Last week lived up to the hype. It was indeed a momentous week.

China joined the SDR, with a weight that puts it in third place behind the dollar and euro.  The ECB did ease policy. It delivered a 10 bp cut in the deposit rate (now -30 bp), extended its asset purchase program for six months (to March 2017), broadened the range of assets that can be bought to include regional bonds, and declared intentions to reinvest maturing proceeds.

The US employment data removed what was perceived as the last potential hurdle to Fed decision to hike rates later this month.  Not only was the headline number a little stronger than expected at 211k, but October jobs growth was revised to almost 300k.

The internals were also generally favorable though the underemployment (U-6) did tick up, but is still at its lowest level since 2008, except for October.  The breadth of job gains (industries) was the best in nine months.   The number of people quitting their jobs stands at a four-month high, and this coupled with labor shortages reported in the Beige Book, suggest reasonably good prospects for increased wage pressure.

A great degree of uncertainty has been removed from the markets.  The BOJ balance sheet is expanding at an incredible clip of JPY80 trillion a year, and Governor Kuroda sees no compelling reasons up the ante further.  In fact, due to more recent data, especially capital expenditures, Japan’s GDP, which contracted in Q3, is likely to be revised to show a little growth.   The ECB reviewed its monetary policy and targets.  It made its adjustments, and, barring a significant shock, is unlikely to review it again until toward mid-2016. The Bank of Canada and the Reserve Bank of Australia have recently reaffirmed their steady course.

The Reserve Bank of New Zealand, the Swiss National Bank and the Bank of England meet in the week ahead.    A Bloomberg survey found 15 of 18 economists expect the RBNZ to cut the cash rate by 25 bp, bringing it to 2.50%.   The vast majority expect this to be the last cut in the cycle.   We suspect there is a greater chance than suggested by the survey that the central bank stands pat.    Ideas that the RBA’s neutral stance, the small move by the ECB, and increased confidence of a Fed hike, may steady the RBNZ’s hand helped spur almost a 1% rise in the New Zealand dollar before the weekend.

Draghi, Constancio, and others at the ECB blame market participants for the second largest single day rally in the euro (the first being when the US announced QE in March 2009) and the sharp backing up in interest rates.  However, the Swiss National Bank was probably as surprised anyone.  The sense of urgency that Draghi had seemed to have expressed and some trial balloons apparently launched, likely spurred SNB officials to prepare for the worst.  What was actually delivered, and the market’s response, take pressure off the SNB from having to go further down the rabbit hole of unorthodox policy.

With the Swiss economy stagnating in Q3, deflationary pressures (CPI -1.2% year-over-year in October), and retail sales contracting in nine of the first ten months of the year (year-over-year basis), a case can be made for easing monetary policy.  However, the sight deposit target rate is already minus 75 bp.  Nor is the currency exerting much pressure.  The franc was trading at five-year lows against the dollar before last week’s correction.  Against the euro, the franc within a lower range that has been established since late-August (for the euro, it is CHF1.0750-CHF1.1000).

The Bank of England is the least likely to surprise.  Policy is on hold though there may still be one (and only one) MPC member that is resisting, favoring a hike. There have been four macro-developments for the MPC to consider.  There has been a further drop in the price of oil.  There is more confidence that the Fed will hike rates this month.  The ECB eased. Sterling had appreciated 4% on a broad trade-weighted measure from the mid-October through mid-November.  The consolidation gave way to a pullback, leaving sterling still about 2% higher.

Earlier this year, there were times when the market seemed more confident of a BOE rate hike than a Fed hike.  Now it is quite a different story.  By the time the BOE delivers its first hike, the Fed, even in a gradual mode, may lift the interest rate target by 50-75 bp.

But is a December rate hike by the Fed a done deal?  How can the December Fed funds futures, which Bloomberg and others calculate to imply only a 74% chance, be reconciled with surveys that suggest 90% or more expect a hike?  The key is the assumption of where Fed funds average after lift-off.  Models assume that it will be in the middle of the Fed funds range.  This need not be the case.

If the Fed wants to drive home the point of gradual tightening and maximize its control of excess reserves, it may choose to provide sufficient liquidity to keep the Fed funds rate below the middle of the target range.   If one assumes that Fed funds will average 31.5 bp instead of 37.5 (the middle of the anticipated new range), a hike has been completely discounted.   Because of the risk that Fed funds do not average the middle of the range, the December Fed funds may not completely discount a hike under the conventional approach.

We dispute claims that the dollar’s rally is over because the divergence of monetary policy has all been discounted.   Consider that according to Bloomberg, the market has discounted a 40% chance of a second hike in March.  Given that the Fed has signaled, through its dot-plots, which will be updated in a couple weeks, that a hike once a quarter or every other meeting is projected to be appropriate, the risk seems greater and not all priced into the futures strip.

At the same time, the high frequency economic data due out in the coming days, including import prices, wholesale and business inventory figures, producer prices, and even retail sales, is unlikely to impact either expectations for the Fed’s first or second rate hike.   An irony not lost on many participants last week was as Yellen and other Fed officials talked about their confidence in the expansion, the Atlanta Fed’s GDPNowcast for Q4 has been halved to 1.5% over the past month.

Policymakers put more emphasis the signal generated from domestic final demand, accepting that the weak foreign growth and the drag from the dollar’s appreciation are temporary. The drivers of the inventory cycle, which still has a strong influence on short-run growth, extend beyond monetary policy.  Household consumption drives 2/3 of the economy and continues to expand by 2.5%-3/0%.  Moreover, the strength of consumption and services is helping the economy weather the headwinds hitting the industrial sector.

Great uncertainty remains over the outlook for China’s policy.  Now that it is in the SDR many expect Chinese officials to intervene less on the currency, with some thinking that devaluation in August was only the “first bite of the cherry, the second bite is coming. Others argue that foreign central banks will begin boosting their yuan reserves soon, and this will provide the offset to the private capital outflows.   There is also speculation that China will increase the band in which it allows the dollar-yuan exchange rate to move (2% from the central reference rate, or fix).

There is scope for the PBOC to ease monetary policy.  There are numerous economic reports that will be released in the days ahead.  Ironically, they are accepted with less cynicism than the GDP figures.  Of the reports, investors tend to watch the CPI and trade figures the closest.  China is expected to report a record trade surplus, which is one of the arguments against a significant depreciation of the yuan.  Exports and imports are still contracting on a year-over-year basis.

China’s CPI has been stable this year.  It has averaged 1.4% year-over-year through October, and it is expected to match it in November.  This means policy rates remain too high.   High reserve requirements may have been a macro-prudential tool during a period of strong capital inflow, but 17.5% rate now seems ill-suited for a period of capital outflows.  Even if the precise timing may be impossible forecast with any confidence, the bottom of China’s monetary cycle is not at hand.

What does this mean for the dollar?  The divergence of monetary policy remains very much in place, and we think it is not fully priced in, and we wonder if it really can be discounted.  We see the price action as an arguably long-over correction to a move that began in mid-October.   The extent of market position had left it vulnerable to a buy (dollar) rumor, sell the fact even if the ECB had not disappointed.

Until we are closer to the peak in the monetary divergence, the main dollar driver, it is difficult to call an end to the third significant greenback rally since the end of Bretton Woods.  For medium and long-term investors who broadly agree with this assessment, this pullback in the dollar is the kind of opportunity that has been awaited and anticipated.  That said, a dollar decline is the pain trade, but given the sharp rally in US stocks ahead of the weekend, recouping everything it lost in the previous day’s debacle, and then some, it is the holiday season and investors prefer pleasure to pain.

This can make for choppy conditions and prevent a new trend from emerging immediately. The dollar bulls have been scared (emotional) and scarred (material losses), and will be reluctant to jump back in immediately.  The bears, may be more opportunistic than true-believers, and want to squeeze more bulls.  However, they do not want to overstay their welcome, with a Fed hike looming, and the low-hanging fruit–the weak dollar longs–have already been picked.