December FX Outlook: Heightened Degree Of Uncertainty; Focus On Monetary Policy

 | Dec 02, 2021 12:55AM ET

The pandemic is still with us as the year winds down and has not yet become endemic, like the seasonal flu. Even before the new Omicron variant was sequenced, Europe was being particularly hard hit, and social restrictions, especially among the unvaccinated, were spurring social strife. US cases, notably in the Midwest, were rising, and there is fear that it is 4-6 weeks behind Europe in experiencing the surge. Whatever herd immunity is, it has not been achieved. Moreover, despite plenty of vaccines in high-income countries, inoculation efforts in many low-income countries won't begin in earnest until next year.

That said, the new variant has injected a new element into the mix, and it is with a heightened degree of uncertainty that we share our December outlook. Given the unknowns, policymakers can choose the kind of error they are willing to make. They are trying to minimize their maximum regret. The utmost regret is that the mutation is dangerous and renders the existing vaccines and treatment significantly less effective. This will leave them vulnerable to accusations of over-reacting if the Omicron turns out to be a contagious but less deadly variation.

Meanwhile, there has been some relief to the supply chain disruptions. COVID-related factory closures in Asia, the energy shortage, and port congestion are easing. Large US retailers have stocked up for the holiday shopping season, some of which chartered their own ships to ensure delivery. There are also preliminary signs that the semiconductor chip shortage may be past its worst. Indeed, the recovery of the auto sector and rebuilding of inventories will help extend the economic expansion well into next year, even though fiscal and monetary policy are less supportive for most high-income countries. The flash November US manufacturing PMI saw supplier delivery delays fall to six-month lows.

We assume that the US macabre debt ceiling ritual will not lead to a default, and even though it distorted some bill auctions, some resolution is highly probable. The debate over the Build Back Better initiative, approved by the House of Representatives, will likely be scaled back by moderate Democratic Senators and Republicans. 

Besides assessing the risks posed by the new variant, the focus in December is back on monetary policy. Four large central banks stand out. The Chinese economy has slowed the People's Bank of China quarterly monetary report modified language that signals more monetary support may be forthcoming. Many observers see another reduction in reserve requirements as a reasonable step. Unlike in the US and Europe, which saw bank lending dry-up in the housing market crisis (2008-2009), Beijing is pressing state-owned banks to maintain lending, including the property sector.

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The Federal Reserve meets on December 15. There are two key issues. First, we expect the FOMC to accelerate the pace of tapering to allow it to have the option to raise rates in Q2 22. The Fed's commitment to the sequence (tapering, hikes, letting balance sheet run-off) and the current pace of tapering deny the central bank the needed flexibility. The November CPI will be reported on December 10. The headline will likely rise to around 6.7%, while the core rate may approach 5%. Second, the new "Summary of Economic Projections" will probably show more Fed officials seeing the need to hike rates in 2022. In September, only half did. The rhetoric of the Fed's leadership has changed. It will not refer to inflation as transitory and is signaling its intention to act. 

The European Central Bank and the Bank of England meet the day after the FOMC. The ECB staff will update its forecasts, and the key here is where it sees inflation at the end of the forecasting period. In September, it anticipated that CPI would be at 1.5% at the end of 2023. Some ECB members argued it was too low. It may be revised higher, but the key for the policy outlook is whether it is above the 2% target. We doubt that this will be the case. 

While the ECB will likely announce that it intends on respecting the current end of the Pandemic Emergency Purchase Program next March, its QE will persist. The pre-crisis Asset Purchase Program is expected to continue and perhaps even expand in Q2 22. The "modalities" of the post-emergency bond-buying program, size, duration, and flexibility (self-imposed limits) will be debated between the hawks and doves. With eurozone inflation approaching 5% and German CPI at 6%, the hard-money camp will have a new ally at the German Finance Ministry as the FDP leader Linder takes the post. On the other hand, the Social Democrats will name Weidmann's replacement at the head of the Bundesbank, and nearly anyone will be less hawkish.

While we correctly anticipated that the Bank of England would defy market expectations and stand pat in November, the December meeting is trickier. The decision could ultimately turn on the next employment and CPI reports due 1-2 days before the BOE meeting. The risk is that inflation will continue to accelerate into early next year and that the labor market is healing after the furlough program ended in September. On balance, we suspect it will wait until next year to hike rates and finish its bonds purchases next month as planned.

Having been caught wrong-footed in November, many market participants are reluctant to be bitten by the same dog twice. As a result, the swaps market appears to be rising in about a 35% chance of a 15 bp move that would bring the base rate up to 25 bp. Sterling dropped almost 1.4% (or nearly two cents) on November 4, the most since September 2020 when the BOE failed to deliver the hike that the market thought the BOE had signaled.

The combination of a strong dollar and the Fed tapering weighed emerging market currencies as a whole. The JP Morgan Emerging Market Currency Index fell by about 4.5% in November, its third consecutive monthly decline, bringing the year-to-date loss to almost 10%. It fell roughly 5.7% in 2020. Turkey took the cake, though, with the lira falling nearly 30% on the month. It had depreciated by 15% in the first ten months of the year. This follows a 20% depreciation last year. Ten years ago, a dollar would buy about 1.9 lira. Now it can buy more than 13 lira. 

The euro's weakness was a drag, and the geopolitical developments (e.g., Ukraine, Belarus) weighed on central European currencies. The central bank of Hungary turned more aggressive by hiking the one-week deposit rate by 110 bp (in two steps) after the 30 bp hike in the base rate failed to have much impact. The forint's 3.1% loss was the most among EU members. The Colombian peso was the weakest currency in Latam, depreciating by almost 5%. It was not rewarded for delivering a larger than expected 50 bp rate hike in late October.