Market bets on U.S. rate cut

[The Federal Reserve and the Bank of Canada now have the ability to pause interest rate hikes]

The Fed and Bank of Canada now have the ability to pause rate hikes as inflationary pressures are easing rapidly. A soft landing for the U.S. economy is within reach as rising borrowing costs have put the brakes on real estate and other rate-sensitive sectors. The cooling in inflation is showing up in data such as the U.S. producer price index (PPI).

The Bank of Canada is expected to raise interest rates again at its decision on Wednesday. Markets are pricing in a high probability of a 25 basis point hike, which would take the overnight lending rate to 4.5%. The Fed's next decision is on Feb. 1, and the Fed is also expected to raise interest rates by 25 basis points, according to the median estimate in a foreign media survey, which would be the smallest rate hike since March 2022.

[UK fiscal policy is still potentially negative for the outlook of the pound]

UK fiscal policy remains potentially bearish for the outlook for sterling, with GBP/USD pair likely to fall to the 1.22 level; sterling faces the risk of more weakness - unless it can stabilize quickly and strengthen. UK fiscal policy and foreign investor participation in the UK gilt market - remain underlying weaknesses in the outlook for the pound.

[The difference continues to develop in favor of the yen]

Markets expect the Bank of Japan to tighten policy, possibly including exiting negative interest rates in the second half of the year. Rate differentials are expected to continue to move in favor of the yen. Indeed, since Japan is the largest foreign holder of US Treasuries, one should expect Japan's appetite for high-yielding overseas assets to decline if longer-term spreads continue to compress, implying a stronger yen.

[Economists believe that the euro zone is still in trouble]

Manufacturing activity in the euro zone continues to shrink, but its pace of contraction has slowed significantly further; factors such as slowing inflation, warm winter, and improved supply chain and business confidence are boosting market expectations for a ""soft landing"" for the euro zone economy ” optimism. Economists warn that the region is far from out of the woods, though a stabilizing economy adds to evidence that the region may emerge from recession.

[The Reserve Bank of Australia is about to suspend interest rate hikes]

The Reserve Bank of Australia is about to suspend interest rate hikes. Since last May, the RBA has tightened policy every month, which has hit the Australian economy. There are currently factors in favor of the RBA holding off on further rate hikes starting in April, although they will raise rates by 25 basis points in February and March. The official cash rate will peak at around 3.60%. Tightness in the Australian labor market has eased as immigration rebounded. Global supply chains continue to heal, boosting the RBA's cautious optimism that inflation will continue to decline through 2023. Recent trade figures show Australian importers are now seeing a drop in global freight costs.

[Traders bet on U.S. interest rate cut]

Many traders expect the Fed to cut interest rates before the end of the year, while other central banks will turn more ""hawkish"" as policy tightens. Investors are now pricing in a softening of the Federal Reserve's stance as U.S. inflation shows signs of stabilizing and avoiding a hard landing for the U.S. economy has become a top priority. The story was different in Europe and Japan, where economic data continued to beat expectations, reinforcing expectations of a ""hawkish stance"" from their respective central banks. A growing rift between the Fed and other major central banks could lead to further dollar weakness.