FX Insights 12/12-12/15

The Federal Reserve held its final meeting of the year last Wednesday which was also the last of Chairwoman Janet Yellen’s lengthy career with the central bank. As expected, the Fed raised benchmark rates by 25bp in a 7-2 vote. The bank also raised its growth forecasts for 2018 and maintained projections for three further rate increases next year, making few changes to its outlook ahead of the transition to incoming chair Jerome Powell. Of concern to markets however were the Fed’s inflation expectations which were mostly unchanged. Commenting on the subject during the following press conference Yellen reiterated that the Fed’s “understanding of forces driving inflation is imperfect” though she still believed those factors would likely still prove “transitory”. The lack of any definitive resolve on inflation going forward left markets dissatisfied, driving the dollar to one week lows as measured by the dollar index.

Moving onward, the main driver for the dollar for the remainder of the year will likely be the progress of tax reforms. Last Wednesday, House and Senate Republicans agreed to several key details of the bill and on Friday, holdout Senator, Marco Rubio agreed to a compromise on the bill although a handful of other GOP senators remain undecided. Adding to the pressure on the GOP was last week’s surprise senate victory of Democrat Doug Jones in Alabama which will reduce the GOP’s senate majority to a razor thin 51-49 next year. With time running out this week’s vote should prove a make or break moment for the fate of the tax reforms. As a result, although next week’s data docket sees important releases expect to see volatility coming off tax developments.

Overseas the UK played host to its own political drama courtesy of ongoing Brexit developments. Despite a week which saw the Bank of England’s final meeting of the year and crucial releases on inflation, wages, and consumption in the end it was none other than political headlines which proved just how betrothed the pound is to Brexit. Despite the finding gains on the back of solid wage and consumption data early in the week nonetheless on Friday the pound relinquished all of its gains in part due to reports from Brussels suggesting that discussions may not formally begin until March of next year. Any delays would further complicate the agenda for Prime Minister Theresa May who is just coming off a damaging parliamentary defeat which gives parliament a vote on the final Brexit deal. This week final third quarter growth is released along with statistics on public borrowing. Even if the data proves positive the drama following Brexit and Theresa May could still keep the pound in check.

The European Central Bank kept its rates and asset purchases steady last Thursday, offering no change in guidance following its announcement in October that it would begin reducing stimulus next year. The ECB revealed updated economic forecasts which showed higher growth over the next 3 years with inflation averaging 1.7% by 2020. ECB President, Mario Draghi, noted that the Governing Council’s discussion “reflected the increasing confidence that we have in the convergence of inflation towards a self-sustained path…”. Draghi’s select choice of words may reflect a change in sentiment regarding the bank’s approach to its mandate. The ECB may be beginning to realize that much like the Fed they may have to end QE before their inflationary targets are firmly attained. By emphasizing the “convergence” of inflationary pressures rather than any discrete target, Draghi may be taking the first subtle step towards making a further change in language next year. Until then expect to see the euro taking its cues from regional data as well as US dollar flows.

An empty economic calendar last week left the Canadian dollar prone to any unexpected shocks. Bank of Canada Governor, Stephen Poloz delivered a shock when he gave surprisingly hawkish comments during a television interview last Thursday. Sounding generally upbeat while delivering comments on the economy, Poloz stated, “We want the economy to run hotter for a while to use up excess capacity.” Poloz’s confident remarks seemed to open the door to a Q1 rate hike next year, giving a boost to the Canadian dollar before seeing it fade much of its gains. Markets may have subsequently reassessed how much value to place in Poloz’s words, who by his own admission does not like to offer up forward guidance. Big Canadian data this week in the form of retail sales, CPI, and GDP should offer markets something more tangible to digest. All three measures, most notably growth, have moderated recently, and the degree to which they should continue moderating or show resiliency will be central to gauging the likelihood of an early rate hike next year.

Asia-pacific currencies finished the week the strongest, against the US dollar, with the Australian dollar notching one month highs and the Yen recovering off one month lows to flirt with the 112 level. The Australian economy added a year-to-date best 61,600 jobs in November, with 41,900 full-time jobs comprising of that amount and the participation rate increasing to 65.5%. Meanwhile, the Japanese yen found itself the primary beneficiary of the uncertainty surrounding the tax bill. The Bank of Japan’s Tankan survey last Thursday also showed big Japanese manufacturers’ business confidence at an 11 year high. Trade statistics will be released for the Japanese economy early next week while the Bank of Japan holds its final meeting of the year Wednesday.

Sources: Bloomberg, Wall Street Journal, Reuters, Barclays, Bank of America, Econoday, 4cast

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