The financial landscape remained relatively calm in the money markets, despite significant changes in the bond markets. Ahead of Donald Trump's inauguration, the dollar showed little change last week, even after a softer-than-expected US Consumer Price Index (CPI) report for December lowered interest rate expectations of the US, giving relief to bond and equity markets.
Analysts at Capital Economics suggest this week could see more volatility, with high expectations for swift action by Trump in his second term influencing market reactions.
Capital Economics notes that with a lighter economic data calendar and the Federal Open Market Committee (FOMC) entering a quiet period before its policy meetings, Trump's policies may dominate the narrative finance next week. The company maintains that Trump's tariff policies are not fully accounted for in current market prices, indicating that the dollar could rise if significant tariffs are implemented.
However, the company also admits that there is a risk of disappointment for the dollar if these targets do not materialize as soon as expected.
In Japan, the currency markets are also preparing for the Bank of Japan (BoJ) policy announcement on Friday. The yen has seen a strong performance this week following official statements suggesting a possible 25 basis point rate hike. The Japan Economics team at Capital Economics has revised its forecast, now expecting a faster rate hike than first expected in March, with money markets assigning a probability of around 80% to this outcome.
The focus will now shift to future BoJ policy signals, as they aim to manage market expectations without causing disruption, similar to the market turmoil following the BoJ rate hike in June.
At the other end of the currency spectrum, the British pound has lagged behind other major G10 currencies for the second consecutive week. Weaker than expected UK inflation and activity data have eased pressure on the Gilt market, leading to lower yields.
Nevertheless, the pound has suffered as UK interest rate expectations have fallen, and the market remains wary of the UK's risk premium. Capital Economics believes that money markets are underestimating the amount of easing by the Bank of England (BoE) expected this year, leading to a less optimistic outlook for the pound's performance.
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