutive month in November. Investors have yet to be won over by the new Mexican government whose constitutional reforms appear to threaten the guardrails that protect their long-term interests. At the same time, the re-election of Trump is seen to be a significant challenge. Within a few weeks of the election, Trump threatened 25% tariff on all imports from Mexico until it curbs the migrant and drug flow. His comments lifted the greenback to a marginal new two-year high, slightly above MXN20.83. After Mexico’s President Sheinbaum pushed back that threatened tit-for-tat response while noting the progress achieved on Trump’s charges, the US president-elect tone improved, and the peso recovered. The dollar pulled back to around MXN20.20. If the pressure rekindles, the next technical target is a little above MXN21.00. It corresponds to the halfway point of the dollar’s trend lower from the pandemic high near MXN25.7850 in April 2020. The central bank meets on December 19. Moderating headline and core inflation will allow the easing cycle to continue. The central bank has cut the overnight rate by 100 bp in four steps that began in March. The overnight rate is 10.25% and the swaps market has it falling by about 125 bp over the next 12 months. In Brazil, fiscal issues weighed on the real, which fell to new record lows at the end of November. The dollar reached BRL6.1150 before recovering and finishing the month near BRL5.97. It central bank has hiked rates in twice and lifted the Selic rate 75 bp to 11.25%. Another hike is expected when the central bank meets on December 11, with the bias toward 50 bp. The swaps market sees the Selic rate between 14.50% and 14.75% at the end of 2025. Spot: MXN20.38 (MXN20.28) Median Bloomberg One-Month forecast: MXN20.32 (MXN19.92) One-month forward: MXN20.48 (MXN20.39) One-month implied vol: 13.6% (18.4%) Chinese Yuan: The dollar fell by 3.4% against the Chinese yuan in Q3 but has come roaring back in Q4. After rising 1.4% in October, the greenback rose 1.75% in November. It reached almost CNY7.26 in late November, its highest level since July. It was trading near CNY7.10 before the post-election dollar surge. The PBOC had been setting the dollar’s reference rate tight to expectations, but the greenback’s surge spurred a shift in the tactics. In late November, the PBOC set the reference rate well below expectations, which effectively limits its scope for appreciation as it is confined to a 2% band around the fix, which it rarely explores. Global investors do not appear persuaded yet by the numerous measures announced to support the property and equity markets and put on more solid footing local government finances. The nominations of the trade and economic team in Trump’s second term appear to have solid credentials as critics of China. Meanwhile, this month China will impose new export restrictions on several metals and minerals with civilian and military applications (e.g., tungsten, graphite, and magnesium). The rolling 30-day correlation between changes in the offshore yuan and Japanese yen recovered to a three-month high near 0.70. Yen Jumps On Rate Hike Speculation Trump’s Tariff Talks Wobble Forex Market, Close Neighbors Suffer MostMarkets Do Cartwheels In Response To Traditional Pick For US Treasury Secretary
