The first full trading week of 2014 promises to be a very busy one for the foreign exchange market. There are 2 monetary policy announcements (BoE and ECB), 3 employment reports (Germany, U.S. and Canada), Chinese trade numbers, the December FOMC minutes along with retail sales from Germany and Australia. On top of all this, the U.S. Senate is expected to confirm Janet Yellen as the next chair of the Federal Reserve. Any one of these event risks could cause an increase in volatility for currencies but combined they can create an explosive start to the New Year.
The focus will be on the U.S. dollar because the most anticipated releases this week are the December FOMC minutes and non-farm payrolls report. In fact, we believe that the minutes could be even more market moving than payrolls because at their last meeting, the Federal Reserve laid out their plan to taper asset purchases and wind down Quantitative Easing. We know that every FOMC voter with the exception of Rosengren favored the move and Bernanke believes that bond purchases will be reduced by $10 billion at every meeting until the entire program is drawn to a close but remember, this is his suggestion and not an official decision. From February 1st onwards, Bernanke will not be involved in any monetary policy decisions. Therefore the rest of the central bank’s level of enthusiasm and motivation for tapering could have a significant impact on the dollar.
If the FOMC minutes show that there was an overwhelming amount of support for tapering before the end of the 2013 their enthusiasm will revive the rally in the dollar and drive USD/JPY back above 105. However if there was significant reluctance and policymakers expressed hesitancy about staying on a predetermined track with bond purchases, then the dollar could come under additional pressure. Boston Fed President Rosengren did not support the move last month because he felt that unemployment is too high and inflation too low. With 1.3 million Americans losing their unemployment insurance at the start of the year, the labor market is still a legitimate headache for the central bank and there are many valid reasons for why some policymakers would prefer to make future tapers data dependent. At the same time, there are Fed Presidents such as Lacker who believe that it would take significantly weaker economic activity to slow tapering. However neither Rosengren nor Lacker are voting members of the FOMC this year. Plosser who is a voter said on Friday that the Fed might have to raise rates aggressively to regain some lost ground after Bernanke brought rates to zero. If the rest of his peers share his view, the dollar could start the New Year off strongly. The bottom line is that the central bank’s eagerness to wind down QE and their rationale for tapering in December will largely determine how well the dollar trades this week.
Friday’s non-farm payrolls report will also play a big role in shaping expectations for the pace of Fed tapering this year. According to this morning’s non-manufacturing ISM report, service sector activity slowed in the month of December but the labor market continued to grow. The non-manufacturing ISM index dropped to 53 from 53.9 but the employment component of the report jumped to 55.8 from 52.5. As the U.S. is a service based economy, this underlying component has a very strong correlation with non-farm payrolls as shown in the chart below. This suggests that Friday’s non-farm payrolls report could surprise to the upside because economists are looking for slower job growth whereas ISM reports stronger growth. A good number would could create renewed demand for dollars at the start of the year.