Yen pulls back after BOJ keeps rates on hold

Important calendar events

• JPY: Trade Balance
• EUR: German GfK Consumer Climate, German PPI, Current Account, Consumer Confidence
• GBP: CPI and Core CPI, PPI Input and Output, RPI, HPI
• USD: Current Account, CB Consumer Confidence, Existing Home Sales

USD

The dollar dipped on Tuesday, with the dollar index dropping to the 102.2 level. US treasury yields also declined, with the US 10-year bond yielding approximately 3.93%. 

The dollar is under pressure, as the Federal Reserve seems to have completed its hiking cycle. The Fed kept interest rates unchanged at its December meeting, within a target range of 5.25% to 5.50%. 

The Federal Reserve kept its policy settings unchanged last week but showed signs of a dovish pivot. The FOMC statement emphasized that inflationary pressures in the US are easing, while economic growth remains limited. The Fed’s forward guidance was more dovish than expected, hinting that the central bank is preparing to pivot to a less restrictive monetary policy. 

The Fed’s latest dot plot, which shows policymakers' future interest rate estimates, projects 75 base points of rate cuts within 2024 and 250 basis points by the end of 2026. Market expectations of future rate cuts are driving the dollar down, as markets are currently pricing in a 25 bp rate cut in March with over 60% probability.

Fed rhetoric has been increasingly hawkish since last week’s interest rate decision trying to rein markets in. This week, FOMC member Loretta Mester stated that markets were getting ahead of themselves in pricing in rate cuts. Fed’s Goolsbee said on Monday that he was confused by the markets’ reaction, stressing that the Fed is not yet committed to cutting rates next year.

The Fed’s hawkish stance over the past year has been paying off and US price pressures are cooling. Headline inflation rose by 3.1% year-on-year in November easing slightly from a 3.2% print in October. CPI rose by only 0.1% in November, while Core CPI, which excludes food and energy, rose by 0.3%. 

Core PCE price index data for November due on the 22nd are highly anticipated, as this is the Federal Reserve’s preferred inflation gauge. Core PCE price index rose by only 0.2% in October from a 0.3% growth in September. 

US Final GDP data for Q3 of 2023 are also due this week on the 21st. Preliminary GDP showed that the US economy expanded by 5.2% in the third quarter of 2023, against expectations of a 5.0% growth and surpassing by far the 2.1% growth of Q2. The US economy seems to be recovering, putting recession fears to rest. 

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EUR 

The Euro benefitted from the dollar’s dive on Tuesday and EUR/USD rose above the 1.098 level. If the EUR/USD pair declines, it may find support at 1.087, while resistance may be encountered near 1.100. 

ECB policymakers voted to keep interest rates unchanged last week at 4.50%. The ECB seems to have reached its rate ceiling, as the fragile Eurozone economy cannot withstand further tightening. Markets are starting to price in rate cuts in March, although ECB officials have stressed that discussions on a rate cut timeline have not started yet. ECB member Bostjan Vasle stated on Monday that market expectations for rate cuts are inconsistent with the stance appropriate to return inflation to target.

The ECB’s policy is starting to diverge from that of the Federal Reserve. At its latest policy meeting last week, the Fed signaled that interest rates would go down in 2024. ECB President Christine Lagarde, however, reaffirmed last week that it is too early to talk about rate cuts. Lagarde stressed that interest rates will remain at sufficiently restrictive levels for as long as necessary to bring inflation back to the ECB’s 2% target.

The economic outlook of the Eurozone appears to be deteriorating, however, and may force the ECB to pivot to a more dovish policy. The Eurozone economy does not show signs of recovery and is on the brink of recession. Revised GDP for the Euro area showed that the Eurozone economy contracted by 0.1% in the third quarter of the year, which was in line with expectations. The Eurozone economy barely expanded in the second quarter by 0.1%, after contracting by 0.1% in Q1 of 2023. Year-on-year the EU economy registered stagnation with GDP flat at 0%. The Eurozone economy is struggling and cannot withstand much further tightening. 

The ECB’s efforts to curb inflation rates are paying off, even due to decreased economic growth. Price pressures in the EU are cooling and this will likely play a decisive role in the ECB’s future policy. Last week the ECB downgraded its inflation forecasts for 2023 and beyond.

Final CPI data released on Tuesday fell in line with preliminary estimates, indicating that inflationary pressures in the EU are easing. Final CPI data showed that headline inflation in the Eurozone dropped to 2.4% year-on-year in November, its lowest level since July 2021, from 2.9% in October. Final Core CPI, which excludes food and energy, eased to 3.6% year-on-year in November from 4.2% in October. 

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GBP 

The Sterling gained strength on Tuesday as the rivaling dollar weakened and GBP/USD climbed above the 1.275 level. If the GBP/USD rate goes up, it may encounter resistance near 1.279, while support may be found near 1.261. 

The BOE maintained its official rate at 5.25% at its policy meeting last week, which was in line with expectations. However, the central bank’s outlook remains hawkish, with three policy members voting to increase interest rates versus six members voting to maintain current rates. 

BOE Governor Andrew Bailey kept his hawkish stance last week. Bailey stressed that inflationary pressures in the UK remain high and that further tightening might be required to bring inflation down to the bank’s 2% target. 

The BOE has likely reached its rate ceiling but will keep interest rates on hold for a long time to bring inflation down. Even though the current restrictive policy is hurting economic growth, the BOE has no choice but to continue its battle against inflation.

Market expectations of the BOE’s future direction reflect the need to keep interest rates in restrictive territory for longer. The BOE policy is starting to diverge from that of the FED, as the Fed has already signaled that rates will be lowered within 2024. Market odds are in favor of Fed rate cuts starting in March, while BOE rate cuts are not priced in before June. 

The British economy remains fragile, reinforcing the notion that the BOE has reached its peak interest rates. Prolonged tightening has taken its toll on the labor market and other vital economic sectors. UK GDP data revealed that the British economy remained stagnant during the third quarter of 2023. The British economy expanded by 0.3% in the first quarter of the year and 0.2% in the second quarter. Monthly GDP data showed that the British economy contracted by 0.3% in October. Economic growth is slowing down in the UK and the country is entering a recession.

British inflation cooled more than forecast in October, reinforcing expectations that the Bank of England has ended its hiking cycle and will be cutting interest rates by the middle of next year. Headline inflation in the UK rose by 4.6% year-on-year in October, registering a dramatic drop from September’s 6.7% increase. Annual Core CPI, which excludes food and energy, grew by 5.7% in October versus 6.1% in September and 5.8% forecast. British inflation data for November are due on Wednesday. Headline inflation is expected to have slowed to 4.4% year-on-year, from 4.6% in October.

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JPY

The Yen pulled back on Tuesday as the BOJ kept interest rates on hold. USD/JPY edged higher, even as the dollar weakened, touching the 145 level before paring some of the day’s gains. If the USD/JPY pair declines, it may find support near 140.9. If the pair climbs, it may find resistance near 146.6.

The BOJ has been keeping interest rates at a negative level, putting pressure on the Yen. The BOJ kept its policy settings unchanged at its meeting on Tuesday. The central bank kept its short rate target steady at -0.10% and its yield curve control unchanged. 

The BOJ’s forward guidance into 2024 was more dovish than expected, putting pressure on the Yen. In the past few months, BOJ policymakers have hinted that the central bank is preparing to pivot to a less accommodating policy. After the conclusion of the policy meeting, however, BOJ Governor Kazuo Ueda delivered a cautious statement, indicating that a policy pivot is still far off. Ueda stated that economic growth remains modest and that underlying inflation will gradually increase, but the BOJ requires sustainable, stable inflation before tightening its monetary policy.

The Fed has signaled a dovish pivot, relieving some of the pressure on the Yen, which has been weakened by the BOJ’s dovish policy. The BOJ has so far maintained its dovish bias, putting more pressure on the Yen as other major central banks, and especially the Fed, have raised interest rates to high levels. 

Final GDP data for the third quarter of the year showed that Japan's economy contracted by 0.5% in the third quarter against earlier estimates of a 0.5% contraction. The Japanese economy expanded by 1.2% in the second quarter of 2023, showing that the country’s economy is shrinking and is on the brink of recession. Final GDP Price Index showed a 5.3% annual expansion in Q2, versus 3.5% the previous quarter. This is a measure of inflation, which shows that inflationary pressures are rising in Japan, increasing the odds of a hawkish shift in the BOJ’s policy. 

Inflation in Japan has remained above the BOJ’s 2% target for more than a year, encouraging the BOJ to tighten its monetary policy. National Core CPI rose by 2.9% year-on-year in October from 2.8% in September against expectations of a 3.0% print. BOJ Core CPI dropped to 3.0% year-on-year in October from 3.4% in September, against expectations of a 3.4% print.

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Written by:
Myrsini Giannouli

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