The ‘Fed put’ emerged at December’s FOMC, boosting short-term USD optimism. EUR/USD dipped to 1.10 amid divergent ECB and Fed signals, cautioning against overly optimistic Eurozone growth. JPY saw stability, while USD/JPY rose with a subtle BoJ shift. In this dynamic landscape, investors navigate central bank dynamics for concise market trend insights

USD

The unexpected emergence of the ‘Fed put’ was noted during the December FOMC meeting, where Fed Chair Jerome Powell and colleagues appeared to endorse, at least in part, the anticipated aggressive market rate cuts for 2024. The Fed’s apparent shift towards a dovish stance has buoyed global hopes for a soft landing and improved market risk sentiment. I anticipate this positive impact to endure in the short term. However, the longer-term trajectory of the market rally will depend on the quality of incoming economic data and the persistence of inflation.

There is a concern that rates markets may be pricing in an excessive number of rate cuts, posing a risk that the Fed might disappoint these dovish expectations. Regarding the FX market, I anticipate that the USD may continue to face challenges, particularly against currencies with central banks either approaching or already undergoing policy normalization, such as the JPY and AUD. Concurrently, the USD could strengthen against the EUR and GBP, especially if rates markets maintain a dovish stance on the ECB and BoE.

The focus for the day will be on the US Consumer Confidence (Dec) as well the GDP, with consensus expectations leaning towards evidence that, while US growth momentum remains positive, it still falls below historical standards. FX investors are particularly interested in any signs of a growing divergence between resilient prices paid and a soft labour component. Despite the potential importance of this data, its impact on FX direction may be limited, as investors shift their attention to next week’s core PCE data for November and Fed speak.

The USD’s vulnerability in the near term may persist if the recent recovery in risk sentiment continues. However, with many Fed-related negatives already factored into the currency’s price, the downside risks for the USD could be restrained from current levels.

EUR

The contrast in the communications from the ECB and the Fed this week has prompted a decline in EUR/USD back to 1.10. Notably, the new FOMC dot plot indicates an average expectation of three rate cuts for the next year, while ECB President Christine Lagarde emphasized that the bank did not consider any rate cuts. This discrepancy reflects divergent anticipated paths for their respective economies. The US is projected to experience a significant slowdown, whereas the Eurozone is expected to rebound, reaching normal quarterly growth rates of 0.3-0.4% QoQ by Q224.

Despite these optimistic prospects, the ECB has consistently delayed such expectations in recent quarters due to a lack of encouraging signs in both soft and hard data pointing towards a sustainable Eurozone recovery. The December ZEW survey further reinforced this cautious sentiment, and potential positives from lower rates/yields and energy prices may have been offset by heightened fiscal uncertainties for 2024. This uncertainty coincides with the ECB’s expectation that government spending will be a crucial driver of next year’s growth in the Eurozone.

The Eurozone flash PMIs for December are eagerly awaited, as any lack of material improvement could dampen the relative optimism associated with the ECB and the EUR.

The composite index is expected to remain in contraction territory for a seventh consecutive month, surpassing the streak seen in 2022. Earlier in the day, the Buba’s new economic forecasts will be closely examined to compare with the ECB’s central scenario. Additionally, ECB speakers and their comments may provide insights into the potential timing of any easing measures. The market will also keep a close watch on Eurostat’s latest Unit Labour Costs data, as the ECB has emphasized that resilient wage growth is a key factor behind the persistent inflation forecasts, contrasting with more benign market expectations.

JPY

Despite the JPY experiencing considerable volatility this week, its short-term fair values against the EUR and USD have seen minimal shifts, as indicated by a preliminary update from our FAST FX model. The final update is scheduled after the New York close later today. USD/JPY‘s short-term fair value has slightly increased from 140.63 to 140.73, even in the face of a dovish pivot by the FOMC and a substantial decline in the US-Japan short-term rates differential. The rise in global equities has influenced USD/JPY’s fair value, and stabilization in oil prices, a stronger Nikkei, and a rise in the US-Japan box yield spread have collectively contributed to pushing the exchange rate’s fair value higher. Despite remaining overvalued relative to this fair value, the recent decline in USD/JPY has reduced the overvaluation sufficiently to no longer trigger a sell trade. However, a move by USD/JPY close to 144 would reignite a sell trade trigger.

Similarly, EUR/JPY‘s fair value has risen from 154.14 to 156.32. The ECB’s mild resistance to market expectations of aggressive rate cuts in 2024 has led to a decline in the Eurozone-Japan short-term rates differential, impacting the exchange rate’s fair value. However, positive factors such as increases in the Nikkei and the Eurozone-Japan box yield spread, along with a decline in peripheral EGB spreads to Bunds, have collectively increased EUR/JPY’s fair value. The currency pair has shifted from being modestly overvalued to trading close to its fair value. A rally in the exchange rate towards 160 would be required to trigger a sell trade.

Notably, it wasn’t solely shifts in market expectations for the Fed and ECB that influenced the JPY this week, but also modest changes in pricing for the BoJ. Following subtle shifts in the rhetoric of Governor Kazuo Ueda and Deputy Governor Ryozo Himino last week, investors began pricing in the risk of a hawkish shift or even a rate hike by the BoJ at the upcoming meeting next week. However, leaked reports indicating that the BoJ sees no need to alter its policy stance in December have pushed this pricing further out. Our economists anticipate a status quo at next week’s BoJ meeting and throughout 2024, with no changes in rates expected until April and after the spring wage negotiations.

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