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With lower expectations, the case for long dollar, at least for 2016, is increasingly seen as non-viable. As a result, we saw market participants scaling back their USD bets. The dollar index fell below 97 this week, widening year-to-date losses to nearly 2%.
Consequentially, the euro and yen benefitted, with the latter also riding on a wave of risk aversion. Clearly, the dovish slant in their respective central banks have been overshadowed by prospects of a slower pace or even a pause in the US rate hike cycle.
As of today, a second rate increase in March is almost a foregone conclusion, with market pricing in just 10% implied probability. Even a second or more rate increase by the end of this year looks to be increasingly unlikely, with a sub-50% market pricing. In contrast, it was over 90% at the end of last year. This suggested that market participants believed that excessive market fluctuations are a key consideration in the Fed’s rate setting decision.
Sovereign bonds also reflected the market view, with more inflows into US treasuries. Yields on 10-year fell deeper towards 1.80, having fallen 8.5 basis points so far in the first week of February, and 43 basis points since December. Another beneficiary is oil. A lower USD is giving crude a much needed boost amid bearish sentiments due to a deterioration in the supply side.
Nonetheless, investors will still monitor the possibility of an extraordinary meeting by the OPEC to cut production. Although, with the absence of large producers like Saudi Arabia and Iran, I don’t see much of a point in the other OPEC members trimming output. Any gaps will be quickly filled by other producers to increase market share.
Back to the Fed, the huge gap between market expectations and the Fed’s projections on the path of future rate hikes will need to narrow at some point.
Cleveland Fed President and FOMC voter Loretta Mester remains hawkish about monetary policy. She still sees a path of gradually higher fed funds rates over time as being appropriate. President Mester acknowledged that while recent market developments may pose some risks to the outlook, it is at the moment premature to materially change its outlook.
Put differently, the Fed would need further data before altering its perspective. Moreover, she dismissed the potential of negative US interest rates, after BOJ joined ECB in implementing negative policy rates, by stressing that the Fed is not keen to take action that is ‘shocking’ to the markets. The March FOMC meeting will be a key event to monitor, especially on the Fed’s outlook on the US economy and the path of US interest rates.
Meanwhile, Asia is unlikely to extend the solid risk rebound from Thursday as overnight leads from the European and US sessions provided a mixed signal. Japan and Australia already started Friday on a shaky footing.
Asian currencies however may strengthen on account of a softer dollar, although the performance may depend on how the yuan moves. Recent efforts by the PBOC to keep yuan stabilised has limited impact in terms of easing fears of further yuan devaluation. The market is still looking at a 58% odds of a lower yuan by the end of 2016 on persistent capital outflows and slowing growth.
- US and European stock indices traded mixed in the overnight session. S&P 500 maintained above 1900, while the Dow remained capped below 16500. DAX fell 0.4% but FTSE climbed +1.1%, helped by a rebound in commodities which lifted UK mining shares. Stoxx 600 Europe edged marginally lower at -0.2%.
- Oil prices trimmed some of the outsized gains made on Wednesday. WTI and Brent pulled back over 1%. Likewise, the Bloomberg Commodity Index shaved -0.2% off Wednesday’s +1.9% rebound.
- The dollar fell to a three-month low on diminishing expectations of further rate hikes. The dollar index dropped to 96.259, eyeing the 96 support. In tandem, EUR/USD surged above 1.12 while USD/JPY weakened below 117.
- PBOC set USD/CNY midpoint at 6.5314, lower than Thursday’s 6.5419.
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