We are in the first full week of the New Year, and if volatility in the third quarter of 2018 is anything to go by, then the start of 2019 should be super exciting indeed.
Market participants will be watching incoming US data closely in 2019, as changing economic conditions there will have a big impact on the Federal Reserve’s upcoming interest rate decisions. At its most recent meeting in December, the Fed’s Chair Jay Powell indicated that the central bank will be more data-dependent than ever moving forward, though expressed no concerns about its ongoing balance sheet reductions and raised interest rates for the fourth time in the year, despite Trump’s persistent criticisms and warnings. Given the outlook for slower economic growth and inflation, and not to mention the recent falls in crude oil prices, inflationary pressures are likely to wane further in 2019, thus reducing the need for the Fed to tighten its policy aggressively. Still, the FOMC reckons two more hikes could be on the way in 2019, should economic conditions still warrant it. But if incoming data deteriorates, as we suspect it might, then expectations over further hikes could fall. That, in turn, may undermine the dollar and underpin buck-denominated gold prices and the EUR/USD exchange rate.
In fact, we think there is a good possibility we may see a more profound recovery in the EUR/USD, after it spent several months in the latter half 2018 consolidating above the 1.1300 long-term support level. While the possibility of a breakdown is there, we think that the prospects of a rate increase after the summer of 2019 from the European Central Bank means the single currency could find support closer to the time. As the divergence of EU and US monetary policies tighten, so too should the yield differential between German and US yields. Consequently, yield-seeking investors could move on a marginal basis into European and away from US investments, thereby stimulating demand for the single currency.But the early part of 2019 is going to be dominated by Brexit, make no mistake about it. The UK parliament is set to vote on the withdrawal agreement on 15 January and if MPs reject the deal then uncertainty is going to rise significantly further. In this potential scenario, the opposition Labour party could call an election and the official exit date may well be pushed further out from March 31, while the prospects of a second referendum could further complicate things. However, if MPs decide to pass Prime Minister Theresa May’s Brexit deal then Britain will leave the EU as planned on March 31 and will then immediately enter the transition period. This soft Brexit scenario would undoubtedly be bullish for sterling, as it means less severe economic damage than would have been the case under a no-deal Brexit. The Bank of England would then most likely move to tighten its belt, thanks to recent improvements in economic conditions in the UK. The BoE will want to have some room for maneuver so that in the event economic conditions deteriorate again then they can at least lower interest rates.