FOMC caution to support the dollar but tariffs still key

USD: FOMC guidance curtailed by uncertainty

The US dollar is 2.0% weaker from the high hit earlier this month and is trading around the level when the FOMC last met and cut rates in December. That was viewed as a “hawkish cut” with the dollar strengthening as Fed Chair Powell suggested that the FOMC was likely to pause its easing cycle. The dollar is weaker now from the January high due to the lack of confirmed tariff announcements that may mean the FOMC is somewhat reassured by Trump’s more pragmatic approach to trade tariff policy.

Reading through the December FOMC statement we suspect there will be very little change to the text with the FOMC still comfortable with its guidance of “considering the extent and timing” of future policy adjustments based on “incoming data, the evolving outlook and the balance of risks”. We do have a different composition of voters for this first meeting of 2025 – out goes Raphael Bostic; Beth Hammack; Thomas Barkin; and Mary Daly. Replacing them are Austan Goolsbee; Susan Collins; Alberto Musalem; and Jeffrey Schmid. The overall balance of doves-to-hawks is seen as not having changed very much and given the mixed nature of the incoming economic data, a message similar to December seems most likely. We have had a stronger NFP report and underlying retail sales data was also stronger than expected. Small business optimism has increased notably following Trump’s election victory and the ISM Services data was also stronger. Crucially though, inflation data has been softer than expected. That points strongly to the FOMC wanting to maintain the status quo in terms of market expectations of future Fed policy changes.

At the moment, the OIS market is implying two 25bp cuts by the end of the year, which is exactly what the FOMC dots profile indicated in December. Given we have had no formal trade tariff announcements a more hawkish shift in guidance based on trade tariff inflation risks would be premature. In addition, the AI-tech related equity market turmoil on Monday adds further reason for the FOMC not to be seen turning more hawkish ahead of trade tariff announcements. Finally, why turn more hawkish now when market rates have been doing the work for you. As can be seen above, the 10-year UST bond yield has risen by more in this Fed easing cycle since the Fed first cut rates than in any of the previous six easing cycles before. This move in 10-year yields of course also reflects investors’ concerns over inflation risks given underlying inflation averaged 3.1% in the 12mth period ahead of the Fed’s first cut in September, the highest level since 1989. That suggests the FOMC will also not want to signal a dovish message. While Powell is unlikely to rule out a March rate cut he will likely stress incoming data as key to determining decisions going forward.

So we expect a very similar guidance from the Fed and Chair Powell this evening with market expectations exactly where the FOMC considers they should be. We also have the Riksbank policy decision this morning (we expect a 25bp cut), the BoC announcement this afternoon (see below) and the ECB tomorrow and these decisions along with whether Trump follows through with his tariff promises for 1^st February will be important for the dollar. If these tariffs are still seen as possible, we’d expect the dollar to have rebounded notably by the end of the week.

CHANGE IN BPS OF 10-YEAR UST BOND YIELD FOLLOWING FIRST FED RATE CUT – CURRENT VS LAST SIX EASING CYCLES

Source: Bloomberg, Macrobond & MUFG GMR

CAD: Muted sell-off points to hope through negotiations

The Canadian dollar is the second worst performing G10 currency so far this year and the only surprise in that is that the pound is performing worse. We see clear downside risks for CAD with signs since Trump’s inauguration certainly clearly pointing to a greater focus on trade tariffs being implemented on both Canada and Mexico imports to the US. The Bank of Canada meets today and given this backdrop of a clear risk of a trade shock for the Canadian economy, we expect the BoC to deliver the 25bp cut to the policy rate that is widely expected. A 25bp cut is close to fully priced and given the clear negative consequences for the economy if Trump does deliver on his plan for trade tariffs of up to 25%, the Canadian economy will need additional policy support. Real GDP in Q4 in fact is looking like it will surpass the BoC estimate of 2.0%, by as much as 0.5ppt. Inflation has also proved a little higher than the BoC expected – 2.6% versus 2.3% expected. The latest inflation reading was weaker than expected but a tax holiday certainly played a role in that. But these divergences won’t be enough to deter the BoC especially given there are grounds for believing that growth may have got a lift from Canadian companies increasing exports in an attempt to avoid the expected trade tariffs.

But for the BoC this meeting will really be dictated to a high degree by the uncertainty over the immediate economic outlook given the 25% tariff threat from 1^st February remains in place and would we believe prove net disinflationary. Yes, Canada retaliating would have inflationary consequences but the demand hit and the potential labour market hit would be clearly deflationary and that for now will likely take precedence in BoC policy deliberations. The increased supply of labour will continue to help ease wage growth – the unemployment rate hit a high of 6.9% in November, the highest level since January 2017 (when covid is excluded).

USD/CAD is certainly not trading to reflect the implementation of a 25% trade tariff on all imports by this weekend. So there remains a high level of scepticism over this policy threat being delivered. Based on data since the start of 2022 USD/CAD is trading exactly where it should be based on the 2-year US-CA swap spread. That spread will certainly move further wider if trade tariffs are confirmed and we suspect comments from Governor Macklem today will indicate greater growth concerns over inflation concerns related to tariff risks that would be a signal of a willingness to ease further if a trade shock is around the corner. A break of the 1.4500 resistance would be immediate with a move quickly to the 1.5000-level and beyond. So Trump’s decision will be far more important for CAD than today’s BoC decision.

USD/CAD TRADING WHERE IT SHOULD BE BASED ON 2-YEAR US-CA SWAP SPREAD – BUT A 25% TARIFF WOULD SEE LEG HIGHER

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Country	GMT	Indicator/Event	Period	Consensus	Previous	Mkt Moving
EC	09:00	M3 Money Supply YoY	Dec	3.90%	3.80%	!
IT	09:00	Consumer Confidence Index	Jan	--	2.180%	!
IT	09:00	Manufacturing Confidence	Jan	0.3%	-0.2%	!
IT	09:00	Economic Sentiment	Jan	0.1%	-1.2%	!
US	12:00	MBA Mortgage Applications	Jan-24	--	-0.4%	!
US	13:30	Advance Goods Trade Balance	Dec	--	-0.2%	!
US	13:30	Wholesale Inventories MoM	Dec P	0.3%	0.4%	!
US	13:30	Retail Inventories MoM	Dec	--	4.5%	!
CA	14:45	Bank of Canada Rate Decision		--	4.5%	!!!!
US	19:00	FOMC Rate Decision (Upper Bound)		4.2%	4.2%	!!!!
US	19:00	FOMC Rate Decision (Lower Bound)		105.9	104.7	!!!!
US	19:30	Powell Press Conference				!!!!!

Source: Bloomberg