USD firm even as dovish December hike seen

The market continues to price in a decelerating tightening from the US Federal Reserve, but the greenback isn’t yet backing down as economic growth concerns have gone global. Fed chair Powell could add colour in a speech late today.

Recently appointed Fed vice-chair Richard Clarida was out speaking on the economy and monetary policy yesterday and expressed a confident outlook in the economy while continuing to advocate a data-dependent policy stance. A glance at US short interest rates going nowhere in a hurry yesterday despite the USD posting a solid bounce suggests that the market is clutching at straws in trying to derive a signal from this speech.

Still, Bloomberg parsed the speech and highlighted a slight shift in Clarida’s language: in his first speech in his new position he touted the need for “some further gradual adjustment” which was reformulated to yesterday’s more vague “gradual policy normalisation.” The article argues that this could be the new policy guidance for the December 19 Federal Open Market Committee monetary policy statement, which the market is beginning to price as a dovish hike scenario. Expectations strongly favour a hike at that meeting, with the highest odds for 2019 only seeing one further rate hike for the cycle; Powell will be out speaking late today.

The strongest signal from the Treasury market would be taking the longer yields lower despite the torrent of Treasury issuance this year. Our focus is on the 3.00% level for the 10-year Treasury note, as a break below would suggest a rejection of the attempts higher and likely a bleaker outlook for risky assets. The market absorbed the large auctions of two- and five-year notes very well on Monday and yesterday, respectively, and seven-year notes are on the block later today. Auctions for 10-year notes and the 30-year T-bond are up December 12-13.

US President Trump is full of the usual bluster ahead of a dinner this Saturday with China’s Xi at the Buenos Aires G20 summit, dangling the idea of slapping tariffs on another $267 billion of Chinese imports and vowing to increase the extant tariffs from 10% to 25% on January 1. Many argue this is merely his usual tactic of starting with an aggressive opening position. Trump’s chief economic adviser Kudlow says that talks between the US and China are ongoing “at all levels” ahead of this weekend’s meeting and that President Trump is open to a deal, while the general line is that China has to offer more from its side to address US concerns.

Our most optimistic scenario is a cease-fire on further escalation in tariffs and an agreement to re-engage in talks as China makes vague promises that may take considerable time to verify and still don’t avert the longer-term risks of a trade war. Not sure how the market is pricing this event as there are many moving parts leading to asset markets’ recent funk.

Chart: USDCAD (weekly)

USDCAD is pushing higher and coming up against a major resistance level just ahead of 1.3400, a break of which shifts the focus all the way to the 1.3800 area highs of 2017. The collapse in oil prices has weighed on CAD, although many Canadian producers never even benefited from higher oil prices in the first place due to supply gluts on a lack of overseas export infrastructure now that US crude production is booming again.

The credit cycle has turned tighter in Canada and the overextended housing market is clearly beginning to feel the squeeze. Still, US-Canada two-year yield spreads are stuck in a tight range and in the middle of the range established over the summer, so we arguably need a negative catalyst to send USDCAD significantly higher.