Currencies Brace for Central Bank Showdowns

The US dollar began the week on the back foot, nursing losses as global markets prepare for a decisive series of central bank meetings and a deluge of economic data. With the new year approaching, the focus in the foreign exchange markets has shifted squarely to the divergent interest rate outlooks across the world's major economies.

Trading in early Asian sessions saw currencies largely rangebound, a sign that investors are adopting a cautious stance before the release of critical US inflation figures and the highly anticipated nonfarm payrolls report. These releases, delayed by the recent historic US government shutdown, are expected to inject significant volatility into the markets as the week progresses.

In Japan, the yen remained relatively stable, trading at 155.94 per dollar, following a crucial central bank survey indicating that business sentiment among large manufacturers has reached a four-year high. This robust data has reinforced market expectations that the Bank of Japan (BOJ) is positioned to raise interest rates later this week.

However, the immediate hike is only part of the equation. Investors are keenly awaiting guidance from Governor Kazuo Ueda regarding the trajectory of future increases. Analysts at Societe Generale suggest a hawkish path forward, stating, "We expect the BOJ to raise its policy rate to 1% in July next year."

Moving beyond that threshold presents new challenges. As the analysts noted, "Once the policy rate reaches 1%, the BOJ will enter uncharted territory, so it will likely raise rates by 25 (basis points) and carefully monitor the impact on the economy and prices." This suggests a methodical approach, potentially involving gaps of nine months to a year between subsequent hikes to prevent economic shock.

Across the Atlantic, traders are navigating a complex landscape involving the Bank of England (BoE) and the European Central Bank (ECB). Sterling eased slightly to $1.3359, while the euro dipped marginally to $1.1730.

Current market pricing suggests the BoE is likely to cut rates, driven by signs that elevated inflation in the UK is finally drifting downwards. However, the upcoming British inflation data due on Wednesday could alter the calculus. Joseph Capurso, head of foreign exchange at the Commonwealth Bank of Australia, described the situation as a "finely balanced decision to cut." He warned that strong inflation figures could "take out some of the pricing for follow-up rate cuts," complicating the BoE’s easing cycle.

Conversely, the ECB is widely expected to hold rates steady. Interestingly, traders have begun to speculate on a hawkish pivot in the longer term, with some pricing in the possibility of an ECB rate hike returning to the agenda in 2026.

The United States faces a unique week of compressed economic reporting. Due to the government shutdown, a backlog of data is set to be released, offering investors a long-awaited glimpse into the health of the world’s largest economy. The November jobs report is scheduled for Tuesday, followed by inflation figures on Thursday.

The dollar index, hovering near a two-month low at 98.43, reflects the market's uncertainty. Although a divided Federal Reserve cut rates by 25 basis points last week to support a softening labour market, Chair Jerome Powell has signalled that further near-term cuts are unlikely until there is greater economic clarity.

Compounding the uncertainty is the political backdrop. US President Donald Trump indicated on Friday that he is considering former Fed Governor Kevin Warsh or National Economic Council Director Kevin Hassett to lead the central bank next year, a move that could significantly alter the Fed’s future policy direction.