Investors are kicking off the penultimate markets week of 2023 in a cautiously-optimistic fashion. Equity futures are pointing up, Treasury yields are incrementally higher, and the dollar is moving sideways amid mixed trading conditions.

The Japanese yen is the only big mover on currency markets, trading with a decidedly-weaker bias this morning after a media report suggested a big policy change was unlikely to come at next week’s meeting. Citing “people familiar with the matter,” Bloomberg said officials weren’t yet seeing the evidence of the sustained rise in wage growth needed to generate higher inflation over the long run. According to the report, Governor Kazuo Ueda’s comments last week – in which he suggested that setting monetary policy would get much more difficult next year – were provided as general commentary, not as part of an effort to set the stage for policy normalization. There was no pushback on Deputy Governor Himino’s yield-supportive speech from the prior day, however – and we think the central bank remains on course toward lifting rates in April or beyond.

The Canadian dollar is clinging to the bottom of its recent trading range as oil prices extend their declines and rate differentials remain tilted in the wrong direction. After a brief pop higher on Friday’s confirmation that the Biden administration plans to begin refilling the Strategic Petroleum Reserve, both of the major crude benchmarks are softening. And yield gaps continue to favour US fixed income instruments after the Bank of Canada held rates as expected last week, pointing to cooling price growth, weaker labour markets, and an evaporation in excess demand as reasons to remain cautious for now. Markets remain convinced the central bank’s next move will be a cut, perhaps as early as the March policy meeting.

Today’s data calendar is quiet, but the cadence will pick up considerably through the remainder of the week. Although the New York Federal Reserve’s consumer inflation expectations report looms as the only obvious event risk in the coming hours, traders are bracing for dangerous dynamics around tomorrow’s US inflation report, Wednesday’s Fed decision, and Thursday’s retail sales number. Policy meetings at the European Central Bank and Bank of England will add to the cross currents.

Ahead of the Fed’s final meeting in 2023, policymakers are facing a serious communications challenge. Financial conditions have eased drastically from their nadir in late October, jeopardizing the central bank’s tightening efforts and threatening to reignite price pressures. But data out on Friday showed the economy coming in for a soft landing: non-farm payrolls grew by more than forecast, and the University of Michigan’s consumer survey brought a dramatic improvement in sentiment, paired with a plunge in inflation expectations.

If officials turn overly dovish and lower policy forecasts in the accompanying “dot plot” summary of economy projections by too much, they could struggle to put the demand genie back in the bottle early next year. Instead, we think the statement will contain new language pointing to a prolonged hold on rates, the dot plot will show 75 basis points in interest reductions next year (less than markets have priced, but more than previously anticipated), and Chair Powell will use the press conference to acknowledge that policymakers are now “thinking about thinking about” what might prompt rate cuts. But a lot can go wrong, we note that this comes against a remarkably-placid volatility backdrop in currency markets – participants are simply not prepared for surprises.

 
Still Ahead

TUESDAY

Experimental data is expected to show UK unemployment holding at 4.2 percent in the three months to October, with wage growth cooling from 7.7 to a still-high 7.5 percent year-over-year. This won’t give the Bank of England enough room to begin a dovish pivot. (02:00 EDT)

Consumer price growth likely continued to cool in the United States last month, helping ratify expectations for a prolonged hold from the Federal Reserve. Consensus estimates suggest headline inflation remained flat on a month-over-month basis in November, with tumbling energy costs helping bring the year-over-year rate down to 3.1 percent from 3.2 percent. The core measure could appear more stubborn, holding near the 4 percent threshold year-over-year, but this will be somewhat deceptive: in the last six months, ex-food and energy prices have risen less than 3 percent on an annualized basis. (08:30 EDT)

WEDNESDAY

The Federal Open Market Committee will almost certainly leave rates unchanged for a third consecutive meeting, but the accompanying economic projections could shift considerably, impacting financial market assumptions. Turbulence could be unleashed across a number of asset classes if the “dot plot” fails to reveal a dramatic 75-basis-point drop in the median forecast for end-2024 policy rates – or, if the number of expected rate cuts exceeds what is currently priced in. We’re not sure whether Governor Waller’s perspective—that the Fed should begin providing accommodation once inflation has fallen for a three- or four-month period, even if the underlying economy remains strong—is widely shared across the committee, and suspect some policymakers are still clinging to the “higher for longer” message that seemed so fashionable a few months ago. Either way, the potential exists for considerable volatility. (14:00 EDT)

THURSDAY

With key inflation metrics remaining far from target, the Bank of England is likely to maintain a rhetorically-hawkish bias at its December meeting, retaining the option to raise rates again if price growth fails to continue its descent. Policymakers could choose to buck global trends in decisively pushing back against the easing in financial conditions that has occurred since October, but in the UK, as elsewhere, markets are unlikely to take this seriously. Global investors believe inflation is on the wane, with interest rates expected to follow suit, and there’s simply not a lot policymakers can do to convince them otherwise. (07:00 EDT)

Virtually no one thinks the European Central Bank will raise borrowing costs again in this tightening cycle, yet there’s significant disagreement around how quickly and aggressively policymakers will begin cutting interest rates next year. Inflation is subsiding quickly and recent commentary from Governing Council members—most influentially, Isabel Schnabel—has turned remarkably dovish, convincing markets to assume at least five rate cuts through the course of 2024. We think price growth could make a modest comeback in the early new year as government energy caps expire, and suspect investors expect too much flexibility from a notoriously slow-moving institution. (08:00 EDT)

Control-group retail sales – critical in assessing the strength of US consumer demand – are seen eking out a small gain in November, rising just 0.1 percent month-over-month on a comparatively anemic increase in holiday outlays. But American households remain the most powerful force in the global economy, and we don’t rule out another month of growth-defying spending. (08:30 EDT)

The Banxico should follow through on its forward guidance, holding its benchmark rate at 11.25 percent for a sixth consecutive meeting. Although the economy is showing signs of vulnerability as the US begins to slow, the first rate cuts are expected to begin late in the first quarter, and are seen coming incrementally so that interest differentials with the Federal Reserve remain strongly positive – meaning that carry traders should remain confident in high returns for now. (14:00 EDT)