Will The Fed Pivot and How to Position for It?
As the Fed raised interest rates for the 5th straight time, making this the fastest rate hike cycle in history, doubts have begun to surface among Federal Reserve officials as more have started to have differing views on the urgency to get to 4.5% - 5% terminal benchmark rate in the past month.
Vice Chair Lael Brainard laid a case for exercising caution as previous increases are still working through the economy and global tightening effects could spill over to the US. Charles Evans has highlighted that he would prefer to find a rate level that restricted economic growth enough to lower inflation and hold it there even with a couple of bad inflation reports to avoid being overly aggressive. Esther George (known to be a hawk) has also said she favoured moving “steadier and slower” on rate hikes and a series of large rate increases might risk oversteering. And finally, just last week, Mary Daly said the time is now to start talking about slowing the pace of recent increases in benchmark interest rates.
There has been a high bar set for the Fed to remain hawkish given the repeated commitments by Powell and his team to keep hiking until data shows that inflation is under control. This is evident in the huge risk off moves we have seen for most of this year in equities and a big swing to the USD in FX as shown below:
SPX: - 20.33%
NDX: - 30%
HSI: - 35%
DAX: - 18.5%
Dollar index DXY: + 17.15%
With market positioned for a hawkish Fed, CPI misses (lower than expected) have led to big risk on rallies / short covering like what we saw in August when July’s CPI print came in at 8.5%, below the 8.9% expected. Market rallied 4.5% in the next 7 days with USD losing bids as well. Right now, the market is pricing a 75-bps hike in November followed by 50bps in December and the terminal rate is expected to be approximately 4.9% by Q1 next year.
Going forward, there is a good probability that the Fed will pivot given the following reasons:
- Some of the FOMC members are beginning to be concerned about hiking too fast and rather take a step back to let the effects of tightening work through the economy.
- We are starting to see data cooling off, including consumer confidence falling to 102.5 below expectations of 106.5, the Case-Shiller index is down 1.6% (2nd straight month of declines) and Philadelphia Fed Manufacturing Index falling to -8.7 vs -5.0 expected.
- The CPI base effect would start to kick in for the October 2022 CPI print with the big jump in prices occurring once in April 2021 and the other in October 2021 last year.
If The Fed Starts To Pivot, What Would Be The Best FX Trade To Participate In?
What does pivot mean? A Fed pivot can mean a pause in rate hikes and keep them at the same level for a few months while monitoring inflation data. Alternatively, the Fed could reduce the quantum of rate hikes going forward to reflect their more cautious stance. In both circumstances, we might see USD strength reverse given market positioning and an extremely hawkish Fed all year.
Let us look at how some of the key FX pairs have moved this year as shown in the diagram below. JPY takes the top spot after falling 22.55% followed by SEK, NZD and GBP. If we look at the policy rate in the G10 space in the next diagram, New Zealand policy rate is currently highest at 3.5% followed by Canada and the US.