All Eyes on Boj Policy Update After Fed Pushes Back Against March Rate Cut

USD
The US dollar continues to trade at slightly stronger levels, maintaining its momentum from a relief rally on Friday. This surge followed remarks from New York Fed President Williams, who sought to dispel market speculation about the Fed initiating rate cuts as early as Q1 next year. Williams stated in a CNBC interview on Friday that discussions about rate cuts are not underway now, emphasizing that it's premature to contemplate a March rate reduction. Although these comments indicate that the Fed leadership is not currently endorsing rate cuts at the March FOMC meeting, market participants are hesitant to significantly revise down their expectations for earlier and more substantial rate cuts in the coming year.

As of now, the US rate market still reflects approximately 21 basis points of cuts by the March 20th FOMC meeting and roughly 145 basis points of cuts in total by the end of the next year. Following last week's FOMC meeting, there is increased confidence among market participants that the Fed will indeed implement rate cuts next year in response to slowing inflation. The upcoming release of the November PCE deflator report is anticipated to offer additional evidence that underlying inflation pressures have decreased, further bolstering the Fed's conviction that inflation is converging back toward their 2.0% target.

Over the last six months up to October, the core PCE deflator had already decelerated to an annualized rate of 2.5%, down from 5.1% a year ago. If inflation continues to trend lower at the beginning of the next year, expectations could persist that the Fed might commence rate cuts as early as March, even if it currently doesn't align with the Fed's primary scenario.

The pessimistic adjustment of expectations for Fed policy in the coming year elevates downside risks for the US dollar in early 2023. However, caution is advised against actively pursuing further weakness of the US dollar in the short term. Conditions could align for a rebound against the euro and pound early next year. Firstly, the US rate market has already factored in expectations for earlier and more significant Fed rate cuts, setting a higher threshold for additional dovish policy surprises. Secondly, the deteriorating economic data from Europe might prompt a more pronounced dovish policy shift from European central banks in the early months of next year.

Further indications of a quicker decline in core inflation, coupled with ongoing economic stagnation or recession risks in the eurozone, could compel the ECB to deviate from their commitment to maintaining rates at restrictive levels. They may lean towards moving back to more neutral levels, around 1.50-2.00%. Even in the UK, where the BoE is primarily concerned about persistent inflation risks, recent developments have shown encouraging signs of disinflation. Wage growth is slowing, and GDP contracted in October. Given these circumstances, the window for additional US dollar weakness against the euro and pound may be short-lived.

Among the major currencies, the yen appears to be in the best position to outperform as the Fed, ECB, and BoE all prepare to lower rates next year.

JPY
The Bank of Japan (BoJ) is set to deliver its final policy update of the year tomorrow, with market expectations for an immediate change diminishing after a recent report from Bloomberg downplayed the likelihood of a shift away from the current negative rate policy. This report initially triggered a sell-off of the yen early last week, but those losses have since been fully recovered. The recent rebound of the yen against the US dollar can be attributed to growing expectations of earlier and more substantial rate cuts from other major central banks, narrowing the existing policy divergence with the BoJ.

Anticipating the BoJ's policy meeting, scheduled for tomorrow, market focus will be on the updated policy statement and comments from Governor Ueda. There is an expectation that the BoJ might reinforce the yen's upward momentum at the beginning of next year by removing negative rates in January, a move not seen since early 2016. Analysts will closely examine the language used in the policy statement, particularly the possibility of removing the bias toward easing, as this could signal a significant shift and prompt reactions in interest rates and foreign exchange markets.

While changes to the assessment of the economy or inflation appear less likely, given the recent release of forecasts, some developments could prompt adjustments in wording related to inflation and wages to signal progress. Governor Ueda's press conference may provide insights into the progress toward price stability and wage growth, leaving room for a potential policy change in January with some flexibility.

The current strengthening of the yen represents the most significant correction since October last year to January. Any unexpected hawkish signals from tomorrow's announcement, such as the removal of the bias toward easing or a more explicit indication of nearing the price stability goal, could further advance the yen. Leveraged Funds still hold substantial short yen positions according to IMM positioning data, and while fundamentals may play a reduced role in FX movements over the coming weeks, liquidity and positioning will be crucial. Although USD/JPY has experienced a 10-point drop from the November high, significant further downward moves are now considered less likely. A status-quo message from Governor Ueda could prompt some renewed selling, with attention also given to global yields. 

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