Fed leads the way in pivoting towards rate cuts

USD: Fed pivots towards cutting rates weighing heavily on the USD

The US dollar has continued to weaken overnight after the Fed’s latest policy update triggered a heavy sell-off. It has resulted in the dollar index declining by around -1.4% from prior to yesterday’s FOMC meeting to the intra-day low overnight of 102.43. The yen has been the biggest beneficiary amongst G10 currencies from the broad-based US dollar sell-off and sharp decline for US yields resulting in USD/JPY dropping to an intra-day low overnight of 140.97. The pair has closed below support from the 200-day moving average that comes in at around 142.50 for the first time since May. The latest leg lower for USD/JPY has been encouraged by the sharp drop in US yields overnight. The 2-year and 10-year US Treasury bond yields have declined by around 30bps and 20bps respectively as market participants have moved to price in even earlier and more aggressive Fed rate cuts into next year. The US rate market is now fully  pricing in the first rate cut by 20^th March FOMC meeting, and a total of around 150bps of rate cuts by the end of next year. It brings market pricing more into line with the forecasts from our US rate strategist (click here).            

The main trigger for the dovish repricing overnight was the Fed’s latest policy update in which they signalled that they are moving closer to lowering rates as inflation converges towards their 2.0% target. In the accompanying press conference Fed Chair Powell stated that policymakers had a preliminary discussion about how long to hold rates before cutting and expect to discuss further, and acknowledged the risk of keeping rates too tight for too long. It was a surprise for most market participants who had been expecting the Fed to push back against expectations for earlier and deeper rate cuts next year given unease over the recent easing of financial conditions. On the contrary, the comments from Fed Chair Powell open up the possibility of the Fed beginning to cut rates from the first quarter of next year although the continued description of inflation as “elevated” and the need for a cautious approach could still mean the Fed waits a little longer.   

The main trigger for the Fed’s policy pivot away from rate hikes to rate cuts was the “very good” progress on inflation. The updated economic projections revealed that the median SEP estimate of core inflation for the end of this year was cut by 0.5 percentage point to 3.2% which was significant undershoot compared to the previous forecast from September. The forecast for core inflation for the end of next year was also lowered by 0.2 percentage point to 2.4%, although both core and headline inflation are still not expected to reach their 2.0% target until 2026. While the Fed lowered the inflation forecasts, it was also able to raise their GDP forecasts highlighting that they have more confidence in a soft landing for the US economy. The GDP forecast for this year was raised by 0.5 percentage point to 2.6% after which growth is expected to slow below trend next year (1.4%). The softer landing for the US economy is expected to result in the unemployment rising only modestly to 4.1% in line with their new forecast for the longer run equilibrium rate. The favourable disinflationary developments have prompted Fed officials to pencil more rate cuts into their plans for next year. The median projections amongst FOMC participants for the Fed funds rate have been lowered to include a third rate cut by the end of next year. From 5.4% in 2023 to 4.6% in 2024 as they plan to lower rates back closer to more neutral levels between 2.5% and 3.0% over the forecast period. The breakdown of views was though widely dispersed. Eight participants expected less than three rate cuts next year while five expected more. Six participants actually favoured three rate cuts. 

In these circumstances, the US dollar is now more at risk of further weakness heading into early next year. While the developments support our bearish outlook for the US dollar, we highlighted in our Annual Outlook report released yesterday (click here) that there are challenges that could provide headwinds for further US dollar weakness in the first half of next year. One potential headwind could be highlighted today by dovish policy updates from the other major central banks of the BoE and Fed. We continue to favour long yen positioning in anticipation that policy divergence between the BoJ and other major central banks will narrow in the year head, and are currently recommending  a short EUR/JPY trade idea (click here). One fresh area of uncertainty for the yen is the pick-up in domestic political risk in Japan. Prime Minister Kishida will reshuffle his cabinet today in a bid to contain a funding scandal that is threatening his leadership. A Jiji poll released overnight that was conducted between 8^th and 11^th December revealed that support for his cabinet fell by 4.2ppts to 17.1%. It was the lowest of any cabinet since September 2009                                

US RETAIL & WHOLESALE MARGIN INFLATION HAS CLEARLY SLOWED

Source: Bloomberg, Macrobond & MUFG GMR

EUR/GBP: Will BoE & ECB follow the Fed by providing dovish policy update?

Market attention will now turn quickly to today’s policy updates from the BoE and ECB to see if they follow the Fed and deliver similar dovish policy signals that open the door to rate cuts from early next year. There is clearly stronger fundamental justification for the ECB to begin cutting rates early next year as we highlighted in our latest FX Weekly (click here). As we have seen recently, inflation in the euro-zone is now falling back towards the ECB’s target much more quickly than expected. The headline rate fell to 2.4% in November and the annual rates of core and services inflation both fell sharply by 0.6 percentage points as well helping to ease concerns over the risk of more persistent inflation in the euro-zone. The faster than expected slowdown in inflation has caught ECB policymakers by surprise. It even prompted the normally hawkish ECB Executive Board member Isabel Schnabel to describe developments as “quite remarkable”.

The stage is now set for the ECB to revise down their forecasts for inflation today. We expect the headline and core inflation forecasts for 2024 to be lowered by around 0.3ppts to 2.9% and 2.6% respectively. More importantly for market participants, the forecasts for 2025 and beyond could now show inflation returning to the ECB’s target at around 2.0%. It would provide justification for the ECB to officially end their hiking cycle, and to begin to turn their attention to lowering rates next year back towards more neutral levels that are estimated  to be closer to between 1.50% and 2.00%. With the euro-zone economy stagnating and at risk of falling into technical recession in Q4 it is becoming more challenging to justify keeping rates at such restrictive levels at 4.00%. The developments support our short EUR/JPY trade recommendation. Even if the ECB attempts today to push back against earlier rate cuts next year, the comments could lack credibility given weakening fundamentals.

Of the three major central banks we thought that the BoE would have the most credibility in pushing back against dovish market pricing that could help the pound to outperform both the euro and US dollar in the near-term based on the view that the risk of more persistent inflation in the UK currently appears to be higher. However, data releases in recent days have cast some doubt on the view that the BoE will lag the ECB and Fed in cutting rates next year. We have been encouraged by the latest UK labour market report showing clearer evidence that wage growth is slowing, and at the same time the UK economy unexpectedly contracted  again in October by -0.3%. After a poor start to the quarter it looks likely that the UK economy will continue to stagnate at best in Q4 compared to the BoE’s forecast for a marginal pick-up in growth by 0.1%. While the developments are unlikely to stop the BoE from pushing back again today against earlier rate cut expectations, if the softening growth inflation data continues into early next year it will encourage the BoE more quickly into a dovish policy pivot. As a result the near-term window for relative pound outperformance against the euro and US dollar could prove short-lived.  

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
SZ	08:30	SNB Interest Rate Decision	Q4	1.75%	1.75%	!!!
SZ	09:00	SNB Press Conference	--	--	--	!!!
NO	09:00	Interest Rate Decision	--	4.25%	4.25%	!!
EC	10:00	EU Leaders Summit	--	--	--	!!
UK	12:00	BoE Interest Rate Decision	Dec	5.25%	5.25%	!!!
EC	13:15	Deposit Facility Rate	Dec	4.00%	4.00%	!!!
US	13:30	Initial Jobless Claims	--	220K	220K	!!!
US	13:30	Retail Control (MoM)	Nov	--	0.2%	!!
EC	13:45	ECB Press Conference	--	--	--	!!!
EC	15:15	ECB President Lagarde Speaks	--	--	--	!!

 

Source: Bloomberg