Head of FX Strategy
Summary: The ECB and BOE pushed back on pivot bets, adding to the post-FOMC dollar slide. Markets now expect a higher chance of a Fed rate cut in Q1 compared to the ECB, which could mean that the ECB falls behind the curve. EUR may be a buy on dips for now, but room for 2024 decline has increased. Yen is up over 4% this month on dollar decline, but also on BOJ pivot bets. Next week’s decision could bring another dovish outcome which may bring back yen weakness, especially against EUR and GBP.
Unlike the Fed, the central banks across the Atlantic delivered a pushback on pivot bets. The European Central Bank decided to slow PEPP reinvestments in H2 2024, and then stop them at the end of next year. This opened the room to simplify the communication for rate cuts when they happen, but for now President Lagarde said that the Governing Council did not discuss rate cuts. She emphasized that ECB is data dependent, but they are clearly lagging in reading their data. Inflation projections were downgraded to 5.4% from 5.6% for 2023, 2024 cut to 2.7% from 3.2% and 2025 held at 1.9%. However the cut-off date was 23 November, which means that the ECB did not take into account the slide in November CPI to -0.5% MoM. On the growth front, 2023 and 2024 projections were cut with GDP next year seen at just 0.8% with the 2025 forecast held steady at 1.5%.
Going into this week, the big question was whether the Fed or ECB will cut first. Markets were betting on ECB to go earlier than the Fed. But this week’s communication will likely shift that. Markets now price in a March Fed rate cut with 80% probability but a March ECB rate cut has only about 50% odds. This will put the ECB behind the curve again.
For the FX space, this means EUR could be a buy on dips for now as market pricing looks stretched compared to the ECB communication. However, it also means that ECB will have to end up cutting more aggressively in 2024 as they lag behind the curve, and room for EUR decline could be higher. December flash PMIs are a key test today, and a recovery could threaten break of 1.10 in EURUSD. Key resistance seen at 76.4% fibo retracement that lies at 1.1081 ahead of July highs at 1.1276.
The Japanese yen has had strong rally, rising by over 4% against the USD in December. But the yen remains a “BOJ problem with a Fed solution”, and gains have come primarily on the back of a slide in Treasury yields. However, part of the strong December gains have also come from speculations around a potential BOJ pivot as early as December or January. BOJ Governor Ueda hinted recently that it will become difficult to keep interest rates negative next year. This pushed the markets to price in odds of a tweak at the BOJ’s December 19 meeting, however he walked back later saying that BOJ officials see little need to end negative interest rates next week.
As we noted in this article last week, we continue to expect BOJ to be gradual and modest with their policy tweak. Pivoting before seeing the wage data could impact their credibility, while waiting too long could mean they will need to tighten policy when other global central banks may have already started to cut rates.
The setup going into next week’s decision will be a tough one for BOJ. After considerable gains this month, JPY will need BOJ to deliver hawkish to sustain the momentum. If BOJ maintains its ultra dovish stance and stays aways from any hints on a potential end of negative rates, that could bring back yen weakness. USDJPY, which closed below its 200DMA yesterday, could move back above the key level around 142.50 and likely move towards 145. Yen weakness could also be pronounced against EUR and GBP, where central banks have stay away from dovish pivots for now.
A low probability outcome could be if the BOJ adds to the speculation on a potential January move, then USDJPY could break below 140 and move into the 137-138 area.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
