Important calendar events
The dollar remained steady on Wednesday ahead of the US inflation report on Thursday. The dollar index exhibited low volatility, hovering around the 103.3 level.
US Treasury yields dipped a little strength on Wednesday on reduced Fed rate hike expectations, with the US 10-year bond yielding 3.58%.
Fed rate hike expectations have been the main factor driving the US dollar and treasury yields over the past few months. At the latest monetary policy meeting in December, FOMC members voted to raise interest rates by 50 basis points, bringing the Fed’s benchmark interest rate to a target range of 4.25% to 4.50%.
Fed rhetoric in the past few days has been cautiously hawkish, with FOMC members stressing the need to bring inflation down, but hinting that inflation indicators will play a decisive role in determining the pace of future rate hikes.
On Tuesday, Federal Reserve Chairman Jerome Powell stressed that the Fed will have to make tough decisions to bring US inflation down. The Fed Chair, however, carefully avoided commenting directly on the central bank’s monetary policy outlook, turning market attention to the US inflation report on Thursday.
US inflation seems to be cooling, as US headline inflation dropped to 7.1% year-on-year in November. Reduced inflation expectations are putting pressure on the dollar as cooling price pressures may give the US Federal Reserve some leeway towards scaling back its interest rate increases.
US economic outlook and inflation will likely determine the pace of rate hikes. Many analysts believe that the Fed will ease its rate hikes, but will continue raising interest rates at a slower pace until the benchmark interest rate reaches at least 5.0%. This means there are likely still a couple of rate hikes up ahead, which may support the dollar.
Global recession concerns remain high, boosting the dollar. US GDP data revealed that GDP rose by 3.2% for the third quarter of 2022. The US economy is still expanding, but at a slower pace than anticipated and recession looms.
US CPI data are scheduled to be released on Thursday and are this week’s most highly anticipated fundamentals. Market participants are anxiously awaiting the US inflation report, which may determine the dollar’s trajectory. A softer-than-expected inflation print may trigger a pivot in the Fed’s monetary policy, putting pressure on the dollar. US Unemployment Claims and Federal Budget Balance due on Thursday may also cause some volatility in dollar price.
The Euro remained steady on Wednesday, trading sideways against the dollar, with EUR/USD hovering around a seven-month high of 1.073. If the currency pair goes up, it may encounter resistance at 1.078. If the EUR/USD pair declines, it may find support at 1.048.
Markets were slow on Wednesday, as the interest of market participants lies mainly in US inflation data on Thursday. Italian Retail Sales data on Wednesday exceeded expectations, rising to 0.8% in December from -0.3% in November.
Hawkish ECB rhetoric this week has been providing support for the Euro. ECB members Isabel Schnabel and Francois Villeroy stressed the need for additional interest rate hikes in the coming months.
Increased price pressures combined with a weak economic outlook have brought stagflation in the Eurozone, a toxic mix of high inflation and stale economic growth. EU headline inflation dropped to 9.2% year-on-year in December from a 10.1% print in November indicating that Eurozone inflation is cooling. This is the first drastic drop in inflation that signals that the ECB’s efforts to tame inflation are bearing fruit. Price pressures in the Eurozone remain high though, and interest rates need to rise significantly to combat entrenched inflation.
EU inflation rates are still far from the ECB’s 2% goal and are forcing the central bank to hike rates aggressively. In its latest monetary policy meeting in December, the ECB raised interest rates by 50 bp, bringing its benchmark interest rate to 2.50%.
However, the question is whether economic conditions in the Eurozone will allow the ECB to continue raising interest rates at a fast pace. The ECB has updated its economic growth forecast by 3.4% in 2022, 0.5% in 2023, 1.9% in 2024, and 1.8% in 2025. These are lower than previous estimates, indicating that Eurozone economic outlook is poor and that the ECB might be forced to raise interest rates in a recessionary backdrop.
Markets are pricing in at least two more 50-bp rate hikes in February and March this year. On the other hand, market odds for the next Fed rate hike are at 25-bp, as a pivot in the Fed’s policy is expected. If this scenario comes true, it will boost the Euro against the dollar. Currently, a lot hinges on the US inflation report on Thursday, which may very well determine the pace of the next Fed rate hike.
The Sterling dipped slightly on Wednesday and GBP/USD edged lower, dropping to 1.210. If the GBP/USD rate goes up, it may encounter resistance at 1.244, while support may be found near 1.184.
The British economy is constrained and the country is already in recession. The final GDP print for the third quarter of 2022 was -0.3%, which fell below expectations, indicating that the economy in the UK is shrinking. The BOE recently revised its economic growth projections, with GDP expected to drop by 0.1% in Q4 2022. The British economy is still struggling and policymakers will have to assess how much tightening it can withstand to bring inflation down.
At the same time, surging inflation has forced the BOE to adopt a more hawkish fiscal policy, bringing its interest rate to 3.50% in December, its highest rate in 14 years. After a year of fiscal tightening, UK headline inflation finally dropped to 10.7% in November, alleviating some of the pressure on the BOE to raise interest rates. In the latest monetary policy meeting in December, BOE members voted to hike rates by 50 bps. With inflation remaining above 10%, this was perceived by many analysts as the start of a pivot toward a more dovish fiscal policy, putting pressure on the Sterling.
The BOE gave uncertain forward guidance at its latest policy meeting in December, leaving the door open for further rate hikes, but signaling that interest rate increases might pause within the first quarter of 2023. The UK’s grim economic outlook may limit policymakers’ ability to increase interest rates sufficiently to rein in inflation.
MPC Member Mann is due to deliver a speech on Thursday, which may affect the Sterling, as traders will scan BOE members’ speeches for hints into the central bank’s policy direction. GBP/USD direction though is more likely to be determined by the US inflation data on Thursday.
The Yen extended losses on Wednesday, with USD/JPY climbing to 132.6. If the USD/JPY pair declines, it may find support near 129.5. If the pair climbs, it may find resistance at 138.2.
On the data front, Leading Indicators were released on Wednesday for Japan, which provides information on the country’s economic outlook. Leading indicators for December were in line with expectations, dropping to 97.6% from 98.6% in November. The declining value points to deteriorating economic conditions in Japan, putting pressure on the Yen
Price pressures continue to rise in Japan, as BOJ CPI rose to 2.9%, mainly due to the high cost of imported energy. Inflation in Japan has gone above the BOJ’s 2% target, touching 40-year highs and putting pressure on businesses and households.
The BOJ caused a stir in markets in December by finally yielding to increased price pressures and tilting its monetary policy. In the latest monetary policy meeting, Japanese policymakers maintained the central bank’s refinancing rate at -0.10%. Still, they changed its yield control target for its 10-year government bond to between plus or minus 0.50%, from a previous 0.25%. The BOJ had set a target range around zero for government bond yields for years, and this adjustment may be the signal of a shift towards a more hawkish policy. Long-term, this move may allow interest rates to rise, cutting off some of its monetary stimuli.
Meanwhile, BOJ Governor Haruhiko Kuroda has been reaffirming the central bank’s commitment to its ultra-easy policy. Kuroda however, is due to retire in April and his successor may decide to unwind the BOJ’s ultra-easy policy. A pivot in Japan’s monetary policy within 2023, would boost the Yen considerably.
The final GDP Price Index for the third quarter of 2022 showed economic contraction by 0.3% on an annual basis and the Japanese economy shrank by 0.2% in the third quarter of 2022, mainly due to the high costs of imported energy. Japan’s economic outlook is poor, raising recession concerns for the world’s third-biggest economy.
Several economic activity indicators are scheduled to be released on Thursday for Japan, which may affect Yen's price. These include Bank Lending, Current Accounts,s and Economy Watchers Sentiment. The USD/JPY though will likely be affected more strongly by the highly anticipated US inflation report on Thursday.
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