MUFG continues to hold a moderate bias favoring US dollar (USD) strength, primarily based on the belief that the FX market's movements in December were overextended. This view is further reinforced by the perception that the market may doubt the Federal Open Market Committee (FOMC) can implement rate cuts as early as March. While inflation is declining rapidly, MUFG contends that for rate cuts to materialize, clearer evidence of a deteriorating labor market would be necessary, potentially arising in the February or March employment reports. Failure to observe such evidence in February could lead to a full retracement of the EUR/USD rally that occurred in November and December, bringing the exchange rate back to the 1.0600-1.0700 range. The recent USD sell-off towards the end of the year is considered overdone, leaving room for additional USD strength, particularly on days when yields experience significant jumps. The upcoming FOMC meeting on January 31st is expected to be challenging for the Fed in providing guidance for the following meeting on March 20th, which may potentially disappoint the markets unless influenced by Non-Farm Payroll (NFP) data two days later.
1. Overextended December FX Move:
- MUFG's moderate bias towards USD strength stems from their belief that the FX market's movements in December were excessive and may have led to doubts about the FOMC's ability to implement rate cuts in March.
2. Labor Market Deterioration Required for Rate Cuts:
- While inflation is decreasing rapidly, MUFG maintains that a more pronounced deterioration in the labor market would be necessary to prompt rate cuts. This evidence may become apparent in either the February or March employment reports.
3. Potential EUR/USD Retracement:
- Failure to observe the required labor market deterioration in February could lead to a full retracement of the EUR/USD rally seen in November and December, potentially bringing the exchange rate back to the 1.0600-1.0700 range.
4. Scope for Further USD Strength:
- MUFG suggests that the USD sell-off towards the end of the year appeared excessive, leaving room for additional USD strength. Particularly, on days when yields experience significant increases, the USD may strengthen further.
5. Challenging FOMC Meeting:
- The FOMC meeting on January 31st is expected to be a complex one for the Federal Reserve in terms of providing guidance for the following meeting on March 20th. The outcome may potentially disappoint the markets unless influenced by NFP data two days later.
- Traders and investors are advised to consider the potential for USD strength and the associated factors, including labor market data and FOMC guidance, when making decisions in the FX market.
- MUFG maintains its moderate bias for USD strength, driven by the perception of an overextended December FX move and the necessity of clearer labor market deterioration for rate cuts. The upcoming FOMC meeting poses challenges, and the USD may experience further strength in specific market conditions.