Economy: Disconnect Between Business Sentiment and Real-Time Activity

US stocks are a tad lower in a choppy session as investors digest and position around an extremely weak Empire manufacturing survey; however, the beat on China’s Q4 GDP suggesting the Mainland economy has turned the corner and continues to hold global risk markets in check.

The odd disconnect between business sentiment and what appears to be happening in the US economy in real-time continues to baffle investors, with the Empire manufacturing survey falling 21.7 points to -32.9 — its lowest level since the depths of the pandemic in 2020.

Why are Activity Indexes Weak When Activity Does Not Appear Stagnant?

So why are the activity indexes so weak when the activity does not appear to be as stagnating? It is due to the surprising nature of what is coming down the “hard data pipe,” which is much better than expected. Last fall, there was broad consensus that China was in the wrong place, Europe was slipping into a recession, and the Fed was ultimately caught ‘wrong-footed” by very sticky inflation. But fast-forward to these early weeks of January, and China’s reopening has put the country on a path to much better growth; investors are far more optimistic about Europe’s recovery and the bane of all ills US inflation is even starting to recede. These improvements only became apparent over the past month. It may take business sentiment another survey or two to catch up.

Equity Implied Volatility Drops Sharply

Equity implied volatility has dropped sharply since the turn of the year, with implied volatility across expiries and indices resetting to levels near their lowest in the last year. As the market narrative has shifted, the sharp drop-off in implied vol is a function of the market lessening the weight on catastrophic economic outcomes from fast and large rate hikes. There has been continued progress towards lower inflation, the Fed looks likely to downshift again, and the labour market has remained strong.

A Modest Increase in Equity Implied Volatility Expected in 2023

That said, under most market calls, where economists still see a 60 % chance of a US recession, it is easier to see scenarios where implied vol moves at least somewhat higher from here than much lower, especially as excess risk premium has been priced out. We expect a modest increase in equity implied volatility throughout 2023 as the unemployment rate rises, while a forex recession scenario would see a sharp increase in vol. So, we do not see investors out of the woods yet, even as the VIX trades sub-20.

While the debate about the pace of increases is leaning towards a further slowdown, as Chair Powell and other Fed officials have emphasized, the focus should shift from how fast to how far rates need to rise and how long those levels need to be maintained. So far, Fedspeak indicates that rates will likely rise above 5% over the coming meetings and be held at those levels for some time which should continue to keep US recession probabilities above 50 % due to an expected material rise in the unemployment rate courtesy of the Feds aggressive rate hikes.

Forex Market Forecast: Japan’s YCC and its Potential Impact on the JPY

In Japan, the market is closely watching the Bank of Japan and the potential for changes to their current policy, specifically the yield curve control (YCC). If the BoJ decides to tweak their policy, it could signal a shift towards a near-term exit and potentially bullish trades for the JPY.

Asian FX: Navigating the “Profit-Taking Pause” Before the Lunar New Year

In Asia, the FX market is currently experiencing a pre-Lunar New Year “profit-taking pause,” but when Chinese consumers start spending their savings, we can expect to see a big boost to the Yuan and other currencies in the region such as the Malaysian Ringgit and the Thai Baht.

Oil Markets: Encouraging Signs for Future Oil Demand in China

The oil markets are also showing positive signs, as traders are encouraged by the strong growth in China’s economy and believe it bodes well for oil demand in the future. Despite this positive outlook, it is important to keep a close eye on developments and see how the next few weeks play out.