On track for a positive end to the year

A solid revision higher to US Q3 GDP at the end of last week sets up a positive tone for risk assets into year end even as they digest the imminent onset of Fed tapering. The data revealed a revision higher to a 4.1% QoQ annualised pace of growth and if anything lent credence to the Fed’s decision to begin tapering. The GDP data will be followed by a series of positive data releases in the US this week including November personal income and spending and a likely upward revision to December Michigan consumer confidence both on tap today.

Tomorrow, November durable goods orders and next week December Conference Board consumer confidence will also paint a picture of broadening improvement in economic conditions, providing further validation to Fed tapering. Against this background US yields should be well supported along with the USD. Into next year US economic outperformance will continue, leading to both higher US yields and a firmer USD.

A Japanese holiday (Emperor’s birthday) today will dampen market action although Japanese data releases over the rest of the week will highlight further progress on the economic front, with November inflation pushing higher and industrial output expanding at a healthy clip. USD/JPY retained a foot hold above 104 but the large extent of short JPY positioning highlights scope for profit taking. Even so, the rise in US Treasury yields suggest limited downside risks for USD/JPY.

There is on little on tap on the data front in the Eurozone allowing markets to digest the steps towards banking union announced last week. Consequently EUR/USD is set to remain rangebound around 1.3650-1.3750.

There may be more interest in events in China as money market conditions and confidence surveys garner interest. Tight money market conditions will weigh on regional sentiment. A likely decline in both the manufacturing and service sector purchasing managers’ indices will also act to dampen Asian currencies reinforcing the pressure already in place from a broadly stronger USD. News in Thailand that the opposition Democratic Party has decided to boycott the Feb 2 elections will add to political uncertainty and pile more pressure on the THB although the regional underperform remain the IDR.

Overall, a thinning in market conditions as both liquidity and market participants disappear for the holidays imply limited activity over coming days. The fact is that the end of the year will market a solid year for equities and a poorer year for bonds but at least the debate over Fed tapering timing has finally been put to the rest. More of the same is likely next year but notably the growth gap between developed and developing economies will narrow, which at a time of heightened competition for capital amid Fed tapering, suggests that capital flows will increasingly be steered towards developed economies.

Dear readers, this is my last post for 2013. Thank you for taking the time to read my blog posts. I wish all Econometer readers happy holidays, success, prosperity and good health in the year ahead.

Fed pulls the trigger

The guessing game is finally over as the US Federal Reserve took a major step away from the extremely easy policy conditions implemented since the financial crisis by tapering its asset purchases by USD 10 billion, split equally by reduced Treasury and mortgage backed securities purchases. Indeed the Fed finally put markets out of their misery but successfully massaged the market reaction.

The Fed is set to gradually reduce asset purchases over coming months, likely ending its QE program by late 2014. The decision was supported by most Fed officials but to soften the blow the Fed strengthened its forward guidance, helping equity markets to rally while encouraging the short end of the curve.

Conversely Treasuries came under pressure and yields rose, giving a boost to the USD. Markets are likely to digest the news well in the Asian session following the lead from US markets. Nonetheless, while the Fed decision was predicated on stronger growth, the decision will presage a competition for capital especially among emerging markets.

The biggest FX reaction unsurprisingly (given its greater sensitivity to US yields) came from USD/JPY, with the currency breezing past the 104 level. However, given that US yields have not pushed significantly higher in the wake of the Fed tapering decision the boost to the USD will be limited in the short term. Indeed, FX markets will likely digest the Fed news will little reaction both in major and emerging market currencies in the short term.

Further out, the prospects for contrasting policy stances between the Fed, ECB and BoJ imply that the USD will forge higher against the EUR and JPY as well as other major currencies. Meanwhile, highly correlated currencies with US Treasury yields, in particular in the emerging markets spectrum, including INR, TRY, and BRL, will be the most sensitive to an expected rise in US yields over the coming months.

Running into resistance

Currency markets will remain range bound today although many currencies appear to be running into resistance in the wake of recent sharp moves. For instance, GBP/USD has run into a wall and lost momentum following the release of softer than forecast UK November CPI data yesterday. Unless the UK jobs report and MPC minutes today are particularly strong, GBP/USD will remain capped around 1.6300.

Similarly EUR/USD will find it difficult to make much further headway although a gain in the German IFO survey will keep the currency pair supported around 1.3730. USD/JPY’s upside is being undermined by lower US yields but firmer Japanese equities are helping to keep the currency pair supported.

AUD faced yet more jawboning by RBA Governor Stevens attempting to talk the currency lower. Given that such comments are nothing new markets are beginning to discount them, with AUD/USD likely to consolidate above 0.8900.

Asian currency direction will be limited ahead of the Fed outcome too although lower US yields will give some relief. Overall, it remains a case of South East Asian FX underperformance versus North East Asia outperformance.

The exception is the INR which has outperformed so far this month but will face an obstacle in terms of today’s RBI policy decision. 25 bps hikes in the repo and reverse repo rates are widely expected in the wake of higher inflation readings but the INR will also have one eye on the Fed FOMC given that it is the most sensitive Asian currency to US yield movements as outflows from India’s bonds continue. INR will continue to remain capped against this background.

What will the Fed do?

Any market action today will be both tentative in terms of risk taking and limited in terms of direction, ahead of the Fed FOMC decision. Equities pulled back overnight while US Treasuries rose as markets tried to second guess what the Fed will do at its policy meeting. The USD meanwhile appears to have benefitted from some, albeit limited pre FOMC short covering amid thinning year end liquidity. Firmer data, especially in the US jobs market over recent weeks and the recent budget deal have raised the odds of tapering being announced tonight although a move in January still looks more likely.

Whether the Fed takes its foot off the QE pedal tonight or in January is probably a moot point however, as the bottom line is that tapering is very much going to happen and markets will need to adjust sooner rather than later. Ahead of the Fed decision there are some useful data releases on tap which may at least provide some direction including the December German IFO survey which is set to improve slightly, UK jobs data and the Bank of England MPC minutes. No change is likely to be revealed in terms of voting in the MPC minutes.

JPY, EUR and GBP view

It is highly unlikely that the Bank of Japan adjusts policy at its meeting later this week but further action next year remains likely. More importantly for USD/JPY will be the actions of the Fed this week and the subsequent move in US yields. US 10 year yields have struggled to sustain a move above 2.9% recently, reducing the yield advantage over JGBs and in turn pulling USD/JPY back from its highs.

It is only a matter of time before US yields resume their uptrend and in this respect the outlook remains for more USD/JPY upside. Nonetheless, I am cognisant of the large short (CFTC IMM) JPY position in the speculative market, which into year end suggests plenty of scope for position squaring and short USD covering.

The EUR is set to end the year on firm note but further upside looks limited and the risk / reward favours selling the currency from current levels. Although economic data reveals continued improvement as reflected in the flash Eurozone composite purchasing managers’ index yesterday, much in terms of recovery expectations is in the price.

While a strong basic balance (current account + FDI + portfolio flows) continues to underpin the EUR I do not expect this to persist. Nonetheless as many bears have found out the EUR is a difficult currency to sell and while EUR/USD is likely to increasingly struggle on its approach to 1.3800, any sell off will not be rapid unless the ECB belatedly adopts a more aggressive monetary policy stance.

Like the EUR, GBP is struggling to push higher, as profit takers emerge and a dose of reality sets in given the magnitude of its rally versus USD over recent months (around 10% since July). The rationale for GBP’s gains are clear; surprisingly good economic data and a reassessment of monetary policy implications. However, GBP bullishness has resulted in net long speculative positions reaching their highest since 15 January 2013.

Further GBP gains will require yet more positive economic surprises but this is unlikely to be delivered in the jobs data, inflation data and Bank of England MPC minutes over coming days. Consequently GBP/USD is unlikely to extend gains above 1.6300 in the near term.

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