Building rate hike expectations driving FX market

AUD: Hawkish RBA update brings forward rate hike expectations

The Australian dollar has strengthened overnight following the RBA’s latest policy meeting. It has helped to lift the AUD/USD rate to within touching distance of 0.6650, and extended the Australian dollar’s position as the best performing G10 currency so far this month. The Australian dollar has been boosted by hawkish comments from RBA Governor Bullock who stated “I don’t think there are interest rate cuts on the horizon for the foreseeable future”. Then added “the question is, is it just an extended hold from here or is it the possibility of a rate rise. I couldn’t put a probability on those but I think they’re the two things that the board will be looking closely at coming into the new year”. The comments send a clear signal that the RBA’s easing cycle has come to an end, and will encourage market expectations that the RBA’s next policy move is more likely to be rate hike than a cut. The RBA had already moved to price in a rate hike by the end of next year prior to today’s policy meeting, and has since moved to bring forward the potential timing of a hike to as early as March or May. A faster shift to RBA hikes next year would reinforce our bullish outlook for the Australian dollar (click here). The hawkish change in tone from the RBA reflects concerns over the the risk of a broad-based pick-up in inflation. Governor Bullock noted that recent data suggest there may be more tightness in the economy. If inflation pressures persist, it would raise questions over the need for a rate hike with the RBA board already uncomfortable with the level of inflation. The RBA board now judge that inflation risks are tilted to the upside. Ultimately whether the RBA leaves rates on hold or hikes rates next year will depend on the incoming economic data, but the RBA is already preparing the grounds to justify hiking rates. The updated statement signalled that the RBA will “take a little longer to assess the persistence of inflationary pressures”. A comment that could be interpreted as the RBA being in a position to raise rates by say Q2 of next year if they judge inflation pressures as persistent.  

HAWKISH REPRICING OF RATE EXPECTATIONS IS UNDERWAY

Source: Bloomberg, Macrobond & MUFG GMR

EUR/JPY: Rising yields outside of Japan encouraging weaker yen

The yen has continued to weaken overnight resulting in USD/JPY moving back above the 156.00-level. The yen has been undermined in part by the move higher in yields outside of Japan at the start of this week encouraged by hawkish central bank comments ahead of tomorrow’s FOMC meeting. At the worst point yesterday, the 2 and 10-year US Treasury yields had both risen by around 5bps as market participants moved to scale back Fed rate cut expectations ahead of what is expected to be a hawkish rate cut from the Fed tomorrow. Similarly, government bond yields in Europe rose sharply as well. The 2-year euro-zone government bond yield jumped by around 7bps in response to hawkish comments from ECB Executive Board member Schnabel to acknowledged that “both markets and survey participants expect that the next rate move is going to be a hike, albeit not anytime soon”. She also added that “I’m rather comfortable with those expectations”. Bloomberg noted that it is the first time that an ECB policymaker has talked about the possibility of hiking rates.

Her more hawkish leaning is supported by the fact that growth “has been much more resilient than could have been expected in the face of the greatest disruption of the international trade order since the Second World War” with business surveys currently pointing to “solid expansion” into year end. Economic growth in the euro-zone was recently revised up to 0.3% in Q3. She also downplayed concerns over inflation undershooting the ECB’s target next year by stating that the ECB can tolerate “moderate deviations from target” as long as there’s no sign of them becoming sustained. She believes that the decline in core inflation has stalled at a time when the economy is recovering, the output gap closing and fiscal policy is expanding which is creating inflation pressures. The hawkish comments have prompted the euro-zone rate market is price in higher probability of an ECB rate hike by the end of next year. It poses a challenge to our forecast for one final ECB rate cut next year. A more likely scenario is rates remain on hold given the ECB hawks lack a majority. It would though support our forecast for a stronger euro if ECB turns more hawkish.

The hawkish repricing of rate expectations outside of Japan is putting a dampener on support for the yen from expectations that the BoJ will resume gradual rate hikes this month. Governor Ueda spoke overnight in parliament and stated that the BoJ will make the appropriate decision at the December meeting while Prime Minister Takaichi reiterated the specifics of monetary policy should be left to the BoJ. Governor Ueda did voice some concern that the recent pace of long-term yield movements is somewhat fast, and reiterated that they remain prepared to increase bond buys in exceptional cases to stabilize the JGB market if required. The sharp sell-off at the long end of the JGB curve reflecting fiscal risks continues to weigh on the yen. It is making it harder for Japanese policymakers to derail the yen weakening trend that has been in place since Sanae Takaichi won the LDP leadership election and became prime minister. She did warn overnight that it is vital that FX moves stably and reflects fundamentals. Adding they will take appropriate action on excessive moves. The risk of direct intervention will increase if the yen continues to weaken after a BoJ rate hike.

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com