As the year draws to a close, a profound sense of gratitude envelops me for the invaluable lessons learned and the remarkable individuals encountered along the way. Given that this Portfolio Update marks the culmination of 2023, I wish to take a moment to reflect on the events that transpired and share a few important lessons that have enriched my journey.

The pivotal event of the year was a profound exploration of my limits, both in the financial markets and my personal life. While I’ve always been focusing on macro, my old readers may remember that my initial focus had been primarily on equities. However, humbly, I came to a realization earlier this year: I recognized a gap in my understanding of equity market drivers at an aggregate level. Faced with this realization, I had two choices: adapt my approach to become a better equity trader, or transition to a market where my methodology aligned more seamlessly. Opting for the latter, I shifted my focus to the currency market.

Of course, the transition was not without its challenges—requiring extensive learning, the development of models and indicators, and the accumulation of valuable experience. Nearly three quarters into this dedicated focus on FX and macroeconomics, I can confidently say that the results have been a source of pride.

Admittedly, I underperformed the market. While still closing the year very positive, the performance could have been better with a simple investment in QQQ. Nevertheless, the invaluable lesson learned and the profound insights gained through introspection into my own personality will serve as guiding lights for years to come. Therefore, it has undeniably been a remarkable year.

As I turn my gaze towards the upcoming year, my aspirations in this “arena” revolve around continuous learning about currency drivers and macroeconomics, but also to delve deeper into the workings of the real economy. Indeed, an evolving fascination with the intricate art of M&A has taken root within me, and I am committed to taking every step necessary to establish myself as a significant player in that dynamic market as well.

Look Ahead

In the markets, this year has been a continuous succession of narratives, more or less well-founded, focused on key features such as growth (or its lack), inflation, and monetary policy. At least from what I’ve seen, many on Twitter have staked their reputation by doubling down on ideas or positions that have proven to be wrong, losing capital and, above all, credibility.

Of course, I’ve made some terrible predictions myself—after all, it’s part of the game. The important thing is to realize when you’re wrong and admit it, especially if you have many followers, and therefore, you have a kind of “additional responsibility” on your shoulders.

Looking at the upcoming year, the primary emphasis seems to be on the cutting cycle and its extent. Over the past two years, the majority of developed economies initiated and concluded their tightening cycles, now waiting for the full impact of those hikes to be felt due to the “long and variable” lags through which policy changes affect the broader economy.

Despite the ongoing impact of delayed policy effects on the economy and the persistent advocacy for the “higher for longer” approach by policymakers, markets are already contemplating the timing of the initial rate cut. Furthermore, there is speculation not only regarding the magnitude of the anticipated cuts but also about which central banks are likely to be at the forefront of such actions. Regrettably, I lack the answer to that question, but I am fairly certain the Fed won’t be the one to initiate it.

This brings us an interesting dilemma. If central banks successfully cut interest rates and achieve a soft landing, it could mark one of the most significant moments in the history of central banking. However, should inflation surge again after the rate cuts, they might be perceived as a joke. Therefore, the pivotal question now is: do they aspire to be heroes, staking their reputation, or do they prefer a cautious approach, risking the possibility of tightening monetary policy too much? This dilemma, I believe, will be the crucial factor to consider while interpreting both economic data and market movements in the first two quarters of next year.

Nevertheless, it’s crucial to bear in mind that, contrary to the seemingly widespread belief, rate cuts aren’t inherently bearish. Given the limited instances of market reactions to rate cuts, we need to delve into the reasons behind the cuts to deduce the rational market response. For instance, if rate cuts occur due to an economic recession, then the outlook is likely bearish. On the other hand, if the cuts are a response to inflation returning to the target and there’s no longer a need for a tightening stance, then it would be considered bullish. The distinction between these scenarios lies not in the action itself (the cut) but rather in the narrative it conveys about the future: the first scenario leads traders to anticipate a decline in growth, resulting in lower earnings and consequently lower valuations; in contrast, the second scenario provides no insight into growth or earnings but does reduce the discount rate, leading to higher valuations.

While policymakers remain hesitant to entertain the idea of implementing cuts due to the potential risk of unintentionally easing financial conditions, nearly all recent economic indicators suggest that the next course of action for the majority of G10 central banks will involve a downward adjustment.

However, unsurprisingly, the BoJ stands as an exception to this trend, with increasing expectations that 2024 will mark the year when the BoJ ultimately concludes decades of ultra-easy policy, positioning them as the lone hawkish outlier among developed market authorities. Whether this will actually happen or not is contingent to the global economic growth.

In any case, if the most profitable FX trade in 2023 was being long MXN and short JPY, resulting in an almost 25% unlevered yield, I anticipate that the optimal FX trade for the next year will once again involve JPY, but on the long side. Specifically, I propose that the “FX Trade of 2024” be a long JPY position against EUR (55%), GBP (30%), and USD (15%). I will revisit this assessment in December 2024 to evaluate the accuracy of this prediction.

Now, let’s look at the individual economic regions.

United States

One year ago, my outlook on the impact of monetary tightening on the real economy, especially in the US, was overly pessimistic: I believed that the depletion of fiscal stimulus, coupled with the adverse effects of persistently high inflation on purchasing power and the erosion of savings amassed during 2020, would render the economy particularly susceptible to the rising interest rates.

Well, that wasn’t the case.

Indeed, I failed to consider the unique nature of the current tightening cycle: unlike previous instances, it doesn’t follow a period of rapid leveraging in the private sector. In other words, there is no sudden “refinancing cliff” compelling corporations into an emergency deleveraging, thereby suppressing spending. Thanks to the solid financial standing of the corporate sector, employment has demonstrated remarkable resilience. While job creation has deviated from its pre-Covid trajectory since late spring, the positive momentum persists. This, coupled with wages showing a gradual deceleration yet maintaining robustness, contributed to sustaining income growth above headline inflation.

However, looking at 2024, I foresee a moderation in consumer spending and, consequently, a noteworthy deceleration in overall economic growth. I expect a decline in real disposable income, with the softening of employment income growth outpacing the easing of inflation. The upswing in tax contribution is also expected to further impact disposable income growth adversely. Furthermore, the positive impulse on consumer spending derived from unwinding excess savings appears to have reached its zenith, and an uptick in the savings rate wouldn’t surprise me.

The trajectory of investment spending is poised for a slowdown, yet its resilience is anticipated to persist. Although this resilience is expected to support spending in the coming quarters, a deceleration looms on the horizon for the upcoming year. Notably, in the absence of any predictions of significant cyclical disruptions and with companies prudently managing their financial structures to avert a looming refinancing hurdle in the upcoming years, we should expect sustained robustness in investment amid ongoing domestic demand—especially when considering investments in energy and AI.

Therefore, a realistic projection places GDP growth in the range of 1.1-1.3% for 2024, which is consistent with the Fed’s objective of a period characterized by growth below potential.

Finally, the decline in inflation is indicative of a reduction in global supply chain pressures and subdued increases in energy prices. Nevertheless, the trajectory of core inflation in the upcoming years hinges on the dynamics of the labor market and, specifically, wages.

Despite a year marked by robust growth, there has been a relaxation in labor market tightness: employment growth has decelerated, unemployment has experienced an uptick, and job vacancies have significantly decreased. While this shift has contributed to a moderation in wage growth, it could pose challenges if this trend persists or worsens in the coming year.

Federal Reserve

In the last meeting of 2023, the Fed announced the decision to keep the rates at 5.25-5.50%, lowering the estimates for next year more than expected. You can read my meeting wrap here.

Looking ahead, as you’re likely aware, I hold the belief that the FFR has reached its peak, despite some participants suggesting a possible final hike: the current policy is restrictive, and with the anticipated decline in inflation, conditions are poised to tighten further as the real FFR appreciates.

Additionally, I expect the Fed to persist with its Quantitative Tightening (QT) over the next two years. Indeed, I believe they will be comfortable reducing the still ample reserves, with only a modest expected impact on monetary tightening. This approach involves dynamically adjusting the real FFR rather than implementing a sharply easing policy.

However, the potential for a more pronounced economic slowdown, necessitating aggressive stimulus, or the emergence of another bank crisis, poses a risk that could lead to an earlier end to QT.

Europe

Unfortunately, the Eurozone’s economic performance has not paralleled that of the United States, and has been teetering on the edge of a recession since the start of the year. Indeed, the persistent vulnerability to energy prices has exacerbated weaknesses in industrial output, particularly noticeable in Germany. However, the softening trend has extended to countries like France and Italy, which had demonstrated resilience during the peak of the energy crisis.

Looking ahead to 2024, I don’t anticipate a significant shift in these divergent transatlantic patterns. Even expecting both the Fed and the ECB to initiate rate cuts around mid-2024, the impact of accumulated monetary tightening is likely to peak in the second half of the year. In Europe, this adverse effect on aggregate demand will be compounded by the shift toward austerity in fiscal policy, already evident in the budget bills for 2024 that have been voted on or are in the legislative process in member states. Ironically enough, the largest member state, possessing the highest capacity for spillover effects across the entire monetary union and one of the broadest fiscal spaces due to its low public debt, remains hesitant to leverage its firepower to alleviate current and structural weaknesses.

Moreover, let’s not forget that Europe is susceptible to external risks beyond its control, which could significantly impact the economic landscape. The distressing situation in the Middle East stands out as a major source of uncertainty for the upcoming year, albeit without any discernible impact on oil markets thus far. However, should the situation escalate—such as through direct involvement by Iran—an oil market scenario with prices exceeding $100 becomes a plausible outcome. Given Europe’s status as an importer, the alignment of elevated oil prices with a strong dollar would magnify the impact on European inflation, posing significant challenges in accommodating such a shock.

Speaking of inflation, there has been a convincing decline in Europe this year, that extends beyond the mechanical effects of the decline in energy prices from the peak of 2022.

The slowdown in core prices has also been facilitated by the normalization of global supply lines. The challenges faced by China in safeguarding demand from the side effects of the real estate correction are contributing to a return to deflation, supporting the moderation of manufactured goods prices on a global scale.

While there is still a considerable distance to cover to bring inflation back to the target, there is enough disinflation evidence to believe the ECB is done with tightening.

European Central Bank

The ECB chose, following the steps of the Fed, to maintain the key interest rates at 4.50-4.75%. Nevertheless, although the economic outlook is bleak, the bank shows no intention to cut next year. I call their bluff. You can read my meeting wrap here.

I anticipate the first rate cut to occur around June. However, it’s worth noting that, historically, the ECB tends to trail the Fed by approximately four months: should the ECB adhere to this historical pattern, the first rate cut would likely be implemented in September.

Regardless, it is safe to say that any anticipated rate cut priced in for the first quarter, or in any case before June, should be faded. If in the first quarter I enjoyed trading eurodollars (when it was still possible!) and fading Fed cuts, I expect to do similarly in the first quarter of 2024, this time involving €STR.

Moreover, I maintain the view that the EUR is excessively overvalued, particularly when considering its REER, which has experienced the most significant appreciation among the G10 currencies. The Eurozone economy has decelerated more than the United States, with inflation declining at a faster pace. Additionally, the ECB policy seems more fragile compared to the current pricing of the Fed. Given the impending growth differential with the US and a renewed emphasis on the ECB’s balance sheet policy, my bias remains tilted towards the downside for EURUSD, and I hold a bearish stance on the EUR overall.

United Kingdom

The United Kingdom faced significant challenges this year, but it managed to reduce inflation significantly from 11.1% to 3.9% within just 12 months, steering clear of an economic recession. Despite all the jokes on Rishi Sunak’s promises to beat inflation, he has, in fact, made remarkable progress in this regard. However, the outlook for 2024 appears more challenging.

While ongoing disinflation is expected to boost household spending power, the implementation of a tighter monetary policy is likely to weigh on households: despite a smaller percentage of outstanding mortgages, the impact of the substantial increase in mortgage rates will be noticeable. This effect has been delayed due to more fixed-rate deals than in previous cycles, but it is anticipated to grow in 2024. Additionally, there will likely be pass-throughs to rents as buy-to-let landlords pass on the higher borrowing costs.

Therefore, the dominant factor affecting GDP will likely be weak consumer spending. The combination of a bleak cyclical outlook, heightened borrowing rates, and political uncertainty, is also expected to contribute to weaker investment. Unsurprisingly, the consensus for GDP growth in 2024 is a mere 0.0%, dangerously close to a recession.

As growth weakens, the labor market is expected to further loosen, contributing to disinflation. The decline in inflation so far is attributed to a mix of reduced energy inflation, slower food price inflation, and a sharper fall in non-energy core goods. However, services inflation remains elevated: the anticipated loosening in the labor market should lead to further disinflation there as well.

Bank of England

At the December meeting, the BoE opted to keep its benchmark interest rate unchanged. As for the ECB and the Fed, I think the rate peak has already been reached.

As mentioned earlier, with the ongoing decline in inflation, the impact of previous tightening measures is likely to intensify, leading to a further tightening of conditions. Consequently, I anticipate that around mid-2024, possibly in August, the BoE will start cutting rates.

Japan

After years of deflation, the Japanese economy seems to be approaching a turning point, thanks to the global inflationary shock triggered by escalating energy costs and a weakened yen, leading to positive changes in pricing dynamics. Although reaching the 2% inflation target may not be imminent, the shift in inflation expectations is a significant development.

Indeed, the longstanding issue of weak domestic inflationary pressures, primarily linked to stagnant wages, is witnessing a sustained uptick. In 2023, the Shunto trade union confederation’s spring wage negotiations resulted in the most substantial pay increase in over two decades. The upcoming round in March 2024 is anticipated to be even more substantial, with unions indicating the likelihood of requesting total hikes of at least 5%.

Hence, if the base effects contribute to a temporary easing of inflation, the sustained pressure on wages is anticipated to be sufficient to anchor inflation at levels higher than those previously observed.

In my projections, I also anticipate the BoJ to formally end YCC and take the initial steps towards rate normalization, potentially hiking by 10bps to 0.0%. However, even under optimistic scenarios, I don’t foresee such actions occurring before April 2024, as I believe the BoJ will await the outcome of the spring wage negotiations.

Moreover, the normalization of policy will be influenced by the policy cycles in other developed markets. Anticipated increases in BoJ rate expectations, coupled with expected easing elsewhere, are likely to result in the appreciation of the yen, posing challenges to both growth and the achievement of inflation targets.

Bank of Japan

This month, the development I’ve been anticipating for several months has finally materialized: the yen experienced its most substantial one-day rally in almost a year following a clear indication from Japanese monetary authorities about a potential policy shift. Governor Ueda explicitly mentioned that the central bank is considering various options for targeting interest rates once it withdraws short-term borrowing costs from negative territory.

However, despite expecting this since September, I unfortunately missed the opportunity to capitalize on this move.

In any case, as the yen began to appreciate, Twitter became flooded with accounts proclaiming an imminent stock market crash because “significant yen movements typically precede a market downturn.” However, there are two fundamental flaws in these assertions. Firstly, the sample size is so small that, from a statistical perspective, the statement lacks credibility. Moreover, the prior instances occurred in economic environments vastly different from the current one, rendering them incomparable.

The second issue with these statements is the outright disregard for the underlying factors driving the yen’s movement. I get it, currencies are hard to understand, but as a general rule we shouldn’t talk about things we don’t have competence on. This year, the yen depreciated because the 1y forward USD cash rate was on the rise, while the 1y forward JPY cash rate remained stable—essentially, the Fed was expected to continue hiking rates, while the Bank of Japan was expected to maintain the status quo. The widening spread between these two 1-year forward rates, known as rate differentials, exerted upward pressure on the USD and downward pressure on the JPY. However, the situation has now reversed: the Fed is expected to cut rates next year, already putting downward pressure on the dollar, while the BoJ is expected to implement rate hikes. As a result, the rate differentials have significantly narrowed, leading to upward pressure on the yen.

Positions

If you recall my previous portfolio update, I had two positions on: short EURUSD and short EURJPY. Well, both these positions were closed with good profits—nearly 2% on EURUSD and almost 6% unlevered on EURJPY. Safe to say I closed the year on a positive note.

As anticipated, I had no intention of initiating new positions in December as my focus was on my studies, career, and goals. Nevertheless, amid the formidable strength of CHF, which poses a potential threat of driving disinflationary pressures in Switzerland, on the very last trading session of the year I have taken a short position on the CHF against the EUR. Or, in other words, I went long EURCHF. Anticipating intervention by the SNB if the current trend persists, I believe there are favorable odds for the trade to be successful, setting the stage for a promising start to the new year.

Moreover, in December, I made the decision to liquidate my long-term portfolio to reinvest the proceeds into my own business. This strategic move significantly enhances the likelihood of achieving the goals I’ve set for 2024.