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Significant change to Fed forecasts to impact USD direction

Financial  markets  remain  in  the  grip  of  severe  risk  aversion  and  against  this  backdrop  current  account  surplus-backed currencies continue to extend gains while receding Fed expectations undercut the USD generally.  The US money market curve is flirting with pricing risk of policy easing, a possibility the Fed Chair did no t dismiss outright in her Senate testimony even if she continued to emphasize it is not her expectation. In response to the tightening of financial conditions we have observed over  the past month, our economists have made significant changes to their Fed forecasts and now no longer expect the Fed to hike rates in 2016 or 2017  (see  here).  Essentially, we expect the fragile risk environment to preclude tightening in H1 and slowing activity to argue against further rate hikes thereafter. The shift in Fed expectations cle arly has big implications for the dollar  outlook  and  we  are  currently  reviewing  our  USD  forecasts  accordingly.  For  now,  the  funding  currencies  are  likely  to remain well supported and the USD on the defensive, though markets will remain wary of action and com ments from other G10 officials, particularly in Japan where verbal warnings are possible as officials return from Thursday’s holiday.

Soft Q4 GDP growth in Europe adds to pressure on ECB

We expect the first estimate of eurozone GDP to show growth of 0.2% q/q in Q4, with the corresponding number for Italy also at 0.2% q/q and Germany a little weaker at 0.1% q/q. With ECB already in full QE mode, eurozone data has typically had little market  impact  lately,  but  given  concerns  over  a  major  global  growth  slowdown,  markets  should  me  more  sensitive  to  this release.  Current  market  conditions  in  the  asset  markets  imply  that  the  EUR  should  continue  drawing  support  from  its  large current  account  surplus.  However,  we  continue  to  see  limits  to  EURUSD  appreciation.  Should  EURUSD  rally  through  1.15, levels last seen before the dovish ECB shift in October, ECB will be more likely to respond quite aggressively to the undesir able tightening in financial conditions at its March policy meeting.

Commodity currencies could follow USD lower

The CAD and AUD have held up better than might be expected this week, holding stable against a broadly weaker USD despite continued weakness in crude prices. We see scope for these currencies to  depreciate  in the weeks ahead, even vs. the USD. Both  are  current  account  deficit  economies  reliant  on  financial  inflows  and  both  are  exposed  to  continued  weakness  in commodity  prices.  While  the  broad  USD  retreat  may  have  reduced  the  risks  of  further  CNY  devaluation  for  now,  the  AUD remains exposed to negative news from China and further pressure on industrial metals prices. There is also scope for markets to increase pricing for RBA and  BoC  easing.  RBA Governor Stevens’  testimony to parliament yielded few surprises,  where he maintained an easing bias but also continued to sound relatively optimistic about the domestic outlook.

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