Stock markets on both sides of the Atlantic continue to trade in a cautious fashion, with politics just as much a driver as economics, as European markets recover from Tuesday's sell-off, while US markets closed mixed.

US markets continue to trade cautiously below their all-time highs as uncertainty about the new administration’s view of the strength of the US dollar clash with the priorities of the Federal Reserve, who still seem quite keen to continuing normalising monetary policy, if Fed chief Janet Yellen’s comments last night are anything to go by.

Ms Yellen's warnings about the risks of waiting too long to raise rates further caused the US dollar to continue its recovery from its sharp Tuesday sell-off, with the pound the biggest casualty as it gave back some of its Tuesday Brexit speech gains, raising the prospect that the rally may merely have been a “dead cat bounce”.

With US core CPI now above 2% and the unemployment rate at 4.7%, markets still appear to be expecting at least two Fed rate rises this year, even allowing for some on the committee calling for more than that. Nevertheless markets had similar expectations last year and we only got a single rate rise, that being said the economic environment now is fundamentally different and as such expectations appear much more realistic.

While the Fed may well want to hasten the removal of an accommodative monetary policy there is a strong feeling that they may not be able to, which begs the question as to what might prevent them from doing so. As Harold McMillan is quoted as once famously saying, “events, dear boy, events” in answer to a question as to what could cause a change of policy.

Firstly there is some concern that the strength of the US dollar along with further monetary policy divergence could well derail the very type of manufacturing renaissance that new President elect Trump would like to generate, with his remarks this week prompting a sharp US dollar sell off in response.

Much is likely to depend on how much further the inflation genie has to go given that we are also seeing evidence of rising prices elsewhere in the global economy, in China, as well as Germany and the UK this week.

In the last three years the US dollar index has risen 28% from its 2014 lows, as well as being at 13 year highs, which would suggest that further gains might well start to act as a drag on the US economy. For now there appears little evidence of that but with other central banks no nearer to reversing their own stimulative policies the monetary policy divergence seen in the last 12 months is likely to get even worse, putting further upward pressure on the greenback.

Last month the European Central Bank surprised no one by extending their own easing programme despite concerns that it was unnecessary given recent evidence that the economy was still performing quite well, while at the same time prices were continuing to rise. Today, in their first meeting of 2017 they are not expected to do anything further with the most recent minutes highlighting sharp divisions between various policymakers about extensions and monthly amounts.

As it is German opposition to further stimulus as well along with pressure for a taper is only likely to increase given this week’s German CPI numbers, which jumped to 1.7% in December. It is already thought unlikely that ECB president Mario Draghi would be able to carry the council to add additional stimulus this year in any case, particularly with a German election coming up in September, which means the press conference is likely to be uneventful, though we could well expect some questions about the state of the Italian banking system, given that the current crisis there seems no closer to a satisfactory resolution. 

EUR/USD – the euro has slipped back from the 1.0720 level, however while above trend line support now at 1.0550, from the lows this year the short term uptrend continues to remain intact. A move below 1.0540 retargets the 1.0450 area.

GBP/USD – having topped out at 1.2430 it appears we are in a clearly defined range with double support at 1.1980. A move through 1.2440 has the potential to trigger a move towards the December highs at 1.2800.

EUR/GBP – the euro continues to look vulnerable here and needs to break back above the 0.8750 area to retarget the recent highs. A move through the lows this week at 0.8620 has the potential to target a move towards the 0.8480 area.

USD/JPY – the sharp rebound from the 112.55 level throws the scenario for a move towards 111.00 into doubt. A move through the 114.80 level would likely confirm that and trigger a move towards 115.30.

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