Will Fed Increase QE Taper?

Fundamental Forecast for the US Dollar: Neutral

• While there are only three ‘high’ rated events in the days ahead, a slew of ‘medium’ ranked US data releases will keep event risk on the radar Tuesday through Friday.
• Ahead of the December Fed meeting, rates markets are effectively pricing in a 91% chance of five 25-bps rate hikes over the next two years – not significantly changed from prior to Thanksgiving, when Fed Chair Powell’s more hawkish commentary emerged.
• According to the IG Client Sentiment Index, the US Dollar has a mixed bias heading into mid-December.

US Dollar Week in Review

Consistent with its mediocre December seasonal tendency, the US Dollar (via the DXY Index) edged lower during the second week of the month. The DXY Index shed -0.11% over the week, and is now up by +0.18% in December. The largest component of the DXY Index, EUR/USD, added +0.09%. GBP/USD rates gained +0.27% while USD/JPY rates appreciated +0.50%. The commodity currency trio were the most significant movers on the week. USD/CAD rates dropped by -0.87%, while two non-DXY components, AUD/USD and NZD/USD rates, added +2.49% and +0.71%, respectively.

US Economic Calendar in Focus

The middle of December brings about another saturated economic calendar for the US economy. While there are only three ‘high’ rated events in the days ahead, a slew of ‘medium’ ranked releases will keep event risk on the radar Tuesday through Friday. Federal Reserve policymakers’ speeches resume at the end of the week after the communications blackout period ends.

• On Tuesday, December 14, the November US producer price index (PPI) will be released, bringing forth another set of inflation data.
• On Wednesday, December 15, the morning will feature weekly US MBA mortgage applications, November US retail sales, October US business inventories, and the December US NAHB housing market index. The afternoon will bring forth the December Fed meeting in which a new Summary of Economic Projections (SEP) will be released, Fed Chair Jerome Powell’s press conference, and October US net long-term TIC flows.
• On Thursday, December 16, all of the significant economic data are due either right before or right after the start of the US cash equity session. Weekly US jobless claims are due, as are November US building permits and November US housing starts. The December US Philadelphia Fed manufacturing index and November US industrial productions figures are also set for publication. Finally, the December US Markit manufacturing PMI will arrive.
• On Friday, December 17, Fed Governor Christopher Waller will give a speech as the first Fed policymaker to talk after the communications blackout veil is lifted.

Atlanta Fed GDPNow 4Q’21 Growth Estimate (December 9, 2021) (Chart 1)

Based on the data received thus far about 4Q’21, the Atlanta Fed GDPNow growth forecast is now at +8.7% annualized. The elevated forecast comes as “the nowcast of the contribution of inventory investment to fourth-quarter real GDP growth increased from +1.51% to +1.59%.”

The next update to the 4Q’21 Atlanta Fed GDPNow growth forecast is due on Wednesday, December 15 after US retail sales and inventories figures are released.

For full US economic data forecasts, view the DailyFX economic calendar.

Market Pricing for Fed Remains Aggressive

We can measure whether a Fed rate hike is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. Chart 2 below showcases the difference in borrowing costs – the spread – for the December 2021 and December 2023 contracts, in order to gauge where interest rates are headed by December 2023.

Eurodollar Futures Contract Spread (NOVEMBER 2021-DECEMBER 2023) [BLUE], US 2s5s10s Butterfly [ORANGE], DXY Index [RED]: Daily Chart (January 2021 to December 2021) (Chart 2)

By comparing Fed rate hike odds with the US Treasury 2s5s10s butterfly, we can gauge whether or not the bond market is acting in a manner consistent with what occurred in 2013/2014 when the Fed signaled its intention to taper its QE program. The 2s5s10s butterfly measures non-parallel shifts in the US yield curve, and if history is accurate, this means that intermediate rates should rise faster than short-end or long-end rates.

There are 146.75-bps of rate hikes discounted through the end of 2023 while the 2s5s10s butterfly is just off of its widest spread since the Fed taper talk began in June (and its widest spread of all of 2021). Ahead of the December Fed meeting, rates markets are effectively pricing in a 91% chance of five 25-bps rate hikes over the next two years – not significantly changed from prior to Thanksgiving, when Fed Chair Powell’s more hawkish commentary emerged.

In order to achieve such a rate lift off, the Federal Reserve will likely need to begin rate hikes by mid-2022. As such, consistent with comments made by Fed Chair Powell as well as incoming Fed Vice Chair Lael Brainard, it seems more likely than not that the FOMC will announce an accelerated timeline to taper its QE program, increasing the rate of tapering from $15B/month to $30B/month beginning in January 2022. This would end the Fed’s QE program in March 2022, allowing for the first 25-bps rate hike by June 2022.

US Treasury Yield Curve (1-year to 30-years) (December 2019 to December 2021) (Chart 3)

Historically speaking, the combined impact of falling US Treasury yields – particularly as intermediate rates outpace short-end and long-end rates – alongside elevated Fed rate hike odds has produced a favorable trading environment for the US Dollar.

CFTC COT US Dollar Futures Positioning (December 2020 to December 2021) (Chart 4)

Finally, looking at positioning, according to the CFTC’s COT for the week ended December 7, speculators decreased their net-long US Dollar positions to 34,867 contracts from 35,841 contracts. Net-long US Dollar positioning continues to hold near its highest level since October 2019, when the DXY Index was trading above 98.00.

— Written by Christopher Vecchio, CFA, Senior Strategist