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Market Briefing
When Doves Cry?

Karl Schamotta December 17, 2018

With the Brexit noise settling down to a dull roar (emphasis on dull), a Chinese economic policy planning meeting and the Federal Reserve’s last decision of the year are likely to take top billing in currency markets this week. In both cases, investors are hoping leaders will move in a more supportive direction, keeping policy accommodative after attempting to tighten conditions over the last few years.

According to sources quoted by Bloomberg and Reuters, Chinese leaders will formalize plans for 2019 at the closed-door Central Economic Work Conference between Tuesday and Friday. The government continues to play whack-a-mole with the financial imbalances that are naturally generated within China’s economic model – but with growth slowing and external pressures increasing, policymakers are increasingly likely to reverse direction on a number of tightening measures. State-owned newspapers have suggested that tax cuts will be approved, and official growth targets lowered (but not formally announced until the early new year). With a trade truce with the United States in mind, “opening-up” reforms will continue.

Deliberations will be conducted far from the public eye, but markets will also be looking for signs that the government intends to provide more private sector support, with market reforms and increased fiscal easing playing a significant role in stimulating the economy after a multi-year deleveraging effort.

Signals emanating from the event could help to lift global risk sentiment, pointing to looser financial conditions in the year ahead – and traders are shifting position to capitalize on a rebound in commodity prices and emerging markets more generally.

Wednesday’s Fed meeting of the year is also attracting heightened trader interest – despite the fact that policymakers will almost certainly choose to raise rates for a ninth time since 2015. Instead, the drama is expected to centre on the latest set of rate and economic forecasts, with markets focused on potential changes in the number of projected hikes in 2019, and shifting estimates of the long-term “terminal” rate of interest.

With the unemployment rate at a 49-year low, the economy expanding at a satisfying clip, and inflation well within acceptable bounds, it would seem that the case for monetary tightening remains strong. But with the European and Chinese economies slowing, markets hitting extreme turbulence, and Republican fiscal stimulus efforts reaching their limits, investors are increasingly convinced that the Fed will begin putting the conditions in place for a pause in the rate hike cycle.

Indeed, with the drumbeat of negative market sentiment growing louder over the last few months, several Federal Open Market Committee members (including Chairman Powell himself) have turned more cautious in public speeches. Probabilities on two or more hikes next year have crashed, and markets are now overwhelmingly positioned for a “dovish” hike.

A move lower in the “dot plot” economic projections does seem likely – perhaps from the three hikes currently assumed for 2019, down to two. With the yield curve flattening and the turn in sentiment beginning to resemble the type of self-reinforcing prophecy that brings on a recession, long-term rate forecasts seem likely to drop. Language contained in the policy statement might also change, with policymakers opting to remove forward guidance pointing to “further gradual increases” in the federal funds rate – in favour of a sentence shifting the bank further onto a data-dependent footing.

It’s worth remembering, however, that markets have consistently underestimated the Fed’s determination to raise rates. Overnight index swap pricing has tended to lag the central bank’s projections through much of the cycle, with investors only belatedly catching up once a decision is imminent.

Continued confidence in the economy’s underpinnings could become evident when Mr. Powell speaks with the media during the press conference – and could trigger a fairly-devastating reversal.

Taken in sum, despite generally-favourable fundamentals, the risk of disappointment is rising. An asymmetric risk profile appears to be developing in currency markets, with traders and investors positioned for upside that may (or may not) be delivered. Maybe markets are just too demanding…

Karl Schamotta
Chief Market Strategist
kschamotta@cambridgefx.com
@vsualst

Counterparties: Background Reading

Financial Times: Inflation Measures Should add House Prices to Prevent Bubbles
GFYCat: The Yield Curve’s Last Thirty Years in Five Minutes
Bank for International Settlements: Gross Capital Flows
VoxEU: Going the Extra Mile: Distant Lending and Credit Cycles
Maclean’s: The Most Important Charts to Watch in 2019
Wall Street Journal: France Tops OECD Table as Most Taxed Country
Reuters: U.S. Oil Reserves Rise to Record Despite Production Boom
Centre for European Reform: Can the Euro Rival the Dollar?

Catalysts: Scheduled Data Releases

MON
19:30  *        AUD Reserve Bank of Australia Meeting Minutes, December

TUE                                        
19:00  ***    European Commission, Brexit Preparation Plans

WED
04:30  **      GBP Consumer Price Index, November
08:30  *        USD Current Account Balance, Q3
08:30  ***    CAD Consumer Price Indices, November
10:30  **      USD Department of Energy Weekly Inventories
14:00  ***    USD Federal Reserve Rate Decision
16:45  *        NZD Gross Domestic Product, Q3
19:30  *        AUD Employment, November

THU
00:00  **      JPY Bank of Japan Rate Decision
04:00  *        EUR Euro-Zone Current Account, October
07:00  ***    GBP Bank of England Rate Decision
08:30  **      USD Philadelphia Fed Business Outlook, December
08:30  **      USD Weekly Jobless Claims
14:00  **      MXN Banco de Mexico Rate Decision
18:30  **      JPY National Consumer Price Index, November

FRI
08:30  **      CAD Retail Sales, October
08:30  ***    CAD Gross Domestic Product, October
08:30  ***    USD Gross Domestic Product, Q3
08:30  ***    USD Durable Goods Orders, November
10:00  *        CAD Bank of Canada Business Outlook Survey
10:00  ***    USD Personal Consumption Expenditure, November
10:00  **      USD University of Michigan Consumer Sentiment, December
13:00  *        USD Baker Hughes Weekly Rig Count

Note: Asterisks indicate our preliminary estimate of the potential market impact associated with each event. One asterisk indicates an event with the lowest, two for a moderate impact, and three for the highest expected impact.

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