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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