FX Update: Will peak US dollar soon come into view?

FX Trading focus: Fed shift risks breaking markets, USD may be nearing a top.

The drama at the weekend in cryptocurrencies looks like the latest expression of the significant adjustment we are seeing across markets to the Fed’s recent clear shift into inflation fighting mode, a move that is already seeing the withdrawal of Fed liquidity that supports the riskiest of assets. The Fed, especially in last week’s testimony to Congressional panels, has made it very clear that a political signal was delivered during the course of US President Biden’s renomination of Powell to a second term: that inflation fighting should be the paramount concern within the Fed’s dual mandate. The Fed had, of course, already begun tapering asset purchases and is now expanding its balance sheet some 25% below the rate it was doing so before the early November FOMC meeting and could be set to announce at the December 15 FOMC meeting that it will double the pace of the reduction, such that tapering is set to be complete by the end of March. The “dot plot” forecasts of the Fed funds rate for the near future will also likely receive a significant adjustment that looks far more like the market’s actual pricing of the Fed policy than it has in some time.

But looking out the Fed expectations curve, the market is struggling to see how the Fed ever gets much above 1.50% for a policy rate, as is evident in the futures pricing for short-term interest rate futures and the pricing of five-year Treasury yields at below 1.18% this morning, up from below 1.15% on Friday’s close. And while the Fed’s shift to a more hawkish stance could continue to impact risk sentiment and even trigger a further deleveraging of risky assets, I suspect the Fed shift has reached maximum momentum for now and between now and either the December 15 FOMC meeting and the turn of the calendar year or shortly thereafter we could see peak US dollar, at least versus the more liquid currencies in the G10 (EUR, JPY, maybe GBP and the traditional safe-haven CHF), if not necessarily against the smaller currencies and possibly EM, as the USD safe-haven status could continue to see these underperform if we are set for significant further deleveraging across assets.

Meanwhile, the market’s reaction to the Friday US data set was rather interesting. There, we got a November ISM Services that broke a new hole in the roof, with a record high reading of 69.1, significantly beating the former record from OCtober, no mean feat for a diffusion index in which things must improve at a faster rate for the reading to continue higher from the prior month. The Nonfarm payrolls change was far below expectations (210k versus more than 500k expected), but will likely be revised up like nearly every other month of late. Meanwhile, the Household Survey registered a massive increase, taking the unemployment rate down 0.4% to 4.2%. The pace of the falling unemployment rate is breathtaking compared to previous cycles. The Average hourly Earnings data was in lower than expected (0.3% MoM and 4.8% YoY), but was held back by a small increase of the Average Weekly Hours denominator.

Chart: AUDUSD
AUDUSD has reached a major inflection point in this 0.7000 area, an important level back prior to the pandemic out break and since. Not sure at all that we will get anything interesting from the RBA tonight, with the bank having declared it would like to wait until the February meeting before taking any next steps on asset purchases or other guidance. Rather, risk sentiment and commodity prices are likely the key drivers here for whether this pivotal level can offer any support after the remarkable slide of late.