The Week Ahead: Inversion Aversion

Inversion Aversion Share this story: Andrew Kositkun Foreign Exchange Analyst This past week, the Fed raised its fed funds rate band up 0.25% to 2.25%-2.50%.  Immediately after this was announced, not only did stocks sell off, but the yield curve also flattened further as markets repriced their outlook on global growth.  Many in the markets focus on the shape of the yield curve as some see it as the best predictor of an impending recession.  This historic fact has created a negative feedback loop for investors where concerns about the economy flattens the yield curve which then creates more concern about the economy.  In fairness, the shape of the curve does impact the ability for banks to make profitable loans and thus could dry up liquidity as banks pull back on lending.  However, when using historical performance to predict future returns, it is important to consider whether conditions have remained the same.   To this end, the Federal Reserve Bank of Richmond took a look at the term premium (extra interest that investors demand to hold longer term assets).  In its study, the Fed found that the term premium (TP) has shrunk over time with the average TP since 1961 at 1.6% and at 0.20% since 2012.  Put another way, the yield curve has a 46% of inverting in any given month at the post 2012 TP level.  However, if the TP were to return to it post 1985 average, this probability drops to 10%.  Clearly, this analysis is an over simplification of a complex question, but it does provide a good point.  In a world where the TP remains low, the frequency of inversion is expected to increase despite the chances of a recession remaining the same.  MAJOR CENTRAL BANK ACTIVITY THIS WEEK There are no Key Central Bank meetings this week KEY MARKET MOVING ECONOMIC RELEASES United States and Canada 12/27 New Home Sales Expectations for a gain from 544k to 569k 12/27 Consumer Confidence Expectations for a decline from 135.7 to 133.4 12/28 Chicago PMI Expectations for a decline from 66.4 to 61.0 Europe/Eurozone 12/28 Germany CPI Expectations for gain of 0.3% after a gain of 0.1% Asia/Japan, and New Zealand 12/27 Japan Jobs Report Expectations for the UR to remain at 2.4% 12/27 Japan Industrial Prod. Expectations for a decline of 1.7%  after a gain of 2.9% FORECASTS EUR Despite all the raw emotion in equities and interest rates, the EUR and DXY remained trapped within recent ranges to the surprise of many. Failed attempts at both bullish and bearish breakouts run out of momentum within 24 hours and fold back to the center. We remain tilted toward a more bearish U.S. dollar view and believe the EUR is nearing a bottoming phase.   GBP The GBP too continues to consolidate like the EUR but with a downward bias.  Continued uncertainty surrounding the Brexit negotiations and an upcoming Parliamentary vote continue to undermine confidence and sentiment regarding the GBP. Expect further consolidation until the Parliamentary vote during the week of January 14. JPY Since equities peaked on October 3, the Japanese yen is one of the top performing major currencies appreciating by nearly 3%...the euro is fractionally lower and the CAD and NOK are down nearly 5.5% for a comparison. A full-risk off environment and sharply lower U.S. interest rates have made this currency a safe haven once again. Expect consolidation next week. CAD The CAD continues to remain very weak ever since U.S. and global equities began to spiral lower in early October. The market perceives that Canada is tethered more to the U.S. economy than other commodity linked currencies. Add into the mix the fact that oil prices have collapsed and the CAD has been on a one-dimensional path of weakness for almost three months. Expect consolidation next week with many centers on holiday. RBC’s new range for Q1 is 1.3600-1.3100 so we are near the top end of that range. CNY The CNY has managed to remain in a relatively narrow range despite all the upheaval in equities, interest rates and related Asian currencies. Expect the Chinese authorities to keep the CNY within recent ranges with a bias toward further weakness. AUD The AUD has been on a roller coaster ride since October. The NZD has been one of the top performing currencies since October 3 exerting a positive pull on the AUD. Conversely, currencies like the CAD, NOK and other commodity linked currencies have been extremely weak pulling the AUD into the opposite direction. Aussie is currently testing yearly lows; expect some consolidation this week and more whipiness. If we can help you with any Foreign Exchange needs, please email foreignexchange@cnb.com or call (800) 447‑4133. Want to learn more about international finance, economics, and global events? Sign up for our other Foreign Exchange emails and videos! Follow City National Bank on social media: Investment and Insurance Products: • Are Not insured by the FDIC or any other federal government agency • Are Not deposits of or guaranteed by a Bank or any Bank Affiliate • May Lose Value This report is for general information and education only and was compiled from data and sources believed to be reliable. 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