8 Brief Thoughts On The Current State Of FX

1. The US-German 2-year interest rate differential (swap rate) is a useful directional guide to the euro-dollar exchange rate. At about 105 bp it is the highest since 2005. The US premium had peaked in late 2004 near 185 bp. In the second half of the 1990s, it was not uncommon for the US premium to be in excess of 250 bp, It has risen 25 bp since the middle of October, encouraged by Draghi, whose dovishness again surprised investors.

2. The eurozone PMI confirms an irony. Economic data from the eurozone has held up well, pointing to fairly steady even if unimpressive growth. Draghi made a case for setting policy based on risk scenarios. The data does not seem to support such sense of urgency. At 52.3, the eurozone manufacturing PMI was slightly better than the flash (52.0) and is a little above the Q3 average. Of note, on a national level, Germany‘s flash PMI was revised higher (52.1 from 51.6) and Italy was a pleasant surprise at 54.1 (consensus 53.1 after 52.7 in September). The service PMI may also surprise on the upside. Although the market has treated Draghi’s comments as if they were a commitment to ease policy at the December 3 meeting, it may not be a done deal.

3. Many still are unconvinced that the Fed will hike in the middle of December. Some argue against it on technical grounds. Raising rates in so close to the end of the year may inject extra volatility into the markets and complicate year-end activity. As a matter of fact, the Federal Reserve has taken action in the month of December. It hiked rates in December 2004 and December 2005, for example. It cut rates in December 2001 and December 1995.

4. If one assumes that Fed funds, which have been averaging 13 bp over the past 50 and 100 days, continue to do so in the first half of December, and then after the rate hike averages 30 bp, then the December Fed funds contract is pricing in a 75% chance of a hike. Some assume that it will average the middle of the range, but besides the fact that it has been averaging around the middle of the range now, there is no compelling argument to assume this remains the case. Indeed, we suggest the possibility that in order to maintain maximum control, the Fed will want to provide sufficient liquidity to keep the Fed funds rate relatively low to ensure the attractiveness of one of the new tools in this cycle, the interest paid on excess reserves (which is the top of the Fed funds target range). It is true that no one really knows where Fed funds will trade after the hike, and we need to take the “odds” only in the context of that assumption. My work suggests that the conventional measure may under-estimate the market-based probability of a Fed hike in December.

5. The euro is in a particularly narrow range. The $1.1060-75 band is blocking the upside, while $1.10 is holding the downside in check. A break of, say $1.0990, could see the euro retesting its recent lows near $1.09. On the upside, the new shorts likely will not be pressed unless the $1.11 area gives, which was the high prior to the Chinese rate cut.

6. The dollar has not traded below JPY120 since October 22. If that is support, then the top-side of the current range is in the JPY121.50-JPY121.60 area. As we anticipated, the incremental additional stimulus for the Japanese economy may come from a supplemental budget rather than monetary policy. Meanwhile, the focus is on the Japan Post IPO, which is expected to raise the equivalent of $12 bln, when Japan returns from Tuesday’s holiday.

7. Despite better than expected manufacturing PMI, sterling ran into a wall of sellers near $1.55, and was unable to recover. There was talk of Asian central banks on the offer. It finished the North American session just off its lows near $1.54. The implied yield of the June 2016 short-sterling futures has risen by 10 bp over the past four sessions. Sterling has gained a net 1% over those four sessions. The market may turn cautious ahead of Super Thursday (MPC decision, minutes and quarterly inflation report). Technical support may be found in the $1.5340-$1.5370 area.

8. Barring a strong rally in oil, the US dollar is unlikely to slip much further against the Canadian dollar ahead of this week’s slew of data, which includes trade and employment data to which the loonie seems particularly sensitive. For the trade figures, to be released on Wednesday, the focus should be on non-oil exports, which may be turning higher. The employment data at the end of the week may be overshadowed by the US figures released at the same time. Although the Bank of Canada’s two rate cuts this year are thought to have completed the mini-easing cycle, another rate cut cannot be completely ruled out. In September, Canada lost nearly 62k full-time jobs. Another dismal report and rate cut talk may resurface, even if the new government wants to pursue a small fiscal deficit. Technical support for the US dollar is seen in the CAD1.3040-CAD1.3060 range.

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