The US dollar underwent a sustained weakening overnight, triggered by the Federal Reserve’s recent policy update, resulting in a substantial sell-off.

The US dollar underwent a sustained weakening overnight, triggered by the Federal Reserve’s recent policy update, resulting in a substantial sell-off. The dollar index saw a decrease of approximately -1.4% post yesterday’s FOMC meeting, hitting an intra-day low of 102.43. Amid the widespread sell-off of the US dollar within G10 currencies, the yen emerged as the primary gainer, causing USD/JPY to plummet to an overnight intra-day low of 140.97. This led to the pair closing below the 200-day moving average support for the first time since May, situated around 142.50. The decline in USD/JPY was fuelled by a sharp drop in US yields overnight, with the 2-year and 10-year US Treasury bond yields decreasing by approximately 30bps and 20bps, respectively.

Market participants swiftly adjusted their expectations, anticipating earlier and more aggressive Fed rate cuts in the coming year. The US rate market is now fully pricing in the first rate cut by the March 20th FOMC meeting, with an anticipated total of around 150bps of rate cuts by the end of the next year. This aligns closely with the forecasts from our US rate strategists.

The pivotal catalyst for the dovish repricing overnight was the Federal Reserve’s latest policy update, signalling a shift towards lower rates as inflation converges toward their 2.0% target. During the accompanying press conference, Fed Chair Powell mentioned that policymakers had preliminary discussions about the duration before cutting rates and expect further deliberations. Powell also acknowledged the risk of keeping rates too tight for an extended period, surprising many market participants who had anticipated a more cautious stance against expectations for earlier and deeper rate cuts next year. Powell’s comments, on the contrary, open the possibility of the Fed commencing rate cuts as early as the first quarter of the next year, although the cautious approach and continued description of inflation as “elevated” may suggest a slight delay.

The primary driver behind the Fed’s policy shift from rate hikes to rate cuts was the “very good” progress on inflation. The updated economic projections showed a significant reduction in the median SEP estimate of core inflation for the end of this year by 0.5 percentage points to 3.2%, compared to the previous September forecast. The forecast for core inflation at the end of next year was also lowered by 0.2 percentage points to 2.4%, although both core and headline inflation are not expected to reach their 2.0% target until 2026. Despite lowering the inflation forecasts, the Fed raised its GDP projections, expressing increased confidence in a soft landing for the US economy.

The GDP forecast for this year was raised by 0.5 percentage points to 2.6%, followed by an expected slowdown below trend next year (1.4%). The favourable disinflationary developments prompted Fed officials to include more rate cuts in their plans for the next year. The median projections among FOMC participants indicate a third rate cut by the end of next year, lowering the Fed funds rate from 5.4% in 2023 to 4.6% in 2024. However, outlooks vary widely among participants, with some expecting fewer than three rate cuts, while others anticipate more, and six participants favouring three rate cuts.

Considering these circumstances, the US dollar now faces increased vulnerability to further weakness in the early part of next year. While these developments support my bearish outlook for the US dollar, potential headwinds could arise from dovish policy updates from other major central banks such as the BoE and Fed. I maintain a preference for long yen positions, anticipating a narrowing of policy divergence between the BoJ and other major central banks in the coming year. Currently, I’m on a short EUR/JPY. A new area of uncertainty for the yen arises from increased domestic political risk in Japan, as Prime Minister Kishida reshuffles his cabinet to address a funding scandal threatening his leadership. A recent Jiji poll conducted between December 8th and 11th revealed a 4.2 percentage point decrease in support for his cabinet, dropping to 17.1%, the lowest since September 2009.

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