Policy Divergence Intensifies

The dollar recovered generally against most of its G10 counterparts on Monday after falling precipitously on Friday. Much of the movement seems to have been mean reversion. For example, NZD and AUD were the best performing currencies on Friday, but they were the worst performing currencies during the European day yesterday.

FX seems to be in the spotlight nowadays. The wild movements in our market – EUR/USD traded in a 1.1% range yesterday while USD/JPY had a 1.4% range – are in sharp contrast to the US stock market, which once again closed with less than 0.1% change on the day. The bond market is somewhere in between: 10-year yields yesterday rose from 2.28% to a high of 2.35% as the Empire State manufacturing survey rose (although was below expectations).

The rise in US yields was somewhat puzzling in light of a San Francisco Fed paper released yesterday that argued “the risk of high inflation in the next one to two years remains very low by historical standards.” The risks “remain tilted to the downside,” it said, adding that “monetary policy is not contributing to the risk of inflation being above the median projection in the near future.” This is an important contribution to the policy debate as it gives academic backing to those who want to delay a rate hike. The Fed funds futures clearly reflected the paper’s conclusion: implied interest rates on the near Fed funds contracts (the next one to two years) fell 2 bps, but implied rates on the far contracts rose by 2 bps.

Given the (slightly) reduced outlook for near-term tightening in the US, the dollar’s strength may be more a result of “process of elimination” investing than anything else. With Japan slipping back into recession, there’s little if any chance of that country cutting back its quantitative easing program any time soon. Meanwhile, two ECB officials yesterday showed the Bank’s strong resolve to do “whatever it takes” to get the Eurozone economy moving again. ECB Executive Board member Yves Mersch , a noted policy hawk, gave a speech devoted to asset purchases. He said the central bank could theoretically extend purchases to gold, shares, or exchange traded funds (ETFs) or other assets if more action is needed, although he focused on the prospects for buying sovereign bonds.

This speech was significant as it was the first time one of the ECB hawks has given such a detailed discussion of the possibilities for QE. Then ECB President Mario Draghi said the central bank is ready for further stimulus if its current efforts are not sufficient to accelerate the region’s recovery. Not only could they increase asset purchases, but they could also alter the size of the targeted long-term refinancing operations if necessary to meet their balance sheet target. Also he linked the “new measures” being investigated to asset purchases, again implying a larger balance sheet. Net net, it’s clear that the ECB is rapidly losing its aversion to extraordinary measures just as the US is embarking on a normalization of policy. The divergence in monetary policy between the US and other countries, notably Japan and the Eurozone, is likely to be a driver of the FX market for a considerable length of time, in my view.

Today’s Schedule

The Reserve Bank of Australia released the minutes from its November policy meeting. They were slightly more dovish, with a little less optimism about the growth outlook. There was no change in their comments about the AUD however and the currency was largely unaffected.

During the European day, the highlights will be the UK CPI for October and the German ZEW survey for November. The UK CPI rate is expected to have remained unchanged at +1.2% yoy. That could push further back the expectations for BoE tightening and could leave sterling under selling pressure. In Germany, the ZEW current situation index is expected to have declined, but the expectations index is estimated to have turned positive. The low levels of the indices will confirm once again that Eurozone’s growth engine is still facing problems, although the improvement in the expectations index could be EUR-positive.

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In the US, both the headline and the core (excluding food and energy) PPI rates are forecast to have declined in October, corroborating the San Francisco Fed’s view on inflation. That could be negative for USD. The NAHB housing market index for November is forecast increase by one unit.

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We have four speakers on Tuesday’s agenda: Reserve Bank of Australia Governor Glenn Stevens, ECB governing council member Klaas Knot, Minneapolis Fed President Narayana Kocherlakota and BoE MPC member Kristin Forbes.

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