Forex: Any potential Dollar weakness may be short-lived

Over the festive season, FX markets held steady. Yet the dollar consistently bucked the typical seasonal downtrend, drawing unexpected strength, even as a brief rally in US Treasuries at year-end ensued. With the dawn of the new year, the dollar surged anew, placing considerable pressure on European currencies. Notably, the euro may have taken an extra hit due to thinner trading conditions, magnifying the effects of what's become a widespread consensus trade.

Yet, even if a surge of liquidity initially softens the U.S. dollar, any such weakness may prove fleeting. As inauguration day approaches, the anticipation of tariffs could place downward pressure on the Euro and Yuan. Domestically, the advent of "Trump 2.0" will likely inject more term premium into U.S. 10-year bond yields, further complicating the financial landscape and potentially bolstering the dollar's strength in the longer term.

Zooming in on the term premium, its significant uptick is mainly attributed to market anticipation of longer Treasury issuances, further stirred by the Federal Reserve's firm stance on inflation and possible longer-term pause in rate cuts than currently priced.

Market whispers are intensifying that the Trump administration is gearing up to increase bond coupon sizes significantly under Scott Bessent's influence. This move is poised to initiate larger bond auctions when the Federal Reserve holds its monetary policy stance “ in check.” Such a strategic shift is anticipated to stir considerable turbulence for those positioned against the U.S. dollar, signalling potential upheaval in fiscal and monetary climates. With President Trump's intent to push the U.S. economy to its limits, the horizon looks stormy for dollar bears, hinting at both fiscal challenges and intensified tighter financial conditions.

The dollar’s remarkable resilience is underscored by its robust performance towards the end of 2024. Impressively, the dollar climbed in 13 of the final 14 weeks of the year, launching its bullish streak paradoxically right after a significant Fed rate cut in September. This unexpected turn of events highlights the sometimes paradoxical nature of financial markets, where policy easing can inadvertently lead to tighter financial conditions. This dance between fiscal moves and monetary policy is starkly illustrated by the surge in the real yield on 10-year Treasury notes, which leapt from 1.90% to 2.26% over the past month, marking a notable ascent of 50 basis points since the year's start, echoing the intricate and dynamic interplay that shapes FX markets.

The Chinese renminbi has started the week on a weaker note, propelling the USD/CNY to a fresh peak overnight at 7.3295, edging closer to its previous high of 7.3503 set in September 2023. Similarly, the offshore renminbi (CNH) surpassed its fall 2023 highs, reaching 7.3695 on December 31st. In response to this slide, Chinese policymakers have initiated efforts to curb expectations of further depreciation. The People's Bank of China (PBoC) has set a robust daily fixing rate at 7.1876, consistently maintaining it just shy of the sensitive 7.2000 threshold in recent months. Yet the USD/CNY is perilously close to the upper limit of its daily trading band, which caps at 7.3320, marking a return to levels last seen from April to July of the previous year. Should the PBoC continue to anchor the daily fixing rate below 7.2000, it could significantly counteract further weakening of the CNY, especially now that USD/CNY is flirting with the upper echelons of its permitted trading range.

In a firm response to recent market volatility, the PBOC announced on Friday plans to tighten its oversight of currency trades and clamp down on practices that could destabilize the market. According to a statement released after its monetary policy committee meeting, the central bank also intends to deter one-sided bets and excessive fluctuations in the exchange rate. This approach underscores a strategy of controlled depreciation, aiming to guide the yuan’s value in Beijing’s terms rather than at that of market forces.

As the new week dawns, the yen finds itself in a delicate dance with the renminbi, both currencies weakening and propelling USD/JPY towards the pivotal 158.00 mark. A surge past this threshold could set the stage for a further ascent towards 160.00, reintroducing heightened volatility into the forex theatre at the outset of 2025.

For weeks, we've underscored that the next significant moves in USD/JPY could be closely tied to the Yuan's trajectory and the People's Bank of China's (PBoC) policy maneuvers. However, any orchestrated moves towards a weaker currency won't simply play out unchecked; Scott Bessent, the newly appointed U.S. Treasury Chief, will scrutinize them closely. He ensures that competitive devaluations, particularly those impacting key currency pairs like USD/JPY, will be met by tariffs.

Amidst this currency drama, BoJ Governor Ueda made his first public appearance of the year at a New Year conference hosted by the Japanese Bankers Association in Tokyo. In a carefully worded speech, he reaffirmed the Bank of Japan's intent to raise rates progressively, contingent on sustained economic and price improvements. Yet, the anticipation hanging over the financial markets remained unquenched as he provided no concrete clues on the timing of the next rate hike.

The Japanese rate market is a cauldron of speculation, betting more heavily on a rate adjustment possibly being deferred until the March policy meeting rather than an immediate action later this month. Governor Ueda’s previous comments highlighted a cautious approach, preferring to gauge the impacts of wage trends and the unfolding of President Trump’s second-term policies before any further monetary tightening. This cautious sentiment from the BoJ has invigorated traders to re-establish short positions on the yen, setting a speculative undertone as 2025 unfolds.