FX Price Action Ahead on Growing Rate Divergence
Last week was busy for major central banks. During a 60-hour window, rates were set for 60% of the global economy, from the US Fed, the ECB, to the BoE.
Central banks’ announcements caused a frenzy in markets. The pivot to a dovish stance by the US Fed contrasted sharply with hawkishness from the ECB.
This paper summarizes rate announcements and their market impact. It also dives into Yen dynamics as the Bank of Japan (BoJ) meets tomorrow.
CAUTION FX TRADERS: GROWING RATE DIVERGENCE AHEAD
Renewed divergence in monetary policies was evident from rate announcements by the major central banks. After more than a year of moving in tandem, central banks’ stances are shifting. The Fed is signaling rate cuts sooner. Meanwhile, ECB and BoE insist that rates need to stay higher for longer to fight sticky inflation.
As interest rates in the US remain elevated relative to other major economies, the Fed has ample room to slash sooner.
Inflation in the EU has contracted at a rapid clip relative to the US. However, economists expect EU inflation to rebound in the near term with fading base-level effects.
Inflation in the US is expected to average 2.4% in 2024 compared to 2.7% in the EU and 3.75% in the UK, as per respective central banks.
The US economy is strong with robust economic growth, resilient consumer spending, and solid PMI numbers.
FED HAS PIVOTED TO DOVISHNESS
The FOMC opted to keep rates steady with their statement pointing to the end of the rate hiking cycle. Most notable was the Fed’s updated economic projections & dot plot. It showed faster-declining inflation, slower GDP growth, and faster rate cuts.
The Fed’s dot plot of rate expectations guided towards three 25 basis point (bps) cuts next year. Markets were expecting five rate cuts before the Fed announcement. Following the Fed meeting, markets now anticipate six rate cuts.
BOE REMAINS HAWKISH
The Bank of England opted to keep rates steady with a hawkish pause. The BoE statement indicates further rate hikes if inflationary pressures remain persistent.
“The full effect of higher interest rates has yet to come through, posing ongoing challenges to households, businesses and governments," ~ BoE Market Policy Committee
ECB JOINED THE BOE WITH A HAWKISH PAUSE
ECB decided to keep rates steady with a hawkish pause. ECB President Christine Lagarde asserted that rate cuts were not being discussed yet and rates may even need to go higher to bring inflation under control.
ECB noted that tighter financing conditions were leading to demand contraction, which weighed on pushing down inflation. Economic growth is expected to remain subdued. ECB estimates gradual ramp up in growth from 0.6% for 2023 to 0.8% for 2024, and to 1.5% for both 2025 and 2026.
BOJ DECISION IS MOST UNCERTAIN WITH A THORNY JOB ON HAND
The Bank of Japan (BoJ) is set to announce their rate decision on December 19th. It has maintained ultra-low interest rates all year while others hiked aggressively.
Recent statements by BoJ Governor Ueda signal a pivot away from the ultra-low policy.
Governor Ueda’s statements have led to market expectation of upcoming monetary tightening in Japan. JPY has strengthened 6% relative to the USD over the last month.
Despite Ueda’s statements, BoJ pivot remains uncertain. Inflation in Japan is running hot and above US inflation. Moreover, wage growth and economic growth in Japan have been moderate despite high inflation creating stagflation risks.
Consumer spending and wage growth remain muted despite record profits. Feeble Yen is boosting Japanese exporter profits.
Nevertheless, the BoJ has been setting up a change in monetary policy. Earlier this year, it raised the cap on JGB yields and eventually changed the cap from a rigid limit to a loose reference. Some economists consider this a prelude to eventual scrapping of the YCC altogether.
CENTRAL BANK DECISIONS HAVE CREATED DEEP RIPPLES ACROSS MARKETS
Commodity markets reacted positively to the rate announcements. The Fed’s signal of upcoming easing opened the door for commodity demand to rise.
Precious metals are likely to benefit from asset rotation out of US treasuries while Crude will benefit from higher economic activity from lower interest rates.
Equities surged on Fed pivot. Small-caps and Mid-caps outperformed the Nasdaq-100 and S&P 500. Both SPX and NDX also extended gains.
Bond yields fell sharply following the FOMC decision. Yields fell to their lowest level in four months. One-year bond yields performed the best while thirty-year performed the worst.
LEVERAGED FUNDS ARE BULLISH EURO, STERLING, AND BEARISH YEN
Asset managers and leveraged funds are net long on Euro FX futures. Asset managers and leveraged funds are net short on Yen and Pound futures but have reduced net short positioning over the past few weeks.
HYPOTHETICAL TRADE SETUP
The Fed’s dovish stance plus the hawkishness of European central banks will result in dollar weakness relative to Euro and Sterling. Upside risks to the dollar persist with stronger economic data and inflation resurgence forcing the Fed to reassess its stance.
To gain from the weakening of the dollar against the euro and sterling, investors can buy into CME Micro FX Euro and GBP futures. A long sterling provides higher upside than long euro given higher inflation in the UK.
Policy uncertainty in Japan is unlikely to usher in a pivot in the short-term. The JPY is likely to weaken against the dollar despite DXY weakness. To harness gains from weakening Yen, investors can establish a long position in CME Micro JPY Futures.
Hypothetical Trade 1 & 2: Long EUR and GBP
Entry: 1.0960
Target: 1.1150
Stop Loss: 1.0860
Profit at Target: USD 238 (= 1.1500 - 1.0960 = 190 pips = 190 x 1.25)
Loss at Stop: USD 125 (= 1.0860 – 1.0960 = -100 pips = -100 x 1.25)
Reward-Risk: 1.9x
Entry: 1.2720
Target: 1.3120
Stop Loss: 1.2490
Profit at Target: USD 250 (= 1.3120 - 1.2720 = 400 pips = 400 x 0.625)
Loss at Stop: USD 144 (= 1.2490 – 1.2720 = -230 pips = 230 x 0.625)
Reward-Risk: 1.75x
Hypothetical Trade 2: Short JPY
Entry: 139.57
Target: 146.28
Stop Loss: 137.97
Profit at Target: JPY 67,100 (= 146.28 - 139.57 = 671 pips = 671 x 100)
Loss at Stop: JPY 16,000 (=137.97 – 139.57 = 160 pips = 160 x 100)
Reward-Risk: 4.2x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Central banks’ announcements caused a frenzy in markets. The pivot to a dovish stance by the US Fed contrasted sharply with hawkishness from the ECB.
This paper summarizes rate announcements and their market impact. It also dives into Yen dynamics as the Bank of Japan (BoJ) meets tomorrow.
CAUTION FX TRADERS: GROWING RATE DIVERGENCE AHEAD
Renewed divergence in monetary policies was evident from rate announcements by the major central banks. After more than a year of moving in tandem, central banks’ stances are shifting. The Fed is signaling rate cuts sooner. Meanwhile, ECB and BoE insist that rates need to stay higher for longer to fight sticky inflation.
As interest rates in the US remain elevated relative to other major economies, the Fed has ample room to slash sooner.
Inflation in the EU has contracted at a rapid clip relative to the US. However, economists expect EU inflation to rebound in the near term with fading base-level effects.
Inflation in the US is expected to average 2.4% in 2024 compared to 2.7% in the EU and 3.75% in the UK, as per respective central banks.
The US economy is strong with robust economic growth, resilient consumer spending, and solid PMI numbers.
FED HAS PIVOTED TO DOVISHNESS
The FOMC opted to keep rates steady with their statement pointing to the end of the rate hiking cycle. Most notable was the Fed’s updated economic projections & dot plot. It showed faster-declining inflation, slower GDP growth, and faster rate cuts.
The Fed’s dot plot of rate expectations guided towards three 25 basis point (bps) cuts next year. Markets were expecting five rate cuts before the Fed announcement. Following the Fed meeting, markets now anticipate six rate cuts.
BOE REMAINS HAWKISH
The Bank of England opted to keep rates steady with a hawkish pause. The BoE statement indicates further rate hikes if inflationary pressures remain persistent.
“The full effect of higher interest rates has yet to come through, posing ongoing challenges to households, businesses and governments," ~ BoE Market Policy Committee
ECB JOINED THE BOE WITH A HAWKISH PAUSE
ECB decided to keep rates steady with a hawkish pause. ECB President Christine Lagarde asserted that rate cuts were not being discussed yet and rates may even need to go higher to bring inflation under control.
ECB noted that tighter financing conditions were leading to demand contraction, which weighed on pushing down inflation. Economic growth is expected to remain subdued. ECB estimates gradual ramp up in growth from 0.6% for 2023 to 0.8% for 2024, and to 1.5% for both 2025 and 2026.
BOJ DECISION IS MOST UNCERTAIN WITH A THORNY JOB ON HAND
The Bank of Japan (BoJ) is set to announce their rate decision on December 19th. It has maintained ultra-low interest rates all year while others hiked aggressively.
Recent statements by BoJ Governor Ueda signal a pivot away from the ultra-low policy.
"Managing monetary policy will become even more challenging from the end of the year and heading into next year." ~ Kazuo Ueda, Governor, Bank of Japan on 6/Dec
Governor Ueda’s statements have led to market expectation of upcoming monetary tightening in Japan. JPY has strengthened 6% relative to the USD over the last month.
Despite Ueda’s statements, BoJ pivot remains uncertain. Inflation in Japan is running hot and above US inflation. Moreover, wage growth and economic growth in Japan have been moderate despite high inflation creating stagflation risks.
Consumer spending and wage growth remain muted despite record profits. Feeble Yen is boosting Japanese exporter profits.
Nevertheless, the BoJ has been setting up a change in monetary policy. Earlier this year, it raised the cap on JGB yields and eventually changed the cap from a rigid limit to a loose reference. Some economists consider this a prelude to eventual scrapping of the YCC altogether.
CENTRAL BANK DECISIONS HAVE CREATED DEEP RIPPLES ACROSS MARKETS
Commodity markets reacted positively to the rate announcements. The Fed’s signal of upcoming easing opened the door for commodity demand to rise.
Precious metals are likely to benefit from asset rotation out of US treasuries while Crude will benefit from higher economic activity from lower interest rates.
Equities surged on Fed pivot. Small-caps and Mid-caps outperformed the Nasdaq-100 and S&P 500. Both SPX and NDX also extended gains.
Bond yields fell sharply following the FOMC decision. Yields fell to their lowest level in four months. One-year bond yields performed the best while thirty-year performed the worst.
LEVERAGED FUNDS ARE BULLISH EURO, STERLING, AND BEARISH YEN
Asset managers and leveraged funds are net long on Euro FX futures. Asset managers and leveraged funds are net short on Yen and Pound futures but have reduced net short positioning over the past few weeks.
HYPOTHETICAL TRADE SETUP
The Fed’s dovish stance plus the hawkishness of European central banks will result in dollar weakness relative to Euro and Sterling. Upside risks to the dollar persist with stronger economic data and inflation resurgence forcing the Fed to reassess its stance.
To gain from the weakening of the dollar against the euro and sterling, investors can buy into CME Micro FX Euro and GBP futures. A long sterling provides higher upside than long euro given higher inflation in the UK.
Policy uncertainty in Japan is unlikely to usher in a pivot in the short-term. The JPY is likely to weaken against the dollar despite DXY weakness. To harness gains from weakening Yen, investors can establish a long position in CME Micro JPY Futures.
Hypothetical Trade 1 & 2: Long EUR and GBP
Target: 1.1150
Stop Loss: 1.0860
Profit at Target: USD 238 (= 1.1500 - 1.0960 = 190 pips = 190 x 1.25)
Loss at Stop: USD 125 (= 1.0860 – 1.0960 = -100 pips = -100 x 1.25)
Reward-Risk: 1.9x
Target: 1.3120
Stop Loss: 1.2490
Profit at Target: USD 250 (= 1.3120 - 1.2720 = 400 pips = 400 x 0.625)
Loss at Stop: USD 144 (= 1.2490 – 1.2720 = -230 pips = 230 x 0.625)
Reward-Risk: 1.75x
Hypothetical Trade 2: Short JPY
Target: 146.28
Stop Loss: 137.97
Profit at Target: JPY 67,100 (= 146.28 - 139.57 = 671 pips = 671 x 100)
Loss at Stop: JPY 16,000 (=137.97 – 139.57 = 160 pips = 160 x 100)
Reward-Risk: 4.2x
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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