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FX Update: Brainard delivers latest Fed attempt to impress markets.

Forex 5 minutes to read
John Hardy

Head of FX Strategy

Summary:  A hawkish broadside from Fed Vice Chair Brainard yesterday turned the tables on risk sentiment, sending US yields and the US dollar sharply higher. It is still a long wait until the May 4 FOMC meeting, but that meeting is now priced to deliver not only a 50 basis point rate hike, but also the beginning of a “rapid” quantitative tightening regime. AUDUSD is an interesting proxy to watch for the impact of the latest Fed attempt to impress the market after the pair broke above key resistance just yesterday.


FX Trading focus: Brainard delivers latest Fed attempt to take the Fed ahead of the curve

Yesterday, Brainard spoke at a virtual conference hosted by the Minneapolis Fed with a speech titled Variation in the Inflation Experiences of Households. In the speech, she opened the speech with an invocation of Paul Volcker’s stance on the risks of runaway inflation, which “would be the greatest threat to the continuing growth of the economy... and ultimately, to employment.” With his taking the Fed Funds rate to 20% in 1981 to help renewed inflation fears, by the way, by 1982, he had engineered an unemployment rate that reached 10.8% by the end of that year and a stock market index that traded in the summer of 1982 at 28-year lows, adjusted for inflation.

Brainard emphasized that high inflation is an especially heavy burden for lower-income households and said that the various inflation metrics don’t capture how different households experience inflation, with the consumption basket of lower-income households likely having risen more rapidly than for higher income households for many years. Then she went on to discuss the implications of current high inflation on Fed policy, which she concluded would mean “a series of interest rate increases and...(reducing) the balance sheet at a rapid pace as soon as our May meeting”. To that, she added that balance sheet reduction would proceed “considerably more rapidly” than the $40 billion/month of the 2017-19 tightening.

The hawkish broadside managed to surprise a market and take US yields to new cycle highs, with longer yields rising slightly more than the yields at the front of the yield curve as it has been assumed that leaning more aggressively on QT impacts the longer end of the yield curve (the balance sheet debate and impact on long yields was specifically discussed in the January FOMC minutes). In that set of minutes, the Fed took the trouble to emphasize that adjustments to the Fed Funds rate are the primary tool for Fed tightening, while Brainard seemed to be raising the profile of balance sheet adjustments in the Fed’s considerations for the policy mix.

In sum, Brainard’s bringing forward QT lift-off to May and at a “considerably more rapid” pace than in 2017-19 is an aggressive hawkish upgrade of the Fed tightening timeline and suggests that the Fed wants to tighten on all fronts to get ahead of inflation as soon as possible. It will be very interesting to peruse tonight’s FOMC minutes releases for the scale of adjustment in the discussion around possible scenarios for the QT pace relative to the January discussion – especially the Fed’s MBS holdings, although it has already signaled that it would like to shed itself entirely of its MBS holdings over time. There has been a brutal tightening in the US mortgage market this year, where the yield is pushing on 5% and the spread to the US 30-year treasury yield has blown out close to multi-decade highs well above 200 basis points.

Despite the further push higher in long US yields in the wake of Brainard’s speech yesterday, I am increasingly inclined to believe that in the short term, US yields may have a hard time pulling higher still, particularly if a significant deterioration in risk sentiment settles over the market. In FX, this could go a long way to supporting the JPY, and even the Euro, in the non-USD crosses.

By the way – the French presidential election’s first round is coming up fast on Sunday and the second round scenarios (for the April 24 run-off, presumably between Le Pen and Macron) have tightened at a breathtaking pace in recent days, even if Macro remains the strong favourite. He is guaranteed to get a weak mandate at best, and if the first round brings notable surprises that suggest Le Pen has a fighting chance in the run-off, it’s gray swan time for Europe.

Chart: AUDUSD
We look at AUDUSD once again today because it just broke aggressively higher yesterday into the zone above 0.7556, and is therefore one of the most pivotal USD pairs after the Fed’s hawkish surprise. If risk sentiment deteriorates badly, the commodity-angle of Australia may suddenly fail to support the Aussie as the primary concern quickly becomes one of liquidity, where the US dollar always shines. Watching the status of the AUDUSD rally around this pivotal 0.7500-50 area as a proxy for USD/risky currencies in general Many EM currencies have also enjoyed a significant run higher, generally speaking, after the market decided that the March 16 FOMC meeting still showed that the market found the Fed still behind the curve.

Source: Saxo Group

Table: FX Board of G10 and CNH trend evolution and strength.
Despite Brainard delivering support to the greenback, it is not really showing up because of the recent heavy commodity focus that hasn’t rewarded the US dollar. If US yields ease off in the context of a significant new deleveraging event as noted above, we could have a swing back into mean reversion, with JPY and EUR finding support, while the “smalls” face sudden headwinds.

Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs.
Watching AUD status in the crosses as noted above after the big break higher in AUDUSD, while watching whether yields are set for some mean reversion after a recent remarkable run higher – if so, JPY crosses are also likely set for a sudden change of pace.

Source: Bloomberg and Saxo Group

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