Santa Claus has an exit clause

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It turns out that Santa Claus has an exit clause. After showering the global financial system with gifts for almost five years, Ben Bernanke and his merry band of monetary elves announced Wednesday that they plan to reduce production – and currency traders are still throwing tantrums. The Federal Reserve’s decision to slow the pace of asset purchases by $10 billion a month caused the US dollar to surge against its rivals, gaining almost a full percentage point against the majors over the week, while emerging market units saw widespread selling.

With the monetary policy outlook in focus, the Japanese yen traded down to the weakest level seen in five years, nearing the 105 barrier. The euro also dropped sharply after Standard and Poors removed the common currency zone’s AAA credit rating, citing deteriorating financial conditions and “reduced cohesion” among member states as justification for the move. This came after European Central Bank President Mario Draghi observed that the institution had a number of tools at its disposal to boost liquidity in the event that price pressures continue to fall.

North of the border, the Canadian dollar has whipsawed like a vehicle on an icy road throughout the week, moving almost two cents through the week from high to low. Yield differentials continue to widen in favour of US dollar investments, providing evidence that asset managers expect the American economy to continue outperforming its snowier counterpart. This is combining with a dovish outlook from central bank Governor Poloz to exert drag on the currency going into year end.

Our bearish bias is well-established, but we would caution market participants that the current trend is not unstoppable and will certainly not be uninterrupted. While Bernanke has effectively committed to keeping monetary conditions extremely accommodative into 2015, the current period of cheap money is coming to an end – with one hand the Fed giveth, but with the other it taketh away.

Thus, as the initial reaction to Wednesday’s Fed announcement fades, more investors are likely to focus on the likelihood of further reductions in stimulus over the next seven or eight meetings. Rapid price appreciation in the equity markets is unlikely to continue, particularly as participants engage in windowdressing before the year ends – and the dollar may come under some selling pressure in the process.

Also, if history is any guide, at some point, traders will begin seeing robust growth in the United States as propellant for the Canadian export sector. When this occurs, expected output will rise and the currency will experience some lift.

There are no clear narratives to trade on in the new world order that is emerging, and this means that movements are becoming increasingly unpredictable. Accordingly, we expect price action to become increasingly choppy over the coming weeks, culminating in a burst of volatility in the last few days of the month.

Fasten your seatbelts – this sleigh ride will get bumpy…

More: FX Outlook 2014 – Conditional Dollar Strength

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About Author

Director, FX Strategy and Structured Products at Cambridge Mercantile Group.

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