USD Still Stuck in Tight Range as Fed Rate Cut Expectation Increase

USD: Weak PPI report reinforces expectations for earlier Fed rate cuts.

The US dollar has maintained relative stability against other major currencies, trading in a narrow range of 102.00 to 103.00 in recent weeks. Last week's notable event for the US dollar was the release of a producer price inflation report, indicating weaker-than-expected results. This report has strengthened market expectations for earlier rate cuts by the Federal Reserve. The US rate market is now pricing in the first rate cut by the March FOMC meeting, with approximately -21bps of cuts expected by March and a cumulative total of around -166bps by year-end. The PPI report disclosed a -0.1% M/M decrease in producer prices in December, primarily driven by a -0.9% M/M decline in food prices and a substantial -3.0% M/M drop in used car prices. Additionally, there was a favourable -0.8% M/M reduction in trade services, indicating a fourth consecutive decline and a compression of gross margins for wholesalers and retailers.

These developments have further fuelled expectations that the upcoming PCE deflator report on January 26 will continue to reveal slowing inflation. The core PCE deflator has already slowed to an annualized rate of 1.9% over the last six months to November, fostering anticipation that the Fed will move to lower rates, making policy less restrictive as confidence grows in inflation returning to target. While the initial release of the weak PPI report led to a sell-off of the US dollar, little follow-through has occurred as the recent range-trading environment persists.

Another significant development impacting the US dollar's performance at the beginning of this week was the Taiwan election results. The Democratic Progressive Party won the presidency but lost their legislative majority, requiring collaboration with opposition parties for legislation passage. Lai Ching-te will become Taiwan's new president, securing 40.05% of the vote. The legislative election saw the KMT winning the most seats (52), followed closely by the DPP (51) and the TPP (8). This loss means the DPP no longer holds a majority in the 113-seat parliament. The initial foreign exchange market reaction has been negative for the TWD and mixed for other Asian currencies, with the TWD declining modestly by approximately -0.4% against the US dollar since last week's end. The KRW has been the biggest underperformer, declining by -0.5%, while the THB has strengthened by +0.5%. Market participants are closely monitoring how relations between the new administration and the Communist party evolve, with the victory for Lai Ching-te increasing the risk of further deterioration. However, the loss of the DPP's majority may be welcomed by the Communist party in China. At this juncture, significant easing of geopolitical risk in the region is not expected, posing a continued headwind for Asian currencies.

GBP: Will the BoE lag the ECB and Fed when cutting rates?

The beginning of 2024 has seen the GBP emerge as the top performing G10 currency, making significant gains. Cable has surged towards the high from the end of the previous year, reaching 1.2827, while EUR/GBP has fallen below the 0.8600-level. GBP/JPY has experienced a notable shift, rising from just below the 180.00-level to the 185.00-level. This marks a turnaround for the GBP after its underperformance in December.

At the onset of the year, market participants have been revising down their expectations regarding the timing and depth of potential rate cuts by the Bank of England (BoE) in 2024. The implied yield on the June and December 2024 three-month SONIA futures contracts has increased by approximately 13bps and 21bps respectively since late last year. Despite these adjustments, the BoE is still anticipated to lag both the Federal Reserve and the European Central Bank in implementing rate cuts throughout the coming year. The first 25bps cut from the BoE is not fully priced until the 20th of June MPC meeting. In contrast, the first 25bps rate cuts from the Fed and ECB are fully priced in by their 1st May and 11th April policy meetings, respectively.

Looking at the broader picture for the year, the UK rate market is pricing in roughly 25bps less in cuts compared to the eurozone and the US. This divergence reflects investor concerns about a potentially higher risk of inflation proving more persistent in the UK. These worries were somewhat alleviated by reassuring evidence of slowing inflation and wage growth at the end of the previous year, contributing to GBP's underperformance in December. In the upcoming week, the release of the latest UK CPI (Wednesday) and labour market (Tuesday) reports will be closely scrutinized to better gauge whether the disinflationary trends observed in December will persist. Inflation is currently running well below expectations.

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