The Federal Reserve’s (Fed) rate cut talk is becoming chaotic and, frankly, hard to follow. After the Fed signaled a possible end to its monetary tightening campaign and European policymakers refused to follow suit, some Fed members, including John Williams and Raphael Bostic, pushed back Fed cut expectations.
Unfortunately, the activity on Fed funds futures price in the first Fed cut by March next year with more than 75% chance, and the first cut in May with almost a 100% chance. Market pricing is consistent with an expectation of about 150 basis points of cuts over the next year, versus only 75 basis points of cuts envisioned by Fed officials, which is already ambitious given the resilience of US economic growth. So either the US economy will be fine and the Fed won‘t start cutting rates in March.
Or we will see a sharp slowdown in US growth, and a potentially deteriorating growth outlook will force the Fed to start cutting rates in Q1 and cut deeply. But a scenario in which the Fed starts cutting rates in March while the economy remains resilient and inflation low makes little sense, as fiscal spending will remain robust through next year’s presidential election and the risk of a turnaround in inflation remains alive.
However, investors may give the Fed doves the benefit of the doubt until Friday’s PCE data. PCE, the Fed’s favorite inflation gauge, is expected to show a further decline in both headline and core inflation. More importantly, if the data is in line with expectations, it would mean that 6-month annualized inflation will be a touch above the Fed’s 2% target. The latter could keep the Fed doves in charge. Nonetheless, the successful dissipation of inflation can be attributed to the fall in oil prices. Even if the base case scenario is a limited upside potential in oil prices, any reversal in the oil price dynamics could tame expectations of a Fed cut. In the short term, the barrel of American oil is around $72pb on Monday on the back of lower Russian exports and suspended transit in the Red Sea due to attacks by the Houthis on ships in the region. Solid bids are seen in the $74/75pb range.
What’s cooking in Japan?
The Bank of Japan (BoJ) will announce this year’s final policy decision on Tuesday. BoJ Governor Ueda’s comments that the BoJ’s policy would be difficult to maintain from the end of the year had raised expectations that the BoJ would finally say goodbye to negative interest rates. There is no more than a small chance that the BoJ will exit negative rates this week, but investors are eager to hear more details on how and when the BoJ will exit negative rates. Concrete details regarding the BoJ’s policy plans and/or changes in the BoJ’s inflation outlook could cause quick moves in the yen markets, which have become very volatile since Ueda hinted that something is cooking in his kitchen. The USDJPY fell from over 150 to near 140 in just two weeks. In doing so, the pair slipped – a little too quickly – into bearish consolidation territory below the important 38.2% Fibonacci retracement of this year’s rally.
The market’s position on the Yen couldn’t be clearer. Right now, going long Japanese yen is the most obvious trade in the currency markets. It is almost too easy. A hawkish signal from the BoJ has the potential to push the USDJPY below the 140 level, even in oversold conditions. Conversely, if the BoJ disappoints the market again, any rallies could attract the attention of top sellers.
