Financial conditions have eased considerably since the FOMC signalled a slower pace of rate hikes. There are good reasons for this: an apparent desire to slow the speed compresses the distribution for the policy rate, an evident desire to slow the rate hike pace supports risky assets via lower rate volatility, and traders respond more to downside surprises.
But there are plenty of tell-tale signs suggesting rates have moved too far, too fast, and a course correction is likely—either from the data or the FOMC this week.
While last month's inflation print was incredibly encouraging, service sector strength, where sticky inflation hangs out, will make it difficult for the Fed to achieve its inflation aim quickly.
Tuesday's CPI release and Wednesday's FOMC should reinforce that there is still a long way to go. So FX traders should position for sticky inflation and a hawkish FOMC delivery where the best expression would be long USDJPY given the pair's sensitivity to rising US yields.
On the flip side, if CPI inflation is benign and the Fed delivers a more easygoing tone, that would benefit the AUD most, especially in light of recent news on China reopening.
The Japanese Yen has strengthened by nearly 9% since the start of November, the second largest gain (after NZD) across G10 FX, driven by a significant decline in US real rates and what looks to be a large unwind of long USDJPY speculative positions.
USDJPY remains the best proxy for US real rates and further Dollar weakness. So a dovish Fed this week would likely extend the recent Yen strength.
The Bank of Japan may also be preparing to shift its current YCC policy at some point next year, which would be positive for the Yen.
ECB meeting features several moving parts this week—a slightly more upbeat outlook, a slower pace of rate hikes, and some balance sheet discussion.
But the fundamentals remain the same: European policymakers face a challenging trade-off between high energy prices and constrained activity. From a currency perspective, aggressive rate hikes are not an appealing option.
And the twist at this meeting—the start of balance sheet discussions—also comes with a critical wrinkle for the FX implications. In the Euro area, sovereign purchases primarily act to ease credit conditions; as a result, ECB QE supports the Euro, and unwinding the balance sheet should weigh on the currency at the margin.
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