Currency Watch: A new year for the markets – but uncertainty remains

Last year ended with more of a whimper than a bang as the US Congress avoided the “fiscal cliff” via postponement more than resolution.

There was a “deal” of sorts, but there are still a lot of questions to be answered before a full resolution to the crisis is found. Especially in light of the fact that the now delayed decision over spending cuts needs to be made before the end of February.

The bill does mean further austerity for the US, with the tax rises likely to hit US GDP by around 0.6% in 2013 – still a big hit – especially to an economy that has by no means hit its straps as of yet. It could have been a lot, lot worse and thankfully wasn’t but we are not out of the political woods yet.

February is shaping up to be very important political month: Italian general elections, the second round of the cliff to assess spending cuts, renegotiations of the US debt ceiling and potential ratings downgrades for sovereigns after the initial publication of Q4 GDP numbers.

In a world that is still very uncertain, the US jobs market is at least bringing an element of foundation to the US economy, finally. We expect to see better US data promote dollar strength and vice-versa following a slight degradation of the relationship in the dollar and risk in recent sessions especially around the jobs market.

Our thinking is that given the association the Fed now has between the unemployment rate and its own monetary policy (i.e. that higher employment will lead to a quicker tightening of policy and a stronger dollar) that the opposite also holds true.

The latest Fed minutes published last week seem to support this, with “several” members thinking “that it would probably be appropriate to slow or stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.”

While this looks and smells like hawkishness, we don’t think that we will see a sudden switch to tighter policy but instead just no increase in the flow of purchases.

Even so, it does suggest and lead us towards market pricing that will likely see a breakdown of the risk-on/risk-off market behaviour that has been so prevalent in the past two to three years. This should lead to an increased reliance on the individual performance of each respective economy. That is likely to increase volatility and the unpredictability of currency markets going forward.

European issues have moved away from the tag of being a “debt crisis” to become more of a “growth crisis” since the ECB promised to do “whatever it takes” to protect the currency and the region. We expect the euro to remain heavy through Q1 as the Continent, including Germany, offers virtually no growth at all.

There’s plenty to keep an eye on this year, and the financial markets will continue to prove difficult to predict.

Jeremy Cook is chief economist at World First foreign exchange.