The revolution of rates can't avoided

If the last chance for the increase of American rates is not used, it will kill the market's confidence in FRS

FRS target reference points have not been achieved by the date of the main decision of the year. Wrong time and bad fundamental background have been selected for rate increase: yuan devaluation, defaults of raw material companies and fall of securities markets, decline of oil prices towards the levels of 2008. However, many promises have been made, and someone will have to be responsible for them. We will count those who incurred real damages after December 16.Strong NFP and the growth of confidence in rate increase have not given a serious momentum to US dollar so far. Most of G10 countries do not plan to tighten their monetary policy at least until 2017, and the Bank of England's decision regarding retention of its rates is another proof of it. If the last chance for the increase of American rates is not used, it will kill the market's confidence in FRS; however, there will be a chance for such a decision until the last moment.

Based on the FRS dual mandate, in case of absence of inflation growth, labor market indicators do not have the decisive significance for rate increase. Let's remember that inflation in the USA is far from its target 2% value and maximum employment has not been attained (Yellen's report to the Congress on December 3). Judging by history, FRS has never increased its rates under such low inflation. There are also no secondary signs of inflation - the growth of salaries in November was only 2.3%. To compare: BoE set its reference points for rate increase under the annual growth of salaries above 3%.

It has not worked out with the growth of economic activity - ISM manufacturing index came out below the recession level. Last Friday, the VIX fear index grew dramatically in the midst of raw material companies bankruptcies, devaluation of yuan, fall of junk bond market - FRS should have paid special attention to the devaluation of yuan and to the actions taken by foreign central banks targeted at devaluation of their currencies for increase of their competitive abilities. It is clear that FRS rate increase will give many countries trade advantages over the USA; however, FRS will complicate the life of its exporters again. As it was earlier, rate increase in the range 0.25%-0.50% with decrease of inflation forecasts and statements regarding the perspective of further rate increase is the most likely outcome of 16 December meeting. In any case, fixation of long positions in dollar at the end of the year is inevitable. Possible behavior: a small downward peak with a quick reversal upward prior to Yellen's speech.

An increase by a value below 25 bps (0.15%-0.35%, or variations) is less likely, although it would be an ideal variant for reconciliation of the economy's current state with FRS tasks. Then US dollar growth will be vertical and more lengthy, regarding EUR/USD - to zone 1.0200-1.0300.An unlikely forecast: FRS rate increase to range 0.25%-0.50% under a small decrease of inflation forecasts, absence of guarantees regarding the further increase of rates and Yellen's pointless prattle. However, that particular meeting outcome will definitely please Draghi. Retention of rates at the previous level with further threats of increase is practically impossible. In such case, the growth of euro to levels 1.1200-1.1400 within several seconds will be guaranteed.

The following of the main events will be noted:

  1. Today, the Central Bank of China conducted another intervention on the open market with the help of 7-day reverse REPO and added 10 bln yuan to the financial system.
  2. OPEC's refusal from the official production ceiling is a de facto acknowledgement of the current reality on the oil market. However, there are signs that the Group's strategy regarding ousting the competitors is being actively put to operation, we will see its results only at the beginning of 2016.
  3. Prices for iron ore have been falling for nine weeks straight. At the same time, the data on the Chinese steel production published on Saturday speak of further demand decrease since the largest consumer is moving away from heavy industry. Within the current year, iron ore has lost almost 46% of its value due to the growth of mining by leading manufacturers, and it is still too far from minimums.
  4. The response to the European statistics is weak. Today, we should track the market's response to the publication of the data regarding the inflation of US consumer prices and real weekly salaries.
  5. The second round of French regional elections will hardly have any serious effect on EUR/USD this week, but they are important prior to the threshold of presidential and parliamentary elections in 2017. In case of her victory Marine Le Pen threatens if not with France's pullout of Eurozone than, at least, with serious problems compared to which Greece will seem as a small inconvenience.
  6. On Friday, expiration of quarterly US stock options and futures will take place; strong multidirectional movement regarding US dollar index with further stabilization, at least, until the second week of January is likely.
  7. FRS holds its traditional "extraordinary" closed meeting today; most likely, there will be no serious inside, however, a crossflow of capital upon its completion may cause nervous jumps in the main pairs.

Considering the coming end of the year, there is a fixation of profit underway, strengthening of US dollar by the results of 2015 will lead to revision of investment portfolios, which must cause sales of US dollar. The behavior of Asian currency risk hedgers speaks of the fact that this time, unlike previous years, yen will be sold in the favor of US dollar. No one can confidently estimate the first response, and based on these fears, we can already see closing of long positions in the pair USD/JPY and short positions in EUR/USD - everybody who wanted to buy dollars, purchased them long ago. Presently, the market has prepared for the changes in the FRS policy. In this regard, large volumes are present in both directions. About 10% of the whole pending demand is on the boundary of range 1.0525-1.1425. Above 1.1600 - there is a strong demand for US dollars and large stops.

Author: Navsher Bartash,
ForexChief Currency strategist