Not All are Convinced of a December Rate Hike

The US-German 2-year interest rate differential (swap rate) is a useful directional guide to the actual euro-dollar exchange rate.  At about 105 bp, it is the highest since 2005.  The US premium had peaked in late 2004 near 185 bp.  In the second half from the 1990s, it was common for that US premium to be in excess of 250 bp.  It has risen 25 bp since the center of October, encouraged through Draghi, whose dovishness again surprised traders. 

The Eurozone PMI confirms an irony.  Economic data from the Eurozone offers held up well, pointing to fairly steady even if unimpressive development.  Draghi made a case for environment policy based on risk situations.  The data does not seem to assistance such sense of urgency.  From 52.3, the Eurozone production PMI was slightly better than the flash (52.0) and is a little above the Q3 typical. Of note, on a nationwide level, Germany's flash May was revised higher (Fifty two.1 from 51.6) and Italy was a pleasant surprise at 54.One (consensus 53.1 after 52.7 in Sept).  The service PMI may also surprise on the upside.  Even though the market has treated Draghi'utes comments as if they were a commitment to ease policy at the Dec 3 meeting, it may not be the done deal. 

Many still are unconvinced the Fed will hike in the center of December.  Some argue towards it on technical grounds.  Raising rates in therefore close to the end of the year might inject extra volatility into the markets and complicate year-end activity.  As a matter of fact, the Federal Reserve has taken action in the 30 days of December.  It hiked rates in December 2004 and December 2005, for example.  This cut rates in December 2001 and December 1995.

If one assumes that Given funds, which have been averaging 13 bp over the past 50 and 100 days continues to do so in the first half of December, and then after the rate backpack averages 30 bp, then your December Fed funds contract is pricing in a 75% possibility of a hike. Some assume that it will average the middle of the number, but besides the fact that it’s been averaging around the middle of the variety now, there is no compelling debate to assume this remains the situation.  Indeed, we suggest the possibility that in order to maintain maximum control, the Fed will want to provide adequate liquidity to keep the Given funds rate relatively low to ensure the attractiveness of one of the brand new tools in this cycle, the eye paid on excess supplies (which is the top of the Fed funds target range).  It is true that no one really knows where Given funds will trade following the hike, and we need to take the "odds" only in the contest of this assumption.  My work shows that the conventional measure may under-estimate the market-based probability of a Fed backpack in December.

The euro is an especially narrow range.  The $1.1060-75 music group is blocking the benefit, while $1.10 is holding the downside in check.  A break of say $1.0990 could see the euro retesting its recent lows close to $1.09. On the upside, the new short likely will not be pushed unless the $1.11 region gives, which was the high prior to the Chinese rate cut.  

The buck has not traded below JPY120 since October 22.  If that is support, then the topside of the current range is incorporated in the JPY121.50-JPY121.60 area.  As we predicted, the incremental additional stimulation for the Japanese economy may come from a supplemental budget rather than monetary policy.  Meanwhile the focus is on the Japan Post IPO, which expects to raise the equivalent of $12 bln, when Japan returns from Tuesday's holiday. 

Despite much better than expected manufacturing PMI, sterling encountered a wall of retailers near $1.55, and was unable to recover.  There was talk of Asian central banking institutions on the offer.  It finished the North American session just off its lows near $1.Fifty four.  The implied yield of the June 2016 short-sterling futures has increased by 10 bp in the last four sessions.  Sterling has acquired a net 1% over those 4 sessions.  The market may turn cautious ahead of Super Thursday (MPC decision, minutes and quarterly inflation report).  Technical support may be within the $1.5340-$1.5370 area. 

Barring a strong rally in oil, the US dollar is unlikely to slip much further from the Canadian dollar ahead of this week's slew of data, including trade and employment data to which the Loonie seem especially sensitive.  For the trade numbers, released on Wednesday, the focus should be on non-oil exports, which may be turning higher.  The US figures arriving at the end of the week may overshadow their employment data launched at the same time.  Although the thought would be that the Bank of Canada's two rate cuts this year completed the mini-easing cycle, another price cut cannot be completely ruled out.  In September, Canada lost nearly 62k full-time jobs. Another depressing report and rate cut talk may resurface, whether or not the new government wants to pursue a small fiscal deficit.  Tech support team for the US dollar is seen in the CAD1.3040-CAD1.3060 range.

A Few Short Thoughts on FX is republished with permission from Marc to Market