Markets are starting the year with a clear picture in mind: prices will fall faster than anticipated due to a marked slowdown in economic activity. Therefore, policymakers will be forced to engage in interest rate cuts earlier and more aggressively than thought.

This picture looks particularly compelling in Europe. The consensus is for inflation to undershoot ECB's projections throughout the year and for headline CPI to hit the central bank's inflation target by the year's third quarter. Economists at Bloomberg paint an even more dovish picture: they expect headline inflation to fall below the central bank's inflation target by the year's second quarter due to negative energy contributions. The core measure is expected to drop below 2% soon after as prices for food and goods stagnate throughout the year.

Such deflationary trends are unlikely to be accompanied by any optimism. The eurozone has suffered a downturn, and growth is forecasted to remain sluggish throughout the year. Eurostat says the number of bankruptcy registrations in the euro area is the highest since 2015. High-interest rates and lower economic activity are unlikely to slow down such a trend, suggesting that the ECB can't remain on the sidelines for long, building the case for early rate cuts.

Contrary to market expectations, rate cuts might already start in March.

Markets give only a 30% chance that the ECB will cut rates in March because policymakers are actively pushing back against early rate cuts, and investors discard the possibility that Lagarde might cut rates without the absolute certainty that Powell will follow suit. The focus is clearly on the euro currency, which, if devalued further, might bring an upside risk to inflation.

Yet, if CPI figures in January and February drop sensibly as economic activity lags, the ECB might be forced to revise its economic projections downwards. At the same time, half of the remaining TLTRO current balance is set to expire in March, making the need for easier monetary conditions likely.

Whether the first cut comes in March or April, the bull-steepening of yield curves is set into motion, with the German yield curve likely dis-invert.

Ten-year Bund yields have recently encountered strong support at 1.9% and are on their rise to test 0.382 retracement at 2.335%. If they break above this level, they are likely to rise to 2.6%. Yet, as inflation beats on the downside, there is room for yields to test and potentially break below 1.9% to find the next support at 1.73%. If the bond rally remains underpinned by deflationary trends and the ECB cuts rates by surprise in March, yields might test and break below this level, finding support next at 0.8%.

When talking about ultra-long duration, we refer to bonds that have a maturity longer than twenty years. These instruments have a high duration and are, hence, more sensitive to changes in interest rates. While the case to extend one's portfolio's duration remains compelling throughout the first half of the year, a more cautious approach is required for buy-to-hold ultra-long fixed-income securities.

Markets are pricing for up to 150bps rate cut by the ECB by the end of the year. Although the central bank might indeed cut by more than 25bps at a time, what is also true is that a rebound of inflation during the second part of the year might stall the rate-cutting agenda. If markets were to price out part of the rate cuts for this year, that would result in higher yield across the sovereign yield curve, weighting particularly heavily on bonds with ultra-long duration.

The ECB is reviewing its operation framework, which is due to be finished by spring. The question is whether the central bank decides to keep a large amount of excess liquidity in the financial system via a large balance sheet like the Federal Reserve or whether it wants to create excess liquidity by providing loans to banks upon demand, as the Bank of England is doing. So far, policymakers are leaning toward the latter option, implying that the unwinding of the ECB balance sheet is likely to continue. Interestingly, roughly half of the outstanding TLTROs will expire in March and the remainder in December, building the case for an early interest rate cut. Reinvestments under the APP program have ended as of August 2023, representing a tapering of just under €30 billion per month on average in 2024. In the year's second half, the ECB will reduce reinvestments in the PEPP program by €7.5 billion a month to end them entirely in 2025, representing an additional tapering of €15 billion a month. With the APP program currently holding securities for €4 billion and the PEPP for €1.7 billion, it would take roughly a decade for the ECB to unload these holdings at the forecasted pace.

Economists are not excluding that we might see a reacceleration in inflation during the year's second half. Geopolitical risk is high, indicating that a rebound in commodity prices is possible despite weak demand. Unemployment remains at a record low, while wage growth is above 5% YoY. As inflation drops, real wages become positive, increasing demand. If the above were to happen, it's unlikely that the ECB will be able to continue to ease the economy, putting ultra-long duration at risk.

Even if the BOJ decides not to normalize monetary policies, Japanese investors might still not be compelled to buy European Government bonds (EGBs) at current levels. Ten-year Japanese government bonds pay 55 basis points. Excluding last quarter's peak in JGB yields, that's the highest they have paid in eight years. If Japanese investors were to buy 10-year German Bunds and hedge them against the JPY, they would record a nearly 2% loss. For these securities to become appetible again, hedge costs need to drop, or German Bunds need to offer a considerably higher yield.

A key feature of price action has been re-steepening from the back end of late. The US 2/10yr spread is in to the -17bp area now, just a smidgen off the -15bp seen a few months back. Still inverted, but now dis-inverting with some vigor. Part of this has been driven by prior front-end falls in market rates as bets for a March cut built. But this week the dominant driver has been a pull higher in longer tenor rates, right out the curve. The US 10/30yr spread is now knocking on the door of 25bp.

The pressure for higher long-term rates is mostly coming from Treasuries, as swap spreads in 10's and 30's are relatively contained. In contrast, front-end swap spreads have been widening, as 2yr yields have fallen in a relative sense. From here the 2/10yr will want to hit zero as a target, while the 10/30yr will eye the 35bp level hit last summer. Curve steepening trades are an obvious way to go as we gear up for rate cuts, but they are negative in carry and thus a pain to hold. Decent steepening episodes like we are seeing now help ease that pain.

At the same time there is a clear manoeuver away from the market discount for a March cut. We've never been believers in a March cut, even though we've been aggressive on our rate cut call for quite some time now. Still, the market has an appreciable expectation for a March cut still priced. It was approaching 80% on Friday. It has since eased in toward 65%. We fully expect it to flip to a 65% discount for no March cut in due course, which should act as a negative driver for bonds.

The move back above 4% for the 10yr Treasury yield reflects many of these factors, and we continue to assess that marks above 4% make sense. There is a route to the 4.15% area as the market looks to get back to where it was just prior to the 13 December FOMC meeting. In fact the 30yr yield is already there. It was in the 4.25% area when Chair Powell stood up at the press conference, and that's where it is now.

Markets have been tinkering with the idea of having rate cuts as early as March or April this year, whilst central banks are doing their best to push back against premature cuts. The ECB pushback over the weekend and on Monday showed some impact with US rates also rising after returning from a long weekend, as they ingested the views as expressed by Lane, Nagel and Holzmann.

Tuesday's interview with ECB Governing Council member Villeroy was more balanced, assigning a high probability to a rate cut this year but also reiterating that it's too early to declare victory over inflation. Again, the data-dependent approach was stressed, which is the recurring theme in recent central banks' messaging.

Having said that, European data points Tuesday were not convincing enough either way to move markets. The ECB survey of consumer CPI expectations declined noticeably, indicative that inflation expectations remain anchored, a condition for any potential rate cuts to be on the cards. Whilst these consumer surveys may not be the hard data point we are looking for, they may help keeping upcoming wage negotiations contained, a closely followed development by the ECB. For now, the forward-looking data also seems sufficiently strong to dismiss the need for imminent rate cuts, as was reflected by the recovering ZEW data from yesterday. A surprisingly negative reading from the US Empire Manufacturing survey seemed to nudge US rates down by a few basis points at first, but most of the decline was retraced shortly after.

Yet despite the soft data and all the pushbacks from central bankers, markets continue to place a high probability on early rate cuts. An escalation of the conflicts in the Middle East is possible, but especially with a view to the ECB, given the supply chain implications and oil price impact, increased inflation pressures in such a scenario could overtake the central bank's growth priorities – at least initially.

European markets open Wednesday with a long list of inflation-related data in the UK, which we can expect to trigger some moves in the Gilt market. US retail sales and industrial production numbers come in during US opening, and together with the Beige Book at the end of the day, these should provide a more thorough look into the underlying strength of the US economy.

The Fed's Bowman will speak about bank capital reforms and Williams is set to speak in the evening about equitable growth.

Tuesday saw Finland mandate a 30-year benchmark issuance, which should come to the market on Wednesday. Germany is also slated for a smaller bond tap in the 30Y sector.

1. Fed's Waller advocates moving carefully with rate cuts.

2. The U.S. launches new strikes on Yemen's Houthis.

3. Trump wins the first Republican contest of U.S. presidential election.

4. The probability of the Fed cutting rates in March falls to 66.9%.

Federal Reserve Governor Christopher Waller dampened expectations of a rapid rate cut on Tuesday. He said that rate cuts should be carried out in a prudent and orderly manner. There is no reason to cut rates as quickly as in the past. They will only do that if they have to. He is more confident that inflation will fall to 2% on a sustainable basis. For the Red Sea crisis, Waller believes that it will not have an impact on underlying inflation. Waller noted that it makes sense to slow balance sheet runoff this year, but only for the U.S. debt portion. Waller sees the surprises in the December jobs report as "largely noise against a trend of ongoing moderation." Many of the 2023 jobs reports have been revised down, and the December report will likely be revised downward as well.

Waller's remarks show his intention to balance the Fed's dual mandate, to avoid keeping tightening for too long while also not starting to cut rates before ensuring the inflation rate reaches 2%. While he seems open to rate cuts, he raises objections in his speech to expectations for as many as six rate cuts this year. After Waller's speech, markets speculated that Wall Street is betting too aggressively on a significant Fed rate cut. Traders have shaved as much as 5 basis points off their pricing of Fed rate cuts this year.

U.S. Central Command issued a statement saying that at 4:15 a.m. (Yemen's Sana'a time) on Jan. 16, U.S. forces launched an attack on Yemen's Houthi-controlled areas, destroying four anti-ship ballistic missiles ready to be launched from Houthi-controlled areas. In addition, the statement also mentioned that the Houthis launched an attack on a Malta-flagged bulk carrier in the Red Sea waters on the same day, and no injuries have been reported for the time being.

The European Union also agreed to move forward with plans for a new naval operation in the Red Sea to protect commercial shipping as the U.S. conducted new airstrikes against Houthi missile sites in Yemen, according to people familiar with the matter. As part of the operation, the EU could send at least three destroyers or frigates with multi-mission capabilities to the Red Sea.

Voting in the first Republican contest of the 2024 U.S. presidential election in Iowa has been completed, with former U.S. President Donald Trump garnering about 51% support, beating the second-place finisher by about 30 percentage points, and receiving support from the state of Iowa for securing the Republican presidential nomination. Trump's approval rating exceeded 50%, reaching about 51%, according to data released by the official Iowa Republican Party. Florida Governor DeSantis came second with 21.2% support, followed by former South Carolina Governor Nikki Haley with 19.1%. Indian-origin entrepreneur Vivek Ramaswamy announced his withdrawal from the presidential race and expressed support for Trump after finishing fourth.

According to the latest data from the CME FedWatch tool, the probability that the Federal Reserve will keep interest rates unchanged in February in the range of 5.25%-5.50% is 97.4%, and the probability of a 25 basis point cut in interest rates is 2.6%. The probability of keeping rates unchanged in March is 33.1%, the probability of cumulative rate cuts of 25 basis points is 65.2%, and the probability of total rate cuts of 50 basis points is 1.7%.

10:00 China GDP YoY (Q4) and Total Retail Sales of Consumer Goods YoY (Dec)

15:00 U.K. CPI and RPI MoM (Dec)

15:05 Interview with ECB President Christine Lagarde

21:30 U.S. Retail Sales MoM (Dec)

22:15 U.S. Industrial Output MoM (Dec)

23:00 U.S. NAHB Housing Market Index (Jan)

23:15 ECB President Lagarde Speaks

00:15 Next Day: ECB President Lagarde Speaks

03:00 Next Day: Fed Releases Beige Book

04:00 Next Day: Fed's Williams Speaks

05:30 Next Day: U.S. API Crude Stocks for the Week of Jan 12

A raft of top-tier Chinese economic indicators for December, culminating in Q4 and 2023 GDP, takes center stage in Asia on Wednesday, with global markets under heavy selling pressure from a sharp rise in the dollar and U.S. bond yields.

The MSCI Asia Pacific ex-Japan equity index slumped 1.8% on Tuesday - its steepest fall in nearly six months - and Wall Street's slide will help ensure that sentiment remains fragile on Wednesday.

Asian stocks ex-Japan are now down 5% this year, and emerging market stocks are off to their worst start to a year since 2016.

Global risk appetite was dented after Federal Reserve Governor Christopher Waller on Tuesday indicated interest rate cuts could come later and be implemented more slowly than markets have been positioning for.

This is likely to spill over into Asia on Wednesday, where the focus will be centered on the Chinese economic 'data dump'. Indonesia's central bank also announces its latest interest rate decision.

Reuters polls suggest annual investment and industrial production growth rates in China held steady in December from the previous month, while retail sales growth slowed. The latest house price and unemployment figures will also be released.

On the broader GDP level, quarterly growth is expected to have slowed to 1% in the October-December period from 1.3%, while the annual rate of growth rose to 5.3% from 4.9%, largely due to base effects.

Chinese Premier Li Qiang in Davos on Tuesday said GDP growth was probably around 5.2% last year. He also said China is open for business, notable comments in light of China recently posting the first quarterly deficit in foreign direct investment since records began in 1998.

At a private lunch in Davos on Tuesday Li and People's Bank of China Governor Pan Gongsheng later met business and finance leaders, including JP Morgan CEO Jamie Dimon, Bank of America CEO Brian Moynihan, and Blackstone CEO Steve Schwarzman.

Beijing may be on a charm offensive, but it will need the data to pay ball if it is to have any chance of succeeding.

Full-year growth is expected to slow to 4.6% in 2024 from 5.2% last year, with risks probably tilted to the downside - the property crisis is rumbling on, consumer and business confidence is weak, local government debt is high and rising, and deflation looms large over the economy.

Bank Indonesia, meanwhile, is expected to keep its key interest rate unchanged at 6.00% on Wednesday. With inflation within BI's 2023 target range of 2.0% to 4.0% for seven months and falling, markets are pricing in the first rate cut in the third quarter.

- China house prices, investment, retail sales, industrial production, unemployment (December)

- China GDP (Q4 and 2023)

- Indonesia interest rate decision

- Japan tankan services index (January)

Data on employment continues to be relatively reliable. In most months, the increase in the labor force is bigger than the rise in unemployment. This is helping to keep the unemployment rate under control, which is currently relatively low at 3.9% but is nevertheless increasing. Even though retail sales have fallen by approximately 2% y/y, they appear to be rather stable and do not indicate any signs of recession or household concern. Despite the Reserve Bank of Australia's (RBA) tightening, housing the single largest source of household wealth appears to be in good shape.

As most people expected, the Reserve Bank of Australia kept its cash rates at 4.35% at its last meeting of the year. Last month, Bullock warned that inflation was being caused more and more by high demand at home rather than supply changes from other countries. The board said it was aware that getting inflation back to the goal range of 2 to 3% was taking longer than expected. They also said that real inflation was higher than expected because the cost of services was going up faster than expected. Policymakers said again that more tightening will depend on the facts and how the risks are seen. The committee also said it would keep a close eye on the global economy, changes in local demand, and the future of inflation and the job market.

Concerns around the cost-of-living and interest rates continue to dominate consumers’ worries. The RBA’s decision to leave policy unchanged in the month provided little comfort, as household incomes remain under intense pressure from elevated inflation, sharply higher interest rates and a rising tax take.

As far as the market pricing is concerned, futures markets are pricing in a 50% likelihood of a reduction in May. By August, the first increase will be entirely priced in, and by December, a subsequent 25bps reduction is fully factored in by the market.

The job market did better than expected in November, adding 61.5k jobs. It has now added 110k jobs over the last three months. This week's news on job openings backs up the idea that the need for workers will remain strong for a while. Even though companies are still able to handle a lot of the extra workers, there are signs that the job market is becoming less tight for those who already have jobs.

This week, the latest Australian labor force report, which is set to come out on Thursday, will also have an impact on how the AUDUSD moves. Currently, the market is plunging near the medium-term ascending trend line around the 0.6600 round number and any drops lower would open the way for a bear market until the 200-day simple moving average at 0.6580. Even lower, the market may challenge the 0.6520 support level.

On the other hand, a rise beyond the 0.6645 barrier could take the price until the 20-day SMA at 0.6740 ahead of the 0.6870-0.6895 restrictive region.

The effective closure of the Red Sea to tankers carrying liquefied natural gas (LNG), while a concern, is unlikely to shift prices for the super-chilled fuel because other factors are driving the market.

QatarEnergy, the world's second-biggest LNG shipper, has stopped sending tankers via the Red Sea, a senior source with direct knowledge of the matter told Reuters on Monday, with at least four vessels being held up since the weekend.

The halt on traversing the channel that links the Indian Ocean to the Mediterranean Sea via the Suez Canal comes as Yemen's Iran-aligned Houthi group continues to attack vessels in the key shipping lane.

If the Red Sea remains closed for an extended period it will force LNG tankers and other vessels to take the longer route around the Cape of Good Hope in South Africa, adding to costs and voyage durations.

But even in this worst-case scenario, LNG cargoes will still be moving from Qatar to customers in Europe.

It's also worth noting the volume of LNG affected is relatively small, and the current market dynamics are flexible enough to compensate without putting significant upward pressure on spot prices.

The bulk of Qatar's LNG heads to buyers in Asia, the top-importing region, with data compiled by commodity analysts Kpler showing that on average Asia takes about 80% of the Middle East producer's volumes.

In December, Qatar shipped 6.02 million metric tons of LNG to Asia and 1.09 million to Europe, and the volume shipped to Europe has been anchored around that level for the past five months.

Even if Qatar's shipments to Europe were to decline, it's likely that any shortfall could be made up by the United States, which became the world's largest LNG exporter in 2023, overtaking both Qatar and Australia.

The United States is a swing shipper of LNG, supplying buyers in both Europe and Asia, but increasingly focusing on Europe, especially with the loss of much of the continent's supply of Russian pipeline gas in the wake of Moscow's invasion of Ukraine almost two years ago.

U.S. LNG exports hit a record high of 8.56 million tons in December, according to Kpler, with Europe receiving 5.87 million and Asia 2.2 million, and small volumes heading to the Americas.

The United States has the ability to boost shipments to Europe if required, and it may also suit to send less to Asia given the current delays affecting shipping through the Panama Canal, caused by a lack of rain leading to draught restrictions and lower shipping movements.

The current situation in the Red Sea has the potential to escalate, but for the moment it's more of a concern than a factor driving prices.

Rather, spot LNG prices are being driven by robust supply from the United States and Australia, which is proving enough to meet the strong demand in Asia over the winter peak period.

Asia's LNG imports were 26.56 million tons in December, the highest in Kpler records going back to 2009 and up from 23.31 million in November.

The strength in demand is continuing into January, with Kpler estimating arrivals at 25.61 million tons, which would be well above the 23.38 million recorded in January 2023.

Joining the United States with record exports in December is Australia, which shipped 7.22 million tons in the month, eclipsing the previous all-time high of 7.18 million in June 2022.

Qatar also saw strong exports in December, recording 7.11 million tons, the most since January 2023, according to Kpler.

The robust supply is keeping spot LNG prices muted in Asia, with the weekly assessment dropping to a seven-month low of $10.10 per million British thermal units (mmBtu) in the seven days to Jan. 12.

New York-traded contracts linked to the benchmark S&P Global Commodity Insights JKM marker didn't trade on Monday because of U.S. public holiday, but they ended at $11.20 per mmBtu on Jan. 12, declining for a fifth straight day.

European natural gas prices dropped on Monday as mild weather forecasts and ample inventories trumped concerns over Middle East instability, with benchmark Dutch TTF contracts ending at 29.90 euros ($32.64) per megawatt hour, down from 31.60 euros at the close on Jan. 12.

The price is equivalent to about $9.59 per mmBtu, which isn't high enough to draw spot LNG cargoes away from Asia, a further sign that so far the market is relatively unconcerned about the attacks on shipping in the Red Sea.

The opinions expressed here are those of the author, a columnist for Reuters.

($1 = 0.9160 euros)