Monetary policy divergences is still around

Since our last quarterly published on 9 Sep, currencies enjoyed a relief rally from the turmoil in summer from two factors. First, expectations for the Fed rate lift-off was pushed out into 2016 from 2015 on a dovish FOMC statement on 17 Sep cited downside risks from the global economy. Second, the Chinese yuan stabilized on increased expectations that the International Monetary Fund (IMF) would include it into the Special Drawing Rights (SDR). 

Unfortunately, the rally did not last long.

Reminding markets that there were two sides to every currency pair, the European Central Bank (ECB) affirmed on 22 Oct that it was missing its inflation target and considering fresh stimulus. The ECB is scheduled to announce its assessment on 3 Dec whether it needs to adjust the "size, composition and duration" of its quantitative easing (QE) program. The ECB clearly does not want a further appreciation in the real effective exchange rate (REER) tightening monetary conditions. Since the last week of August, ECB officials had been consistently warning of more QE whenever EUR/USD threatened to appreciate above 1.15. 

While the Bank of Japan (BOJ) is also missing its inflation target, there is no strong conviction that its quantitative and qualitative easing (QQE) program will be expanded again. Unlike the start of Abenomics in 2013, the JPY is no longer excessively strong as evidenced by its very weak REER. Policymakers now see a weak JPY as also negative for importers and consumers. Given the globally weak trade environment and low oil prices, the benefit of a weak JPY are limited for exporters and lifting inflation. Overall, the BOJ and Abe's advisors seem content with a stable USD/JPY between 116 and 125. If so, this opens the door for EUR/ JPY to head south if the ECB make good its promise to deliver more stimulus. 

That said, the final two months of 2015 will not be easy to navigate. China's growth worries have not gone away. Apart from disappointing data, China's stock market has yet to respond positively to the monetary easing measures. The CNY may also resume its depreciation after the IMF makes its decision on the SDR, most likely in November. In removing global concerns from the FOMC statement on 28 Oct, a Fed hike on 16 Dec is no longer a zero probability. Even so, Fed Chair Janet Yellen will need US data to surprise on the upside to convince the Joint Economic Committee of the pledge to hike in 2015.