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Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

Christopher Vecchio, CFA, Senior Strategist
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Central Bank Watch Overview:

  • As 2020 comes to a close, 2021 doesn’t look like it will bring about much change in terms of central banks’ policies.
  • None of the Bank of England, European Central Bank, or Federal Reserve are expected to raise interest rates in the new year. The Fed is likely to lead all central banks in terms of easing, which leaves the US Dollar at a disadvantage.
  • Retail trader positioning suggests that the major currencies are on mixed footing heading in 2021, which may simply be a reflection of lower trading activity during the Christmas-New Year’s interlude.

Central Banks’ Exciting 2020 Yields to Quieter 2021

The final week of the month has seen little by way of central bank activity – fairly typical for the Christmas-New Year’s interlude. But the lack of activity in terms of new announcements or policy changes veils what has otherwise been another banner year for central banks. Central banks have added over $7 trillion to financial markets since March 2020, led by the Federal Reserve’s expansion of its balance sheet by over $4 trillion.

Looking ahead to 2021, no major central bank is expected to raise rates in the new year.Even if the global economy heats up, central banks will not tamper with the early stages of a global recovery and pullback support to markets in 2021. ‘Overshooting’ of inflation targets will be popular conversation among central bank watchers, a suggestion that interest rates will stay low for many more years.

Even if growth is gathering pace, traders shouldn’t be surprised if the major central banks (Fed, ECB, BOJ) announce additional quantitative easing measures. We’re in a period immediately post-crisis – an appropriate historical allegory in early-2009: low interest rates and ample liquidity.

For more information on central banks, please visit the DailyFX Central Bank Release Calendar.

In this edition of Central Bank Watch, we’ll cover the trio of central banks that typically garner most of the attention in financial markets. Both the European Central Bank and Federal Reserve have pumped trillions of dollars (and euros) of liquidity into financial markets. Meanwhile, the Bank of England will be juggling the economic recovery from the coronavirus pandemic while making sure Brexit doesn’t lead to other issues for the UK financial system.

Federal Reserve Just Wants Stability

One of the questions in 2021 will be, “will Jerome Powell serve a second term as Fed Chair?” as his term comes to end in February 2022. It stands to reason that, much like his predecessors before him, US President-elect Joe Biden will retain the Fed Chair during a crisis, allowing him to continue his work to do “whatever it takes” to save the US financial system from a collapse (a job well-done so far). Fed Chair Powell’s tenure at the Fed will be extended, making this a non-issue.

Federal Reserve Interest Rate Expectations (DECEMBER 30, 2020) (Table 1)

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

Accordingly, with Powell at the helm for years, the course that he has thus far charted will not be deterred or altered: interest rates will remain low through 2023, as the Fed has indicated after each of the past three recent FOMC meetings. Fed funds futures are pricing in a 1% chance of a change in the Fed’s main rate by the end of 2021.

IG Client Sentiment Index: USD/JPY Rate Forecast (DECEMBER 30, 2020) (Chart 1)

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

USD/JPY: Retail trader data shows 69.34% of traders are net-long with the ratio of traders long to short at 2.26 to 1. The number of traders net-long is 12.34% higher than yesterday and 7.25% higher from last week, while the number of traders net-short is 10.11% lower than yesterday and 0.84% lower from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests USD/JPY prices may continue to fall.

Traders are further net-long than yesterday and last week, and the combination of current sentiment and recent changes gives us a stronger USD/JPY-bearish contrarian trading bias.

ECB May Do More if Euro Gets Too Strong

The ECB has struggled for years in its efforts to achieve its price stability target of +2% inflation, and the coronavirus pandemic will only make that more difficult moving forward. But one facet that may not help the ECB’s efforts is a strong Euro. The ECB upgraded its forecasted 2021 EUR/USD exchange rate up from 1.08 to 1.18, and EUR/USD rates were already near 1.2300 prior to the end of 2020. Historically, the ECB has only raised concern over the Euro exchange rate if the currency is +/-5% beyond its year-end target. There is a reasonable basis of expectation that the ECB may begin to saber rattle about more dovish policy adjustments in early-2021 if the Euro continues to climb.

EUROPEAN CENTRAL BANK INTEREST RATE EXPECTATIONS (DECEMBER 30, 2020) (TABLE 2)

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

According to Eurozone overnight index swaps, there is an increasing likelihood of action by the ECB as 2021 progresses: in January 2021, there is a 7% chance of a 25-bps rate cut; by December 2021, those odds rise to 66%. Seeing as how the market ‘favors’ a shift in rates once a monthly contract passes the 50% threshold, interest rates markets are currently predicting that the ECB will act again in July 2021. But if the Euro continues to rally, traders should be surprised if these odds get pulled forward towards June or March 2021 (when the ECB updates its Staff Economic Projections).

IG Client Sentiment Index: EUR/USD Rate Forecast (DECEMBER 30, 2020) (Chart 2)

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

EUR/USD: Retail trader data shows 32.08% of traders are net-long with the ratio of traders short to long at 2.12 to 1. The number of traders net-long is 3.41% higher than yesterday and 4.51% lower from last week, while the number of traders net-short is 8.22% lower than yesterday and 4.59% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests EUR/USD prices may continue to rise.

Positioning is less net-short than yesterday but more net-short from last week. The combination of current sentiment and recent changes gives us a further mixed EUR/USD trading bias.

Bank of England Juggles Pandemic Recovery with Brexit

Brexit is resolved. What Brexit might look like is no longer a theoretical exercise; we now know that the EU-UK trade relationship will resemble the EU-Canada trade relationship. This is a relief for BOE policymakers, who are contending with a struggling economy thanks to the coronavirus pandemic. Avoiding a ‘no deal, hard Brexit’ means avoiding the sudden imposition of tariffs and taxes, which would further stifle an economy that appears to be backsliding heading into 1Q’21.

BANK OF ENGLAND INTEREST RATE EXPECTATIONS (DECEMBER 30, 2020) (Table 3)

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

Nevertheless, with BOE policymakers having dismissed the possibility of negative interest rates in recent weeks and months, we are effectively at the lower bound of interest rates. Interest rate expectations are stable throughout 2021, with less than a 1-in-3 chance of another interest rate cut by the end of the year. In context of no negative rates, the shifts in the UK overnight index swaps (OIS) curve is likely a reflection of shifts in UK Gilt yields. If the BOE does do anything in 2021, it will likely be enhanced quantitative easing; but if the BOE is acting, so too will the ECB and the Fed, neutralizing the BOE’s effects on EUR/GBP or GBP/USD rates.

IG Client Sentiment Index: GBP/USD Rate Forecast (DECEMBER 30, 2020) (Chart 3)

Central Bank Watch: BOE, ECB, & Fed Interest Rate Expectations Update

GBP/USD: Retail trader data shows 40.23% of traders are net-long with the ratio of traders short to long at 1.49 to 1. The number of traders net-long is 23.63% lower than yesterday and 0.52% higher from last week, while the number of traders net-short is 23.05% higher than yesterday and 13.58% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests GBP/USD prices may continue to rise.

Traders are further net-short than yesterday and last week, and the combination of current sentiment and recent changes gives us a stronger GBP/USD-bullish contrarian trading bias.

--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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