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Geopolitical risk returns

Rising geopolitical risks in China is triggering large-scale damage to China-sensitive assets, despite improving growth data there. Meanwhile, US labor data remains firm, ISM has upside risks and used car prices may rise again. The perfect storm is brewing in favor of the dollar, at least, near term.

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The risk of geopolitical instability is causing concerns over China's assets, resulting in an increase in the risk premium and a boost to the US dollar. Despite positive indicators such as strong PMIs, an increase in long-term loans to corporates, and signs of stabilization in property markets, China-related assets including copper, H-shares, CNY, and NJA FX all experienced significant declines last week. Investors and locals are becoming increasingly worried about the potential repercussions of the rapidly deteriorating relationships between China and the US and the West, especially given China's strong ties to Russia.

Simultaneously, the US's recent strong data set can cause anxiety about a possible 50bp hike and higher terminal rates. The US's growth and other regions continue to improve, with initial claims indicating a robust labour market and most regional Fed indicators exceeding expectations this month. Importantly, the Manheim survey showed a significant increase in used car prices for three consecutive months in February, which could significantly affect the disinflation narrative keeping risky assets resilient to large moves in yields (up) if it translates to higher goods inflation within the US CPI.

Although my predictions are that the dollar will normalize to a fair value by the end of 2023 (around 1.12 vs EUR), in the near term, there are risks of further dollar strength. The Fed repricing alone is unlikely to drive the dollar beyond 1.04 to the EUR. My recent note showed that a large gap between an inverting US curve and the dollar is due to improvements in growth in China and lower natural gas prices. Therefore, a meaningful setback to China's growth prospects could see parity revisited.

In Focus

USD: Risks for further near-term strength

The US dollar is being supported by robust data and positive surprises in inflation gauges, such as last week's Personal Consumption Expenditure (PCE). This has led to an increase in the probability of a 50bp hike in March, and the disinflation narrative is now being questioned. The market and the Fed will remain data-dependent, with a focus on the ISM PMIs this week and the key employment report next week.

Although my outlook is for the dollar to return to fair value by the end of 2023, such as towards 1.12 vs EUR, there are still risks of further dollar strength in the short term.

EUR: More Upside in 2023

It is expected that the EUR will experience more upside in 2023 due to a faster exit from zero-COVID in China and a maturing tightening cycle for the Fed. There are indications that US inflation is peaking, which further supports this outlook. According to my estimates, there is an additional 3-4% potential upside for EURUSD from China's reopening alone. However, geopolitical concerns surrounding China-Russia relations have put China's reopening plans on hold, as discussed in the Big Picture section. While there have not been any significant increases in energy prices due to geopolitical risks or China's reopening, there are still upside risks.

The ongoing policy normalization by the ECB also supports medium-term EUR upside, despite some ambiguity in February's message. This week, Flash CPI and final PMIs are the standout data points on the docket.

JPY: Focus remains on BoJ governor/deputy nominee remarks

This week, the BoJ nominee hearings in the Upper House will remain the focus of attention. During the Lower House hearing last Friday, Ueda stated that monetary easing should continue for the time being, while refraining from commenting on the timing or method of any future policy changes. As we approach the March BoJ meeting, expectations that the BoJ will move to normalize monetary policy soon should support the yen.

In terms of data releases, the Tokyo CPI is a key indicator to watch on Thursday.

GBP: Risk-reward shifts towards weak pound

The BoE's shift towards a more dovish stance in February, despite mounting inflation pressures at home, is causing a shift in the balance of risks towards a weaker pound. Even if the MPC decides to raise rates further, it would likely be in response to persistently high inflation, and the experience with reactive tightening throughout 2022 suggests that this would be unlikely to help the currency much. Consequently, I believe that risks to my medium-term forecast of 0.87 for EURGBP are tilted towards the upside, even though valuations are generally neutral.

In terms of upcoming data releases, final PMIs and housing credit are noteworthy, while BoE speakers including Governor Bailey, Mann, Pill, and Broadbent will also be in focus.

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