Will Bernanke Be Santa Or The Grinch?

FX: Will Bernanke Be Santa Or the Grinch?

The big question for the financial markets next week is whether Fed Chairman Ben Bernanke will be Santa or the Grinch. Depending on when Janet Yellen decides to take office (Bernanke could step down early), next week's monetary policy meeting could be Bernanke's last. He faces a tough decision that involves not only the economy but also his legacy. During the global financial crisis, Quantitative Easing was introduced as a way to provide longer lasting support to the economy and the record-breaking moves in equities are the fruits of this policy. However as his tenure at the Fed draws to a close, the rally in stocks is stalling because Bernanke could start the process of ending the program he first introduced in 2008. This would allow Bernanke to see the QE program from start to finish and make his involvement on both ends an important part of his legacy. If he chooses to do so, it could come at a cost for equities and Treasuries -- a consideration he will weigh carefully if he doesn't want to be known as the Grinch who stole Christmas.

Yet when it comes to monetary policy actions, it doesn't have to be black or white or in policymaking terms hawkish or dovish. One of the great things about monetary policy decisions is that forward guidance can be just as useful in setting market expectations as the change in policy. If the Federal Reserve were to refrain from tapering next week, the immediate reaction in the financial markets would be one of relief with stocks rallying, yields falling and the dollar dropping but the lasting reaction would depend on whether they include plans to taper in January. If they do, the sell-off in the dollar would be limited but if they provide zero forward guidance, we could see a more dramatic decline in the dollar along with new highs in equities. If they taper in December and lay out a clear plan to reduce asset purchases over the next few months, the dollar would soar and equities would slide. However there's a middle ground that should be the most palatable option for the Fed, which is to cut monthly bond purchases by only $5 to $10 billion in December and say that further reductions will be data dependent. This would allow Bernanke to begin the process of unwinding stimulus but leave Yellen with the flexibility to adjust the program as she sees fit. It would also limit the reaction in equities and currencies, allowing for a more moderate sell-off in stocks.

Aside from the FOMC meeting, Janet Yellen is expected to be confirmed as the new Fed Chairwoman in the coming week. Stanley Fischer has been nominated as Vice Chair and with him at her side the U.S. will have more balanced leadership. Fischer is generally known as a hawk that does not support forward guidance. While it can argued that he could stand the way of her desired changes, we view the opposing biases as complimentary as it would provide a more balanced conversation. If the Federal Reserve does not taper in December, we can assume that Fischer will support early and more aggressive tapering in 2014. The FOMC rate decision is the most important event risk next week but consumer prices, housing starts, building permits, existing home sales, industrial production, Empire State and Philadelphia Fed surveys are also scheduled for release.

EUR/USD: Double Top Or Pause Before Further Gains?

While the euro extended its losses against the U.S. dollar Friday, the fact that it is still trading above 1.37 makes Friday's move nothing more than consolidation. We have talked at length about why we think the EUR/USD should be trading lower but the strong uptrend should not be ignored. This past week, the currency pair attempted to break its 2-year of 1.3832 but the rally failed just shy of that level. Whether 1.38 becomes a double top or a level that the currency pauses at before further gains will be decided next week. Aside from the all-important December FOMC meeting and the busy U.S. calendar, euro-zone flash PMIs for December, the German IFO report and ZEW survey are also scheduled for release. These market moving releases provide us with the most up to date assessment of how the region's economy is faring. In order for the EUR/USD to maintain its gains, we need to see improvements in business confidence along with manufacturing and service sector activity. According to ECB officials, the growth in the euro zone is very slow and if next week's economic reports show an uneven recovery, the weakness of Europe could finally catch up to the currency. If EUR/USD traded on euro zone fundamentals alone, it should be closer to 1.35 but Fed policy also has a significant impact on the currency. Therefore even if euro-zone data is weak the EUR/USD could rally if the Fed refrains from tapering. Meanwhile a large LTRO repayment to the European Central Bank shielded the euro from further losses Friday. Banks will return EUR22.6 billion next week, 3 times more than usual and the largest amount since the second repayments of 3-year loans began in February. The distortion is most likely caused by the cancellation of the next 2 repayment dates - the next opportunity to repay the loans will be on January 10. Repayment of these loans reduces the liquidity in the financial system and puts upward pressure on rates, something the dovish ECB won't be happy with especially since banks failed to funnel the loans into the real economy.

GBP: Looking For More Positive Data Surprises Next Week

The past week has been a quiet one for the British pound. Tuesday was the only day with U.K. data and the mixed releases left sterling with little direction. That will change next week not only because of the FOMC rate announcement but also because of the number of important U.K. economic reports on the calendar. The minutes from the last Bank of England meeting is scheduled for release along with consumer prices, employment and retail sales. Healthy numbers are expected all around that will pain a picture of growth and recovery in the U.K. economy. We also expect the BoE minutes to contain a tinge of optimism but nothing market moving is expected considering that the central bank had just released its Quarterly Inflation report in which they brought forward their forecasts for when their unemployment rate target will be reached. The recent improvements in the U.K. economy have simply made the policymakers more comfortable with the current level of monetary policy. We still have at least another 6 to 12 months before the BoE considers reducing stimulus. The positive growth outlook makes sterling is one of our favorite currencies for 2014 and while the FOMC rate decision could decide how the GBP/USD trades, we look for sterling to outperform other major currencies.

AUD/NZD On Its Way To 1.05

The Australian, New Zealand and Canadian dollars traded slightly higher against the greenback Friday. The 0.2% rebound in the AUD/USD is nominal when compared to the 2.35% decline experienced in the previous 48 hours. RBA Governor Glenn Stevens comment that the AUD/USD should be trading lower closer to 85 cents paves the way for further weakness in the currency. The minutes from the last RBA meeting will be released next week and given the dovish comments from Stevens, we believe that details will be more negative than positive for A$. One of our readers brought up a very good point about the differentiation between the AUD and NZD that explains why the currency pair can fall further. Not only is there a divergence in monetary policy but also the terms of trade. New Zealand's terms of trade has been improving rapidly with dairy prices rising by the largest amount in 40 years. Australia's terms of trade on the other hand has deteriorated and this reflects the divergences in price trends for hard commodities produced in Australia versus soft commodities produced in New Zealand. Last night's uptick in New Zealand's manufacturing PMI index confirm that the economy is improving but it is worth noting that consumer confidence grew at a slower pace in December. Nonetheless, with 1.10 in rearview mirror, there's a strong case for AUD/NZD to hit 1.05. All is quiet for the Canadian dollar, which continued to consolidate below 1.07. No Canadian economic reports were released Friday and the decline in oil prices does not appear to be affecting the loonie. We start next week off with China's flash manufacturing PMI report for the month of December. The Australian dollar will be particularly sensitive to this release - a small improvement is expected but if activity slows, it could drive the AUD/USD to its August lows.

JPY: Tankan To Provide More Evidence Of Recovery

Thanks to the combination of fiscal and monetary stimulus along with Yen weakness, Japan continues to enjoy a healthy recovery. In the month of October, industrial production grew 1.0% compared to an initial estimate of 0.5%, pushing the annualized pace of growth to its highest level since May 2012. This strength in manufacturing activity will be mirrored in next week's Tankan Survey. The quarterly Tankan report is a poll of confidence in the manufacturing and service sectors. It is one of the most important pieces of Japanese data and can have considerable influence on stock prices and monetary policy. Broad based improvements are expected in expected in both the manufacturing and non-manufacturing sectors. These improvements should lift the Nikkei and lend support to USD/JPY. Like the Federal Reserve, the Bank of Japan has a monetary policy announcement next week. If the Fed tapers and the BoJ holds monetary policy steady, the yen will become an even more attractive currency for long dollar trades. In the meantime, the yen ended the week higher against the dollar and European currencies and lower against commodity currencies. At this stage, traders looking for a break of 104 in USD/JPY will most likely have to wait until the FOMC rate decision.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.