Roger J Kerr says the evidence from all the US economic data over the last month has to be that the risks have subsided, therefore the Fed have done enough with tight monetary policy to achieve their 2.00% inflation target

Summary of key points: -

• Evidence continues for further reductions in US inflation
• Contemplating potential currency risk events in 2024

Evidence continues for further reductions in US inflation

Global financial and investment markets are bracing themselves for the final US Federal Reserve meeting of the year this week (Thursday morning 8.00am NZT), because the tone from the Fed on monetary policy and the subsequent responses by the markets will determine price direction over coming months.

Forward pricing by the US short-term interest rate markets for cuts in 2024 came back somewhat last week from 1.30% to 1.00%, as the markets digested a marginally stronger Non-Farm Payrolls employment report for November. The US dollar depreciated sharply from 107.00 on the Dixy Index at the start of November to below 103.00 by the end of November on tumbling bond yields and consistently weaker US economic data. The first week of December has seen some consolidation for the USD between 103.00 and 104.00 as traders take profits and lower risk positions ahead of the Fed statement. As a consequence of the USD correction, the NZD/USD exchange rate has pulled back from 0.6200 to 0.6120. After the rapid climb from 0.5800 to 0.6200 during November, it is a natural market pattern that a short-term downward correction follows as the traders who have been “long” Kiwi take their profits and clear out their positions before considering new positions.

It seems unlikely that the Fed will be more “hawkish” than what the markets currently expect in this 13th December statement. It largely comes down to whether the Fed, in their assessment of the US economy, consider that the risks of inflation going back up again from the current 3.20% are higher, the same or have been lowered. The evidence from all the economic data over the last month has to be that the risks have subsided, therefore they have done enough with tight monetary policy to achieve their 2.00% inflation target. The dramatic drop in oil prices and deflation in China have certainly reduced inflation risks from external influences.

The markets should not expect that the Fed will talk about the timing and extent of interest rate cuts in 2024. They never do that; however, the markets will continue to speculate with forward pricing as to that timing based on emerging economic data supporting weaker demand in the economy, or not. The most intriguing part of the Fed’s statement this week will be the “dot-plot” interest rate forecasts for 2024 from the individual Fed members. Back in September, the majority of the Fed members increased their forecasts from below 5.00% to well above 5.00% (causing USD appreciation at the time). Lower inflation, weaker data and much lower market interest rates since September will cause some embarrassing U-turns in forecasts to back below 5.00% again. The individual “dot-plot” forecasts are anonymous, so difficult to hold anyone to account for wildly inconsistent views on economic conditions, inflation and outlook.

Whilst the November jobs increase at 199,000 was marginally above prior forecasts, it was not so strong to cause equities to fall or the US dollar to lift. Yet again, all the increases in jobs in the US economy during November were in the less-productive healthcare and government sectors. Manufacturing did increase, however that was due to auto-worker strikers returning to work. The overall medium-term trend in US employment remains firmly downwards. Weaker monthly increases are expected over the next few winter months.

Evidence for the continuation of decreases in the US annual inflation rate came from two sources last week: -

• Consumer’s expectations of future inflation plummeted in the December University of Michigan consumer sentiment survey. The one-year outlook for inflation slid to 3.10% from 4.50% in November, the lowest result since March 2021. Fed Chair Powell often highlights the importance of inflationary expectations, he should be very encouraged by this survey.
• Up-to-date market house rental figures pointed to a 0.57% decline in rents in November, bringing the decrease over the last year to 2.10% (according to Rent.com data). Rent measures in the official CPI are notoriously lagged, but they are also on a serious downtrend.

US CPI inflation numbers for November are released the day before the Fed meeting. Consensus forecasts are for another 0.00% headline result and +0.20% core result for the month. A negative result would not be a surprise as gasoline and gas prices have tumbled. Lower than expected US inflation outcomes have caused bouts of USD selling all year, we expect that to continue.

The debate continues as to whether the US economy will have a “soft-landing” in 2024 (i.e. inflation down to the 2.00% target without causing a recession). Forward looking indicators suggest that a soft landing will be achieved, therefore FX forecasters who see another bout of USD strength due to the US economy being in recession (and that causing a global economic recession) are part of a dwindling minority (e.g. CBA/ASB).  

Contemplating potential currency risk events in 2024

FX markets will always price-in the future today, based on expected economic developments, leading to “no surprises” and generally stable market conditions or nice smooth uptrends and downtrends.  Therefore, it is the unexpected or the unknown, that the markets have not anticipated in advance, that often cause the sudden gyrations and big shifts in currency values.

Looking into 2024, the following events or developments may well cause FX rate movements outside the anticipated: -

• Tectonic shift in Japanese monetary policy: The Bank of Japan may move at a glacial pace of change after 30 years of super loose monetary policy settings; however, the stakes are increasing that they will move to “normal” settings of positive interest rates over coming months. The Japanese Yen has already reversed sharply from a weak 152.00 level against the USD a month ago to 145.00 today. A continuation of Yen strength as investment funds return home from offshore has to be expected. A return to the January 2023 level of 130.00 is very likely over coming weeks, followed by the Yen potentially appreciating all the way back to the 110 level against the USD prevailing in 2020 and 2021.
• Reserve Bank of Australia forced to tighten monetary further: There is a better than even chance that the RBA will be increasing their interest rates again in February 2024, just ahead of the Fed getting nearer to cutting their interest rates. The RBA are not on top of their inflation fight as they sat on their hands in an overly-complacent manner for most of this year. In early 2024 they will be doing the opposite to all other central banks with their rate hike. Interest rate differentials back in favour of the Aussie dollar over the US dollar point to substantial AUD gains over coming months.
• Reducing geo-political risk?: Wars, as in Ukraine and the Middle East over recent times, always increase geo-political risk and the US dollar strengthens with such events. What are the chances of a fresh new military conflict somewhere in the world in 2024 to prompt USD safe-haven buying? Many pundits cite China taking military action against Taiwan as a major geo-political risk that would cause the USD to appreciate. Our view is that China has no stomach at all for such conflict, given their domestic economic challenges at this time.
• Impact of the US Presidential Election campaign: The US of A will progressively become preoccupied and obsessed with their Presidential election campaign through next year in the lead up to the November vote. If Donald Trump is not in jail, there is a very good chance that he will be the Republican candidate in a crazy “back to the future” situation. An interesting political development recently in the US was the highly influential and financially powerful Koch brothers putting their support and money behind Republican candidate, Nikki Haley. They foresee the damage to the US economy that another Trump Presidency would cause. The volatile and unpredictable Trump as US President again would not be favourable for the US dollar currency value. When he was President from January 2017 to January 2021 the US dollar lost value, particularly towards to end of his term as his behaviour became increasingly bizarre (refer chart below).

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.