Forex: Yen May Outpace US Dollar if the Fed Opts to Taper Stimulus

Talking Points:

Euro Unlikely to Find Lasting Support in Improved German IFO Data
British Pound at Risk of Dovish Rhetoric Turn in BOE Meeting Minutes
USDJPY a Possible Exception to Dollar Gains if FOMC Tapers QE3

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Germany’s IFO Survey of business confidence is expected to show sentiment improved for the second consecutive month in December, hitting the highest level in 20 months at 109.5. As with yesterday’s ZEW data however, the improvement may not boost the Euroin that it would offer little reason to suspect the ECB will temper or abandon its dovish policy stance. In fact, the improvement in executives’ outlook may follow-on from last month’s surprise interest rate cut. While monetary stimulus can certainly buoy confidence in the future trajectory of economic growth, it likewise undermines yield-based support for the exchange rate.We remain short EUR/USD.

Minutes from December’s Bank of England policy meeting are likewise on tap. Traders will look to the voting pattern on the rate-setting MPC committee to see if unanimous support for the status-quo policy setting remained in place. UK economic news-flow has proven supportive over recent weeks, helping build out yield-based support for the British Pound amid speculation that the BOE may be forced to unwind monetary accommodation sooner than previously expected. Observed inflation has increasingly underperformed relative to expectations since September however (according to data compiled by Citigroup), a trend punctuated by yesterday’s soft November CPI print. Meanwhile, speculative net-long Pound positioning hit an 11-month high last week. That makes Sterling vulnerable to a bout of profit-taking if official rhetoric surprises on the dovish side.

Currency markets are unlikely to show meaningful follow on European event risk however as the spotlight firmly points to the pivotal FOMC monetary policy announcement. A Bloomberg survey shows that 24 out of 67 polled economists now expect some kind of cutback in asset purchases. That reflects a dramatic increase in “taper” bets compared with what the same survey showed just a few weeks ago but still leaves those calling for the status quo ($85 billion in Treasury bond and MBS purchases per month) in the majority. That skews outsized volatility risk toward the hawkish side of the scenario spectrum.

An outright QE cutback stands to boost the US Dollar against most of its major counterparts. USDJPY may be singular exception in the event that stimulus reduction fuels risk aversion, exposing the pair to spillover from an unwinding of Yen-funded carry trades. A decision to hold off this time coupled with taper-supportive cues in the Fed’s updated set of economic forecasts and/or Ben Bernanke’s press conference may yield a similar (albeit arguably less dramatic) result. The greenback may likewise find the upside limited if the FOMC lowers its unemployment and/or inflation thresholds to temper investors’ response of reduced accommodation.

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