USD: Limited upside potential - Rabobank

Jane Foley, Research Analyst at Rabobank, notes that the market implied probably of a December Fed rate hike has approached the 70% level this week on the back of last Friday’s nonfarm payrolls report.

Key Quotes

“While the headline data was softer than expected, the report was seen by many as being ‘sufficient’ to allow the Fed to hike rates at the end of the year. The hawkish commentary of several policymakers had already been instrumental in steering the market towards the view that a December rate hike is on the cards. In September, three Fed officials dissented against the decision to leave interest rates unchanged.

While the release of the September FOMC minutes later today will be scoured for extra clues and although US economic data releases will continue to be important, in the absence of a significant negative surprise we maintain the view that that the Fed is positioning itself for a tightening in policy in December.

Growing expectations for a December US rate rise fed the rise in sovereign bond yields last week. A newswire report that the ECB was considering bond tapering also contributed to the re-adjustment in yields. The report played to the market’s sensitivities over the likelihood that central banks have become more concerned with the side-effects of extraordinary easing policy. A surge in UK inflation expectations on the back of the battered pound has also added to the changing mood in bond markets.

The market has spent large parts of the past year and a half lowering US inflation expectations and pushing out its forecasts for the trajectory of Fed tightening. This exerted significant downside pressure on US treasury yields and the USD and has overwhelmed the impact of other central banks’ actions on the FX market. Currencies such as the JPY and the EUR have been unable to weaken vs. the USD this year despite the easing announcements by the BoJ and the ECB. This week the firmer tone in treasury yields had supported the USD and thus allowed a softer tone to emerge in the EUR and JPY vs the greenback. However, we suspect that this move may not extend too far.

Since the market is still not fully priced for a December rate hike, it seems reasonable to assume that the USD may still have some upside potential between now and year end. However, we expect that this will be limited by the perception that the pace of Fed tightening is likely to remain slow. We see at most one rate hike in 2017 and forthcoming data will dictats how big the downside risks to this view are. A December rate hike can be expected to contain US inflation expectations and prevent a significant up-move in treasury yields. We see scope for EUR/USD to edge towards 1.09 by the middle of next year, but see risk that this may be the bottom for the currency pair.”