dovish pivot

The recent US Consumer Price Index (CPI) reading has ignited discussions and speculation regarding the future monetary policy of the Federal Reserve. Traders and investors have closely scrutinized the implications of this report, seeking insights into the direction of interest rates and the overall stance of the central bank. To gain further perspective on the matter, we reached out to Matthew Ryan, CFA, an expert in the field, for his analysis. Ryan emphasizes that the US dollar experienced a widespread sell-off in response to the soft US inflation report. The June data revealed a significant easing of headline inflation, reaching its lowest level in over two years. Equally notable was the unexpected drop in the critical core index, falling below 5% for the first time since November 2021, marking a significant turning point.     The dollar selling off across the board after soft US inflation report intensified bets that the Federal Reserve's rate hike cycle may soon be nearing an end. Headline inflation eased sharply in June, falling to its lowest level in more than two years, while the critical core index also unexpectedly dropped below 5% for the first time since November 2021 - somewhat of a watershed moment.   The retreat in the sticky core inflation measure will be particularly welcome news for the Fed, as it suggests that the bank's ultra-aggressive tightening cycle is finally bearing fruit. There remains a long way to go before underlying price pressures return to target, though the notion that almost all metrics of US inflation are trending in the right direction will be highly comforting for officials.     Recent hawkish communications from FOMC officials, including chair Powell, suggest that another 25 basis point rate hike remains highly likely later this month. We are, however, of the opinion that additional hikes beyond then are far from guaranteed, and are increasingly confident in our call that the July hike will be the last in the current cycle, before rate cuts commence at some point in H1 2024. We think that this dovish pivot should open the door to additional downside in the US dollar in the coming months.    - Matthew Ryan, CFA    

Romanian GDP falls below expectations in the second quarter Looking at today's data, one thing is clear: the Romanian economy is slowing more than expected. Therefore, we are revising our 2023 GDP forecast lower from 2.5% to 1.5%.   As this is a flash release, we don’t have other data except for the overall growth numbers. Details are to be published on 7 September. The gross numbers show a marked slowdown in economic growth in the second quarter of the year to 1.1% compared to the same quarter of 2022. This takes the overall GDP growth after six months of 2023 to 1.7%, while our estimate – which was already at the lower end of the consensus – was 2.3%. Some information on growth drivers has been revealed in the high-frequency data available for the second quarter. It shows that it’s been a pretty weak time for consumption, as retail sales have contracted by 0.5% versus the previous quarter. Industrial activity has been contracting as well, by 2.8%, one of the largest quarterly contractions in a while. Constructions is also losing speed as the available data point to quasi-stagnant activity, while some marginally better numbers can be seen in the services sector where there could be a 2-3% quarterly expansion. Investments and net exports are likely to have contributed positively to second-quarter growth.   We’ve had a long-standing GDP growth forecast of 2.5% for 2023. While the detailed data due on 7 September might shed a different light on the growth dynamic, we are already revising our 2023 GDP growth forecast to 1.5%, while maintaining 2024 at 3.7%. Depending on the specifics of the budget revision due later this month, risks might be skewed slightly to the downside. Today’s data confirm the National Bank of Romania’s (NBR's) latest assessment of an accelerated narrowing of the output gap. From a monetary policy perspective, the lower growth is likely to offset the marginal higher inflation forecast and lead to a stable interest rate environment for the rest of the year. We believe that the NBR is not yet contemplating the timing for a dovish pivot, despite the more frequent dovish statements coming from other central banks in the region. We maintain our view of a first rate cut in the first quarter of 2024 with a key rate of 5.5% by the end of 2024.

Gold is traditionally seen by investors as a hedge against inflation. However, it is not inflation that drives the XAU/USD quotes, but recession. In the spring, the precious metal confidently rose towards historical highs amid expectations of an impending downturn in the U.S. economy. However, a stable labor market and positive macroeconomic indicators suggested a soft landing. This led to a collapse in the price of gold during the summer. As autumn approaches, the cooling economy is once again translating into its rise. Disappointing statistics from the U.S. are a reason to buy gold. The weaker the data, the less likely the Federal Reserve will implement its June forecast and raise the federal funds rate to 5.75%. Regardless of how much Fed Chairman Jerome Powell argues otherwise in Jackson Hole.   Furthermore, once a tightening monetary policy cycle ends, a dovish pivot usually follows. Monetary expansion creates a favorable environment for XAU/USD. Dynamics of the federal funds rate and gold     In this respect, the sharp decline in consumer confidence from the Conference Board in August and the continued peak in job vacancies and layoffs in the U.S. labor market in June are alarming signs for the U.S. economy and great news for gold enthusiasts. The chances of the Fed raising borrowing costs in 2023 have once again dropped below 50%, which adversely affected the dollar and allowed XAU/USD to counterattack. In essence, asset managers who reduced their net short positions on precious metals to their lowest levels since mid-March were mistaken. Aswere investors who withdrew money from ETFs for 13 weeks in a row. They were betting on the highest yield of U.S. Treasury bonds in over a decade. However, as soon as the U.S. macro data began to deteriorate, U.S. debt market rates declined, and XAU/USD quotes went up.   Dynamics of market expectations on the Federal Reserve rate   What's next? Gradual cooling of the labor market, a sharp reduction in excess savings, and mortgage rates rising above 7% paint a picture of new cracks in the U.S. economy. The tightening of the Fed's monetary policy occurs with a temporary lag. The more time that passes since the beginning of the cycle, the more painful the monetary restriction will be. Under such circumstances, recession risks will increase again.   In the end, the markets will return to the original conditions that existed in the spring and pushed gold to $2,075 per ounce. However, there is another scenario. The U.S. economy will continue to pleasantly surprise; the likelihood of forming a new inflation peak increases, as do the chances of raising the federal funds rate to 5.75%. Technically, on the daily chart of the precious metal, there is a "Double Bottom" pattern. Thanks to this, gold broke above the EMA and has the opportunity to continue its rally towards the fair value of $1,962 per ounce. As long as prices hold above $1,929, traders should focus on buying.    

Romania: Fiscal adjustments needed to contain the widening deficit The second-quarter flash GDP print confirmed that the Romanian economy is slowing rather rapidly. GDP advanced by 1.1% in the second quarter and 1.7% in the first half of the year, visibly below our 2.3% estimate. While the detailed GDP data due on 7 September might shed a different light on the growth dynamic, we have already revised our 2023 GDP growth forecast from 2.5% to 1.5%, while maintaining 2024 at 3.7%. From a monetary policy perspective, the lower growth is likely to offset the marginal higher inflation forecast of the National Bank of Romania and lead to a stable interest rate environment for the rest of the year. We believe that the central bank is not yet contemplating the timing for a dovish pivot, despite the more frequent dovish statements coming from other central banks in the region. We maintain our view of a first rate cut in the first quarter of 2024 with a key rate of 5.5% by the end of 2024. Particularly relevant for future growth and the interest rates pattern is the final form of the fiscal package which is under discussion at the moment. We are likely to see a budget deficit target of around 5.0% of GDP (up from 4.4%) but how exactly it will be achieved is important. An emphasis on taxes such as VAT (e.g. a generalised VAT hike) will likely skew the inflation profile higher while it might have a lesser impact on growth, while a more aggressive stance on increasing income taxes (e.g. by eliminating some facilities for employees in IT, constructions, agriculture) could be more growth-detrimental in the short term, but more helpful on the inflation side.  

Consensus is expecting no change to BoJ’s monetary policy, but its policy statement and Governor Ueda’s press conference may signal an imminent shift away from short-term negative interest rates. Mounting pressures from public and private sectors with Economy Minister Shindo attending today’s monetary policy decision meeting as a representative from the Cabinet Office. Technical analysis suggests further potential weakness in the USD/JPY. This is a follow-up analysis of our prior report, “USD/JPY Technical: Potential JPY bullish pressure reasserts” published on 12 December 2023. Click here for a recap. In December, the JPY was the best performer among the major currencies against the US dollar where it soared by +4.85% as of 19 December at this time of the writing. The recent JPY strength has been attributed to two factors; the US Federal Reserve’s dovish pivot where it guided market participants by projecting three cuts on the Fed funds rate in 2024. In contrast, hawkish guidance from top BoJ officials made two weeks ago where Governor Ueda and Deputy Governor Himino’s remarks have dialled up speculations that the current short-term negative interest rate policy in Japan in place since 2016 is likely to be scrapped sooner than expected and may come as early on the 23 January 2024 monetary policy meeting where BoJ releases its latest economic outlook report on the same day. Today, the Bank of Japan (BoJ) will conclude its last two-day monetary policy meeting for 2023 while the consensus expectations are expecting no change to the current monetary policy setting, BoJ can still potentially lay the groundwork for its upcoming shift away from short-term negative interest rates via its policy statement and BoJ Governor Ueda’s press conference at 3.30 pm after the close of the Japan’s stock market. BoJ faced mounting pressures from the public and private sectors Interestingly, ahead of today’s monetary policy decision outcome, it seems that mounting pressure from the public and private sectors has arisen, prominent Jaan business lobby Keidanren head Tokura said yesterday that BoJ must normalize monetary policy as early as possible. Also, today’s meeting outcome will be attended by Economy Minister Shindo as a representative from the Cabinet Office who cannot vote on monetary policy decisions. It is rare for a cabinet minister to attend BoJ monetary policy meetings as such “attendee roles” are usually assigned to deputy ministers. In the past meetings that cabinet ministers attended had resulted in major monetary policy changes such as the launch of the mega quantitative asset-buying programme in April 2013. USD/JPY is hovering around the 200-day moving average Fig 1: USD/JPY medium-term trend as of 19 Dec 2023 (Source: TradingView, click to enlarge chart   The medium and short-term downtrend phases of the USD/JPY in place since a test on its 151.95 major resistance on 13 November 2023 remain intact as price actions remain below its downward sloping 20 and 50-day moving averages without a bullish divergence condition seen on its daily RSI momentum indicator at its oversold region. Short-term momentum has turned bearish Fig 2: USD/JPY short-term minor trend as of 19 Dec 2023 (Source: TradingView, click to enlarge chart In the shorter term as depicted on the hourly chart, the RSI momentum indicator has staged a bearish breakdown below its parallel ascending support after it hit overbought status yesterday, 18 December. Watch the 143.30 short-term pivotal resistance and a break below the recent 140.95 low printed last Thursday, 14 December may expose the next intermediate support at 139.20 in the first step (also the close to the 50% Fibonacci retracement of the prior medium-term uptrend phase from 16 January 2023 low to 13 November 2023 high). On the other hand, a clearance above 143.30 negates the bearish tone for a potential minor countertrend rebound to see the next intermediate resistances coming in at 144.80 and 146.70 if 144.80 is taken out.    

A disappointing set of domestic economic data sent the yen lower against the dollar once again last week, with the Japanese currency opening trading this week around the 145 level. Expectations for the first Bank of Japan interest rate hike have continued to be pushed further into the future amid signs of an easing in wage pressure and a drop in inflation. Last week’s earnings data for November was a massive miss, with wages growing by only 0.2% year-on-year, the lowest rate since December 2021 and well below the +1.5% consensus. Bank of Japan officials have placed heavy emphasis on earnings data in recent communications. The upcoming annual ‘Shuntō’ salary negotiations, which conclude in March, will be key in determining the timing of the first hike. As things stand, a strong wage negotiation will likely be needed to convince investors that tightening will commence soon, with swaps now assigning only around a one-in-three chance of a first move in April. National inflation data will be the focus this week, with the December data due on Thursday.   CHF We recently said that it might be difficult for the franc to hold onto its gains and, indeed, the currency sold off last week and was among the worst performers among the G10 currencies. We continue to view the franc as expensive, and believe that more weakness could be in store in the coming quarters, particularly should the Swiss National Bank begin to shift its attention towards supporting the country’s growth outlook. We don’t view the recent uptick in inflation as something that could potentially prevent the SNB from delivering a dovish pivot, particularly as both measures of inflation remain firmly within target. The focus this week should be on external news, although Thursday's speech by SNB President Jordan in Davos will also be worth following.

Bank of Canada preview: Too early for a radical pivot Core inflation came in hotter than expected in December which rules out the Bank of Canada shifting meaningfully in a dovish direction at the January meeting. However, higher interest rates are biting and we continue to look for rate cuts from the second quarter onwards. US-dependent BoC rate expectations and the Canadian dollar may not move much for now.   Hot inflation warrants caution before dovish turn The Bank of Canada is widely expected to leave the target for the overnight rate at 5% when it meets next week. Policymakers continue to talk of their willingness to “raise the policy rate further if needed”, and inflation does indeed continue to run hotter than the BoC would like, but we see little prospect of any additional policy tightening from here. Instead, the next move is expected to be an interest rate cut, most probably at the April meeting. The latest BoC Business Outlook Survey reported softening demand and “less favourable business conditions” in the fourth quarter with high interest rates having “negatively impacted a majority of firms”, leading to “most firms” not planning to “add new staff”. Job growth does appear to be cooling and the Canadian economy contracted in the third quarter and is expected to post sub 1% growth for the fourth quarter. Also remember that Canadian mortgage rates will continue to ratchet higher for an increasing number of borrowers as their mortgage rates reset after their fixed period ends. This will intensify the financial pressure on households, dampening both consumer spending and inflationary pressures. Unemployment is also expected to rise given the slowdown in job creation and high immigration and population growth rates. Given this backdrop, we expect Canadian headline inflation to slow to 2.7% in the first quarter and get down to 2% in the second versus the consensus forecast of 2.6%. As such, we see scope for the BoC to cut rates by 25bp at every meeting from April onwards – 150bp of interest rate cuts versus the consensus prediction and market pricing of 100bp of policy easing.   Rate expectations in US and Canada   Fighting market doves is still hard Markets currently price in 95/100bp of easing by the Bank of Canada this year. As shown in the chart above, the pricing for rate cuts in the US and Canada has followed a very similar path. The implied timing for the first rate cut is also comparable: May for the Fed (March is 50% priced in), June for the BoC (April is 45% priced in). That is despite the communication by the Federal Reserve which has already pivoted (via Dot Plots) to the easing discussion while the BoC officially still retains a tightening bias. In practice, even if the BoC chooses – as we suspect – to delay a radical dovish pivot and stay a bit more hawkish than the Fed, pricing for the BoC will not diverge too much from that of the Fed. So, the room for a rebound in CAD short-term rates appears more tied to USD rates than BoC communication.     FX: USD/CAD to stabilise In FX, the story isn’t much different. The Canadian dollar has been a de-facto proxy for US-related sentiment, acting less and less as a traditional commodity currency – that would normally be hit by strong US data – thus outperforming the rest of high-beta G10 FX since the start of the year. The rebound in USD/CAD to 1.35 is in line with a restrengthening of the USD primarily due to risk sentiment, positioning and seasonal factors, rather than a divergence in Fed-BoC policy patterns. In fact, the USD-CAD two-year swap rate gap has widened further in favour of CAD so far in January, from 20bp to 32bp.   We expect the impact on CAD from this BoC policy meeting to be modestly positive as expectations of a radical dovish shift are scaled back. However, Governor Tiff Macklem already introduced the idea of rate cuts in a speech this month and will need to acknowledge the downward path for the policy rate to a certain extent. While waiting for the Fed meeting a week later and the crucial US CPI numbers for January, US-dependent rate expectations in Canada may not move much. USD/CAD may trace back to 1.34, but we don’t see much further downside for the pair this quarter as USD shows the last bits of strength.    

CAD: BoC to make dovish shift more gradually than the Fed The Bank of Canada announces monetary policy today and will almost surely keep rates on hold. As discussed in our BoC preview, the focus is on whether the Bank is ready to deliver a Fed-like dovish pivot. We think it may be too early for a radical shift in the policy message. December’s core inflation figures were hotter than expected, with the trim measure rising from 3.5% to 3.7% and the median measure holding at a revised 3.6%. That may well be enough to outweigh concerns about a cooling off in the jobs market: full-time employment declined by 25k in December. While the hawkish bias should be softened and the discussion on rate cuts opened, we think the BoC will fall short of the dovish stance expressed by the Federal Reserve in December. Expect the policy message to include concerns about the path of inflation and readiness to keep policy restrictive for longer if necessary. Markets are pricing in around 110bp of tightening by the BoC in the next 12 months: we suspect today’s meeting will fail to endorse those expectations, and CAD can find some moderate support. Still, we expect USD/CAD to find good demand below the 1.34 mark.