Will central bank updates disrupt FX market trends heading into year end?

USD/JPY: Holding up well ahead of BoJ policy meeting

The foreign exchange market has remained relatively stable overnight ahead of the upcoming policy meetings today from the BoE and ECB, and then tomorrow from the BoJ. The dollar index has found support at the 98.000-level after attempting and failing to break below after the release of the weak nonfarm payrolls report for November. While the report provided further evidence that labour demand remained weak and the US labour market continues to loosen, it has been judged as not weak enough to alter the Fed’s current plans to leave rates on hold at the next FOMC meeting in January. US rate market pricing for the January FOMC meeting has remained largely unchanged with only around 7bps of cuts priced in. The next Fed cut is not expected until the March or April FOMC meetings. A slower pace of Fed cuts at the start of next year would help to provide more support for the US dollar at a time when the US economy is expected to strengthen driven by a bounce back in activity following the record US government shutdown in Q4 and the boost to growth from stimulus kicking in from President Trump’s One Big Beautiful Bill. However, we still expect the Fed to deliver multiple rate cuts next year as they continue to move the policy rate further into neutral territory encouraging a weaker US dollar (click here).

Dovish Fed Governor Christopher Waller, who is still reportedly in the race to become the next Fed Chair, made the case yesterday for further rate cuts. He stated that current monetary policy settings are up to 100bps above neutral. He favours “steadily” bringing the policy rate down to neutral. He emphasized though that with inflation still above target, the Fed can take it’s time to lower rates, and there’s “no rush to get down”. The “very soft” labour market with close to zero jobs growth provides justification to lower the policy rate to neutral. The dovish comments and soft NFP report for November have contributed to short-term US rates dropping back closer to year to date lows.   

USD/JPY has held up well over the past week, and has even moved further above support at around the 155.00-level overnight. The recent Fed rate cut, soft nonfarm payrolls report and building market expectations for the BoJ to raise rates tomorrow have failed to trigger a bigger rebound for the yen, even as US AI/tech stocks have come under renewed selling pressure over the past week. The unfavourable price action highlights the risk that the yen weakening trend, that has been in place since Takaichi won the LDP leadership election, could resume heading into year-end if the BoJ’s hawkish policy update disappoints expectations. A 25bps rate hike is already fully priced so the market reaction is more likely to be driven by the updated guidance delivered by Governor Ueda. We expect the BoJ to stick to guidance that further gradual rate hikes remain likely consistent with our forecast for another hike to be delivered by the middle of next year. However, plans for further gradual tightening may not be sufficient to reverse yen weakness while fiscal concerns remain elevated in Japan. If the yen continues to weaken it will increase pressure on Japan to intervene.           

NARROWING YIELD SPREAD IS HELPING TO LIFT EUR/GBP

Source: Bloomberg, Macrobond & MUFG GMR

EUR/GBP: ECB-BoE policy divergence points to further upside for the pair

The pound  has continued to trade at weaker levels ahead of today’s BoE policy meeting following the release yesterday of the much weaker than expected UK CPI report for November. The report has reinforced expectations that the BoE will vote to cut rates today by a further 25bps, and deliver multiple rate cuts in 2026 as well. There is a compelling case for the BoE to continue cutting rates as the policy rate is not yet in neutral territory, inflation and wage growth continues to slow, and weakening labour demand is creating looser labour market conditions. The main caveats which could still justify caution from more hawkish MPC members include wage growth did not slow as much as expected and core services inflation is still proving sticky. The bigger drop in inflation in November was partially exaggerated as well by early Black Friday discounts. With a 25bps cut fully priced in, market participants will be closely scrutinizing the updated guidance to assess the future path for rate cuts. Another close 5-4 vote could offer some initial support for the pound while a stronger majority in favour of cut would trigger a further sell-off. We expect the guidance to indicate that further quarterly rate cuts are likely during the 1H of next year. We have been forecasting a low for the policy rate at 3.25% next year, but the risk of more cuts has increased recently supporting our outlook for further pound weakness in 2026.

In contrast to the BoE, the ECB are expected to leave rates on hold today (click here) and signal with more confidence that policy is in a “good place”. Recent activity, wage and inflation data have all surprised to the upside encouraging market participants to scale back expectations for further cuts next year. It has helped to lift short-term rates in the euro-zone providing more support for the euro. President Lagarde has already indicated that the ECB staff forecasts for growth are likely to be raised. The ECB is unlikely to be overly concerned by the release of the softer euro-zone PMI survey for December. With the ECB keeping rates on hold for longer and the BoE still cutting rates, we expect EUR/GBP to rise up closer to the 0.9000-level next year.              

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Source: Bloomberg & Investing.com