USD: Has Taper Been Priced In?

Dollar: Has Fed Tapering Been Priced In?

The U.S. dollar traded higher against the commodity currencies but sold off against the Japanese Yen, euro and British pound. This diverging price action suggests that there is little conviction in the market about what the central bank will do this week. The uncertainty can also be seen in the conflicting performance of equities versus Treasuries as stocks rallied and bond yields both moved higher. While we believe that traders in the bond and FX markets have priced in tapering by the Fed this month or next, with 10 year Treasury yields off their September highs, we don't believe that they have priced in the end of QE and more specifically the pace at which bond purchases will be halted next year. Originally the Fed had planned to begin reducing its monthly bond buying in the third quarter of 2013 and end the program by mid-2014. Its now December and its not even clear whether the central bank will slow purchases this month which means there is a good chance QE may not end until 2015. In all likelihood, policymakers themselves probably don't know how quickly they want to wind down the program which is why there's still room to upside for the dollar and U.S. yields when the Fed tapers.

Our base case scenario is for a small amount of tapering this month ($5 to $10 billion) followed by a noncommittal outlook for further reductions that would minimize the market's reaction and give Janet Yellen the flexibility to design her own strategy for unwinding stimulus. Yet the decision will be a very close one with a reasonable number of economists looking for the Fed to taper in January or even March. For the Federal Reserve, the greatest motivation for December tapering is the strength of U.S. data. While the Empire State manufacturing index fell short of expectations, manufacturing activity turned positive in the NY region this month. Industrial production also grew at its fastest pace in a year in November while non-farm productivity rose 3% in the third quarter, the strongest pace of growth since September 2009. Since the last FOMC meeting, we have seen a significant recovery in consumer spending and the labor market but there are still pockets of weakness in other parts of the economy.

Putting ourselves into shoes of the central bank, we have compiled a table illustrating how economic data changed since the last FOMC announcement on October 30th. Non-farm payrolls have averaged 204k over the past 4 months and this strength drove the unemployment rate down to 7%. Retail sales also rebounded in November after contracting in September and according to the latest consumer sentiment survey, Americans are feeling more optimistic. Considering that it is only a matter of time before the Fed starts reducing its monthly bond buys, it may be strategically sensible to begin tapering this month so they can spread the reductions over a longer period of time. However as indicated in the table below, inflation remains very low, giving policymakers the option to wait because inflation is not a major risk. The housing market has also been mixed but more importantly, stronger manufacturing activity is offset by slower growth in the service sector. U.S. yields have increased significantly over the past 7 weeks and by tapering, the central bank risks driving 10-year yields to 3%. As you can see, strong arguments can be made for tapering in December or January, which is why this month's FOMC announcement could trigger unusually large volatility in currencies.

EUR: PMI Report Shows Continued Dispersion In Growth

The euro traded slightly higher against the greenback Monday on the back of stronger-than-expected euro zone PMI numbers and the rally in U.S. equities. ECB President Draghi reminded us that the risks for the region is to the downside and given the dispersion in growth within the euro zone, the central bank has every reason to be cautious. The euro zone PMI composite index as a whole hit a 31 month high in December but the gains were driven entirely by manufacturing as service sector activity slowed. More importantly, manufacturing activity in Germany remains strong but France is lagging behind while both countries saw weaker growth in services this month. Until the rest of the region catches up with its largest economy, the ECB will err on the side of caution. Tuesday's German ZEW survey is expected to reflect the same positive outlook that we saw in Monday's PMI report. The one bright note according to our colleague Boris Schlossberg is "the improvement in economic activity in the European periphery, which helped to offset the weakness in France and led to the better headline number. Although economic activity in Spain Italy and the rest of the Club Med countries is far from booming, its is showing clear signs of improvement. Monday's Italian Trade data for example saw the surplus rise to 4.07B from 1.24B eyed."

GBP: Inflation Not Expected To Be A Problem In U.K.

It was a quiet day for the British pound, which held steady against the U.S. dollar and traded slightly lower against the euro. The only piece of U.K. data released over the past 24 hours was Rightmove house prices. While prices declined in December, on an annualized basis, prices are up 5.5%. The director of the country's largest property website believes that price growth will slow in the coming year on the prospect of a higher capital gains tax for foreign investors. This vulnerability may be one reason why the U.K. government accelerated its supported for the housing market this year. It is busy week for the U.K. with the Bank of England minutes, inflation, employment and retail sales figures scheduled for release. Consumer and producer prices are on the calendar T and economists are looking for a small uptick in prices that will be consistent with the smaller decline in shop prices reported by the British Retail Consortium. Although the annualized pace of CPI growth exceeds the central bank's 2% target, inflation is not a major problem for the central bank. The other reports this week should have a more significant impact on sterling than Tuesday's CPI and PPI numbers.

AUD: Holding Steady Ahead Of RBA Minutes

All three of the commodity currencies started the week slightly lower against the U.S. dollar on the back of weaker Chinese manufacturing activity. Economists had actually been look for manufacturing activity to improve but the HSBC Flash PMI index dipped to 50.5 from 50.8. Many people have been concerned that China's recovery is losing momentum and last night's report confirms that manufacturing activity hit a peak in the third quarter. The Chinese government has planned for slower growth this year, an outlook that doesn't bode well for countries like Australia and New Zealand who rely on their demand for growth. The minutes from the last RBA meeting were scheduled for release Monday night and based on the comments from RBA Governor Glenn Stevens last week, we were expecting more concerns about the high level of the currency but it will be interesting to see whether the RBA minutes will be dovish enough to drive AUD/USD to its 3-year low of 0.8850. The December monetary policy statement was virtually unchanged from November with the central bank maintaining its easing bias but also expressing their comfort with the current level of monetary policy. Last night's New Zealand economic reports were mixed with consumer confidence rising in the fourth quarter and service sector activity slowing. Economic data from Canada was also far from impressive as home sales growth declined for the second month in a row and foreign purchases of Canadian securities slowed.

JPY: Tankan To Provide More Evidence Of Recovery

While U.S. equities rallied Monday, the 1.6% slide in the Nikkei overnight prevented all of the Yen pairs from trading higher. USD/JPY in particular is trying to resume its rally but the pair is finding resistance at 103. Last night's economic reports show that more firms in Japan are riding the wave of the recovery but the bar has been set high for Japan and the failure to meet the lofty expectations contributed to the weakness in Japanese stocks and Yen crosses. The Tankan report is one of the most important pieces data released by Japan and according to the latest release, manufacturing and non-manufacturing firms feel more optimistic about current and future business conditions. Large firms felt current conditions were stronger than economists had projected but they were not as optimistic about future conditions as Wall Street analysts. Small firms on the other hand were significantly more optimistic than forecasts as the Tankan survey for small firms improved significantly. The outlook from small manufacturing firms turned positive for the first time since 2007 and for non-manufacturing firms, this was the first positive print in more than 2 decades. While the data confirms that Japan's recovery gained momentum in the fourth quarter, lofty expectations and disappointing numbers from China has made it difficult for Japanese stocks and USD/JPY to rally. We still expect the Yen crosses to head higher but there could be more consolidation before FOMC.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.