A setback for the USD as US yields correct lower

USD: Fed is less confident over need for final hike  

The US dollar has continued to trade at weaker levels during the Asian session following the sell-off in response to the latest FOMC meeting. It has resulted in USD/JPY falling back towards the 150.00-level and EUR/USD rising up to the 1.0600-level. The correction lower for the US dollar has been encouraged by the sharp decline in US yields yesterday. The 10-year US Treasury yield declined by almost 20bps yesterday and hit an intra-day low overnight of 4.70% as it moved further below the recent peak at just over 5.00%. Yields at the short end of the US curve also moved lower but by a lesser extent. The 2-year US Treasury yield declined by around 14bps as it dropped back below 5.00%. The Fed’s latest policy update has reinforced market expectations that the rate hike cycle has ended which has encouraged market participants to price back in more cuts into next year. There are currently around 7bps of hikes priced in for the January FOMC meeting, and around 80bps of cuts priced in by the end of next year. The dovish repricing of Fed policy expectations has been triggered by comments from Fed Chair Powell in the press conference who stated that “the question we’re asking is: should we hike more?”. As a result the Fed sounds less confident that they will follow through on their plans to deliver one final hike later this year as forecast at the September FOMC meeting. He downplayed the importance of September’s dot plot by saying “that’s not like a plan that anybody’s agreed to, or that we will do”. He did still emphasize though that the decision as whether to hike again will be made on a meeting by meeting basis with the committee having an abundance of data to assess ahead of the next FOMC meeting on 13^th December including two US employment and inflation reports. While one final hike still can’t be completely ruled out, the comments from Fed Chair Powell give us more confidence that the Fed is unlikely to hike rates further but it will also require the US economy and inflation to slow heading into next year. The next key test of that view will be the release of the latest non-farm payrolls report on Friday. The release yesterday of the ADP survey for October has estimated that private employment slowed to 113k. It compares to private non-farm employment growth of 263k in September and an average of 195k over the last three months.

The Fed’s more cautious stance over the need for further rate hikes mainly reflects the recent sharp tightening in financial conditions. Chair Powell stated that financial conditions have “tightened significantly in recent months driven by higher longer term bond yields, among other factors”. He noted that the tightening in financial conditions would have implications for the fed funds rate decision provided that the move higher in yields is “persistent” and not driven by expectations that the Fed needs to hike rates further. While long term yields fell sharply yesterday we expect them to remain at higher levels than prior to the summer bond market sell-off. The sharp move lower in long-term yields yesterday was initially driven by the US Treasury’s quarterly refunding announcement which saw a slight adjustment in issuance away from longer durations towards shorter durations in response to recent market conditions. At the same time, Fed Chair Powell sounded more optimistic over the supply side of the US economy which would help inflation to slow further and support growth. He highlighted that increased labour supply from rising participation and immigration is helping the labour market to move into a better balance. He views the ECI data for Q3 as “validating” the recent step down in wage growth. Overall, the developments have provided a setback for the US dollar and will help to dampen upward momentum in the near-term. However, we do not yet see a sustained reversal lower while the US economic data flow remains strong.        

USD’S UPWARD MOMENTUM HAS EASED RECENTLY

Source: Macrobond & MUFG GMR

GBP: BoE set to leave rates on hold as hiking cycle close to an end

Market attention will now shift to the BoE’s latest policy update today. Cable has risen modestly ahead of the BoE meeting driven mainly by the weaker US dollar from a low yesterday of 1.2096 to a high overnight of 1.2196. EUR/GBP has also fallen back towards support form the 200-day moving average that comes in at just above 0.8690. For the pound to extend those gains today, the BoE will have to provide a more hawkish than expected policy update that signals a higher risk of a further hike. The UK rate market like the euro-zone and US rate markets has moved to price out further BoE rate hikes, and has started to price back in more cuts into next year. There are currently only around 8bps of hikes priced in by the February MPC meeting, and around 44bps of cuts are priced in by the end of next year. The pricing is moving more in line with our own view that the BoE will not hike rates further and will deliver more rate cuts next year as outlined in our latest monthly FX Outlook report (click here).

The case for the BoE to bring an end to their rate hike cycle has strengthened recently supported by weaker than expected economic growth in Q3, slowing inflation and contracting money supply growth. The BoE’s latest forecasts are likely to show a downward revision to the near-term growth outlook. The BoE will be encouraged that inflation is slowing but it will not be sufficient to ease concerns amongst more hawkish MPC members over the risk of higher inflation proving to be more persistent. As result, there is likely to be another divided vote to leave rates on hold today. We still expect the pound to weaken further as the UK rate market moves to price in more BoE cuts into next year, but are wary of the risk of a temporary bounce today if the BoE does not signal as strongly as expected that they are unlikely to hike rates further.    

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
GE	08:55	German Unemployment Change	Oct	15K	10K	!!
NO	09:00	Interest Rate Decision	--	4.25%	4.25%	!!
EC	09:00	Manufacturing PMI	Oct	43.0	43.4	!!
EC	11:00	ECB's Lane Speaks	--	--	--	!!
UK	12:00	BoE Interest Rate Decision	Nov	5.25%	5.25%	!!!
UK	12:00	BoE MPC Meeting Minutes	--	--	--	!!!
US	12:30	Initial Jobless Claims	--	210K	210K	!!!
US	12:30	Nonfarm Productivity (QoQ)	Q3	4.1%	3.5%	!!
US	12:30	Unit Labor Costs (QoQ)	Q3	0.7%	2.2%	!!
UK	14:15	BoE Gov Bailey Speaks	--	--	--	!!!

Source: Bloomberg