FX Update: USD running out of room to fall on current drivers.

FX Trading focus: USD eyes huge support ahead of next important incoming data next week. Time for a shift in focus for the greenback?

The FOMC minutes Wednesday confirmed the market’s well-established expectation that the Fed is set to downshift to a 50-bp hike in December, with a bit more tightening thereafter and a hold for most of next year. The action in the curve has been farther out, where the market is getting more aggressive in expressing the view that the Fed will be cutting rates quite aggressively in 2024, with the December 24 EuroDollar STIR future pricing some 170 basis points of easing from the mid-2023 peak – that is up from around 100 basis points just a month ago. It is a strong indication that the market is pricing for an oncoming recession, unless inflationary pressures can somehow normalize in a very soft landing scenario.

For now, the markets are celebrating US yields falling (from 3-years and further out, at least), but at some point will have to consider what a recession normally entails in terms of impacts on corporate profits, the credit cycle, asset prices etc. – in other words, a more widespread deleveraging. At this point in the cycle, we have mostly only neutralized many of the excesses inspired by the pandemic, not priced a significant recession. As well, we are in a novel environment relative to every cycle since at least 1982. Especially the 2007-09 global financial crisis is not seen as a good model for what comes next and partially for good reason: the Fed and other central banks have thoroughly learned the lesson that raging contagion in the financial system is unacceptable, and they are so used to extreme intervention to prevent disorder, with further lessons learned in the pandemic response. So markets feel comfortable in taking the financial chaos option off the table. Nonetheless, once we do cross into a recession in the US as well as Europe and elsewhere, the central banks, and more importantly governments in this age of rising fiscal dominance, will have to be far more wary of triggering an inflationary rebound when considering new easing/stimulus.

In that light, there are perhaps three paths from here.

• More of the same (another month max): we continue to see softer, but relatively benign data that allows the market to continue to celebrate an easing of Fed tightening and the anticipation that no new inflationary shock awaits. Max USD bearish scenario.
• Recession fears rising with yields falling: This is the most interesting test of the USD and its correlations across assets. Would the greenback continue lower as yields fall on the anticipation that the Fed is set to eventually ease, or would weak risk appetite and increasingly poor liquidity and the fear that the Fed will prove too slow to pivot toward easing cause more significant deleveraging across markets that keeps the USD well supported? I think the US dollar’s safe haven status will still be around if we do see a new cycle of widespread risk aversion.
• Inconveniently sticky inflation with or without rising recession fears: Evidence continues to point to an oncoming recession, but that path could take considerable time to materialize and, in the meantime, any sign that the inflation is failing to maintain a steady downward path won’t be welcome. This could be aggravated by a situation in which China eases up on its restrictive Covid policies and is stimulating and driving commodity prices higher just as Europe and the US tilt into a recession? This scenario would be more likely to see USD sensitive to risk sentiment, as yields would have a hard time falling further in this scenario.

Chart: EURUSD
EURUSD has been interacting with its 200-day moving average again while not quite able to mount an attack on the recent pivot highs near 1.0480. Given our scenarios above, the two+ week into the December 14 FOMC meeting offer an interesting test of the current market backdrop – is data particularly strong and spoils the decelerating inflation narrative, or is it far weaker than expected, raising recession fears? And if the data is indifferent to stronger than expected, how unhappy is the Fed that financial conditions are at their easiest since May, before the Fed even began hiking rates in 75-bp increments? On a somewhat different note, long range weather forecasts are beginning to see very cold weather across Europe starting in about 10 days. Energy markets in Europe are not fretting this development, but if they do, it will remind euro and sterling traders that external deficits remain a risk for the single currency and sterling. Technically speaking, the first sign of weakness would be a run below the 1.0223 pivot low from the start of this week, but the bigger break-down area looks like 1.0100.