Head of FX Strategy
Summary: The Reserve Bank of Australia only checked a couple of the boxes in its shift in the direction of tightening overnight, far short of where the market has priced the central bank to head with its policy rate in the coming year, but how much should the market care when it feels as though central bank guidance is loosing its sway? Elsewhere, rapidly flattening yield curves and lower long US yields are a boost to the yen, which is gaining broadly today ahead of the FOMC meeting tomorrow.
FX Trading focus: RBA dovish, FOMC preview, JPY thoughts
RBA goes dovish – but what is a trader to do when the market can supposedly front-run future policy shifts? The Aussie lower after a dovish performance from the RBA. Yes, the central bank made a shift in the tightening direction and abandoned its yield-curve control of 0.10% out to April of 2024, but this was merely a recognition of the market breaking the control policy ahead of the meeting. More disappointing for the market’s more hawkish tilt, the RBA said in its very extensive statement that it would wait until February on whether to do anything with its still heavy pace of AUD 4 billion per week in QE, a far more dovish stance than the RBNZ (abandoned in July) or even the Bank of Canada (abandoned last week). The statement also outlined an extensive and rather strange prediction that inflation outcomes would prove lower in Australia than elsewhere even as the outlook has improved, reminded that wage rises are a key component of when the bank will actually move to hike rates, and was only willing to open up the possibility that the original time frame of 2024 may shift forward into late 2023. The AUD was of course lower in the wake of this, but given that markets are feeling increasingly comfortable with challenging central banks’ guidance nearly everywhere, it is hard to say whether we can extract sustained Aussie weakness from this decision. Another development that is also Aussie negative is the ongoing dump in coal and iron ore prices in China.
Chart: AUDJPY
The Aussie was weaker on the dovish RBA, with weak metals and coal prices also weighing to a degree – but the move over the last 24 hours in AUDJPY isn’t all down to Aussie, but also the JPY, which is firmer as long US treasury yields have pressed lower and the yield curve flattens. Plenty more downside needed in most JPY crosses (perhaps 82.00 here) before we can call this a reversal of the recent rally move, but lower long yields certainly challenge the narrative and are a strong support for the JPY, though for it to fire on all cylinders, we would likely need weak risk sentiment, particularly in EM credit to combine in the mix.
Big test for market themes on the FOMC tomorrow. As discussed in yesterday’s update, this week’s FOMC is an important test of how much stock the market puts in Fed guidance, as much as it is an exercise in wondering what the Fed will actually deliver tomorrow. The Fed is seen as the central bank most behind the curve in bringing policy tightening, relative to what is unfolding in the US economy. It is supposedly set to launch a ponderous asset purchase tapering move this month that will be followed, only on the completion of that tapering to zero, by eventual rate hikes further down the road. The base case for the pace of tapering was laid out in the September FOMC meeting at a sedate $15B a month ($10B less per month of treasury purchases, $5B less of MBS purchases) which would require a long eight months to complete. But pre-declaring that pace without forward flexibility is a dangerous bit of forward guidance, requiring an embarrassing backtrack if inflation and earnings jump further in next few months (See the risk already here in the great discussion of “trimmed mean” inflation in a recent opinion piece from John Authers) Given all of the embarrassing tripping over prior guidance we have seen under the Powell Fed since the early 2019 about-face from tightening to loosening policy, and now as “transitory” seems to be leaving the Fed’s vocabulary, the Fed may try to provide as much flexibility as it can on how quickly QE will wind down. So the range of options is perhaps: $15B to start plus flexibility as the base case, with no flexibility indicated the unlikely dovish outcome, and a more rapid pace of $30B the most hawkish conceivable guidance. Then we shift to whether to how the market actually prices Fed actions in the wake of what they deliver: thumbing the nose at the USD in the belief that no matter what the Fed is saying, it will stay behind the curve relative to other central banks and relative to inflation risks (i.e., no real improvement prospects for real US rates), or expressing the belief that the Fed and other central banks are risking having to hike rates and upsetting the economic growth outlook and especially financial markets and therefore committing a “policy mistake” as the market beast needs ever more stimulus to continue higher. Some of the latter may be why yield curves are flattening as aggressively as they have recently, with the longest treasury yields actually dropping.
The latter have been brought significantly forward, with the market now pricing the Fed to move approximately twice by the end of next year. Just as with the ECB and as discussed in the RBA preview above, will the market really care what degree the Fed adjusts its guidance, given that guidance seems worth very little and that data outcomes are in control here, not the Fed? I’ll provide more thoughts tomorrow and/or Wednesday, but one idea could be a starting pace of tapering 15B/month, but pre-declaring “flexibility” that could see the pace even doubled if necessary if inflation/wages/job growth make a mockery of Fed caution in the coming couple of months.
NZD on the move lower in Europe today. The FX Board is off-line due to technical difficulties – hope to have that back as soon as possible. NZD traders should note the important data up late today from New Zealand as AUDNZD traded near the locally pivotal 1.0400-25 zone today. The big bounce in the latter and the sell-off in NZDJPY suggest that NZD longs are a bit crowded ahead of these data. With markets second guess all of the dovish central banks, does that also mean that the most hawkish central bank suddenly seems far less as we have to discount all guidance now, don't we?
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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.
