China Reopening Optimism Counterbalanced by Rising US Yields

USD: where opposing forces meet from China optimism & rising US yields

I noticed that the US dollar had rebounded overnight after a sharp sell-off yesterday, and this was due to renewed optimism over stronger growth in China. As I had read earlier this week, China reopening trades had lost momentum in February alongside the rebound for the US dollar. However, in Wednesday release of the much stronger than expected China PMI surveys for February, with the manufacturing PMI rising to its highest level since April 2012, gave the China reopening trades a boost. The renminbi recorded its third consecutive day of gains against the US dollar yesterday as USD/CNY fell below the 6.9000-level. The US dollar weakened more broadly as well, resulting in the dollar index initially falling back to a low of 104.09 before staging a modest rebound during the US trading session that has continued overnight. I also observed that the Chilean peso and Thai baht were among the currencies that benefited the most from the renewed optimism over stronger growth in China in recent days.

Sell-off USD x EUR

YIELD SPREADS HAVE BEEN MOVING AGAINST THE GBP

I read a report from Reuters overnight that China may aim for a higher 2023 GDP growth target than the 4.5%-5.5% target proposed back in November, according to sources involved in policy discussions. The report stated that China's GDP target for this year could range between 5.0% and 5.5%, and be as high as 6.0%. This supports the expectations for stronger growth in China, which has been weighing down on the US dollar, but it is still deriving support from rising US yields. The hawkish repricing of Fed rate hike expectations and recent pick-up in inflation expectations has helped to lift the 10-year US Treasury yield back above 4.00% yesterday for the first time since the first half of November.

I remembered that on that occasion, China reopening optimism and falling US yields combined to trigger a sharp US dollar sell-off, whereas they are currently working in opposite directions for US dollar direction right now. Even the release of the softer US data on Wednesday (US manufacturing PMI survey, construction spending, & ISM manufacturing survey) failed to dampen upward momentum for US yields. Market expectations for the Fed's terminal rate have risen to a fresh cyclical peak of just under 5.50%. I noted that higher US yields are helping to support the US dollar amidst renewed optimism over stronger growth in China. Amongst G10 currencies, the Australian dollar, which is the most sensitive to China reopening optimism, has already reversed around three quarters of the initial gains following the release of the China PMI surveys for February.

EUR/GBP: Governor Bailey’s comments weigh on the pound

Yesterday, the pound performed poorly compared to other currencies, resulting in EUR/GBP rising to the 0.8900-level from its recent low of 0.8755. Even cable has fallen back below the 1.2000-level amidst the broad-based US dollar sell-off. As I expected at the start of the week, the initial rally for the pound following the EU & UK Brexit deal related to Northern Ireland was modest and short-lived.

The main trigger for the sharp correction lower for the pound yesterday was the pushback from BoE Governor Bailey against the recent hawkish repricing of rate hike expectations in the UK. Bailey's comments provided further evidence that the BoE is currently the least hawkish compared to the ECB and Fed, resulting in short-term yield spreads moving against the pound at the start of this year.

The implied yield on the December 2023 three-month SONIA had increased by around 90bps since the last MPC meeting at the start of February, as UK rate market participants moved to price in the BoE’s policy rate reaching a higher peak of closer to 5.00% prior to yesterday’s comments from Governor Bailey.

After Governor Bailey made his statement that "I would caution against suggesting either that we are done with increasing the Bank rate, or that we will inevitably need to do more", the expected peak for the terminal rate has nudged back closer to 4.75%. The Bank of England (BoE) dropped the stronger guidance for further hikes at the February MPC meeting. In his statement, Governor Bailey indicated that "some further increase in the Bank rate may turn out to be appropriate, but nothing is decided". He also said that the UK economy is "evolving much as we expected it to" since the February policy decision and described the recent stronger wage and activity data as only slight changes. Therefore, I believe that the UK rate market has overreacted recently. While I anticipate that the BoE will deliver one more 25bps hike this month, I doubt that rates will need to rise as far as current market pricing. In the near-term, the relatively dovish policy stance of the BoE remains a negative factor for pound performance. Conversely, I expect the European Central Bank (ECB) to maintain their hawkish policy stance when they meet this month. I anticipate another larger 50bps hike, and I expect the guidance to leave the door open to another 50bps hike in May following further upside inflation surprises in the Eurozone.

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