Week in FX – Risk Steadies Dollar Ahead of Elections and FOMC

Investors have just completed navigating through a week that was not for the fainthearted. The market was peppered with news of new record lows for crude (West Texas Intermediate +$58.80, down –10% on the week and –20%, month-over-month), the Russian rouble’s nosedive ($57.98, down –44% year-to-date), and a massive scramble to own less risky assets like U.S. Treasurys (10’s +2.125%) and Bunds (10’s +0.638).

Anything oil-related has suffered be it equities or commodity-sensitive currencies (CAD, NOK, AUD, RUB). Current market sentiment and price action would suggest that both dealers and investors are happy to continue to exert fierce downward pressure on oil dependent stocks and currencies. The crude bears have managed to gather some additional support on Friday from the International Energy Agency (IEA). The IEA has again cut its 2015 demand growth forecast by another –230k bpd to +0.9M bpd (this is the fourth cut in five months), and noted that the sharp decline in oil prices would not hit production and boost demand in the short term.

In addition to uncertain oil prices, investors are keeping a close watch on China. The newly crowned world’s largest economy is not looking great. For instance, data this week revealed that factory production slowed more than estimated in November (+7.2% versus +7.7%). Weak data usually fuels a market bet that further stimulus could be in the offing. Who can forget the surprise November cut from the People’s Bank of China? Nevertheless, it seems that global equities on Friday see ‘red’ and few are buying into that particular scenario yet.

Where to Hide?

The U.S. dollar is stabilizing against other major currencies ahead of Japan’s general election on Sunday. Japanese polls are currently indicating that Prime Minister Shinzo Abe’s ruling party would win an overwhelming two-thirds of the lower house seats. If so, the market will expect the current form of Abenomics to continue. The event risk is that if the polls are wrong, do USD/JPY traders have the results already priced in (¥118.30)?
By Monday, the market focus will quickly shift to U.S. economic conditions and the two-day Federal Open Market Committee meet midweek. The question to be answered is “if and how“ the Federal Reserve’s officials would signal a rate hike by dropping an assurance that rates would stay low for a “considerable time.”

The Inflate and Deflate Debate

The big decline in oil prices is about to take a massive bite out of already weak inflation in major nations. Analysts expect that the average inflation rate among the Group of Seven’s members is likely to fall to around +1% in 2015. Investors should be expecting a number of economies to experience outright deflation. If the European Central Bank thought it had low-price problems now, wait until the effect of crude prices filters throughout the eurozone.

On Friday, the U.S. reported that November’s producer-price index for final demand fell –0.2%, month-over-month, while the core measure (ex-food and energy) was flat. The result reversed October’s numbers, but remains in line with year-over-year expectations (headline +1.4% and core at +1.8%). Excluding plummeting crude prices, there is little evidence of any inflation pressures along the U.S. supply chain.

On Tap for Next Week

With most of the major event risk out of the way for this month, except for the FOMC’s rendezvous and the Japanese election results, investors should now be expecting the market’s pace to subside a little. With that said, it might be an opportune time for a number of central banks to apply some pressure to their respective currencies and domestic yields.

Meanwhile, the Reserve Bank of Australia releases its monetary policy minutes on Monday. On Tuesday, the Bank of England’s Governor Carney discusses the U.K.’s bank stress test results, and the Old Lady’s official rate vote will be revealed on Wednesday. The Fed will deliver a post-meeting statement as well as rates and economic projections on December 17, along with Chair Janet Yellen’s press conference. Across the Pacific Ocean, the Bank of Japan and Governor Haruhiko Kuroda will follow suit at the end of the week.

Experienced traders know the deeper we go into December, both liquidity and volatility become heightened issues with or without economic releases. Capital markets should expect that most of the risk-averse investors will wisely wade to the sidelines, while year-ending U.S. dollar squaring becomes a market-dominating event as we approach the “turn.”

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