FX Update: Predicted low terminal Fed rate holding back the USD?

Forex 6 minutes to read
John Hardy

Head of FX Strategy

Summary:  Long US yields are rangebound and the market has lowered its predicted end-point for the coming Fed rate hike cycle, which continues to take the sting out of the USD rally in the wake of the FOMC meeting last week. CEE currencies are all aglow after the Hungarian central bank not only hiked, but provided hawkish guidance, and the Czech central bank looks to follow suit with a rate hike today.


FX Trading focus: Falling predicted “Terminal” Fed rate holding back the USD?

The USD has been offered since yesterday, in part on Fed Chair Powell’s fresh reassurances yesterday that the Fed will be in no hurry to hike rates even if inflation has surprised in the near term as the Fed sees benign medium term inflation outcomes. Still, as I have highlighted in the most recent couple of FX updates, perhaps the most interesting development in the week since last Wednesday’s FOMC meeting is the reaction in the US yield curve: long yields were initially choppy but are now essentially flat since last Wednesday. At the front end of the US yield curve, meanwhile, the market has pulled forward the expected Fed hikes while actually slightly lowering the expected “terminal rate” of the hike cycle to less than 2% if we look out four-plus years into the future of Fed expectations. The December 2025 three-month yield is priced at just below 180 bps, versus more than 230 bps at the beginning of April, when long US yields peaked for the cycle. The market, in other words, seems to be buying more firmly into the Fed’s position that inflation will prove transitory, so with the medium to longer term anticipated Fed rate level actually falling, the immediate effect of when the Fed hikes seems less urgent.

Of course, in the past the market has anticipated Fed and inflation outcomes very poorly. In the summer of 2009, the market thought that the Fed’s unconventional QE would quickly prove inflationary and require 250 bps of hiking within 18 months and a policy rate north of 5% within five years. Five years later, in mid-2014, the Fed was still more than a year from its first rate hike for the new cycle. Then in 2016, the viciously stronger US dollar and Yellen’s backpedaling from a steady diet of rate hikes had the market predicting a Fed funds rate of under 1% for 18-months forward and 1.4% for 4-5 years forward. The Trump presidency and supply side tax cuts goosing US growth saw the Fed funds reach above 2.0% by the end of 2018. Still, the narrative is the thing, and for now the market is having a hard time adding on to the FOMC reaction when the market thinks inflation is going nowhere (US breakeven inflation measures have eased lower over the last month, even with oil prices posting new cycle highs).

This backdrop is allowing EM- and procyclical currencies to rally back the hardest here against the greenback and the yen. Let’s see if we get a full reversal or if this is merely the sign of a choppy summer ahead as we await more incoming data to test the narrative and then how the USD behaves once the liquidity the US treasury is providing dries up by August 1 through its reduction of its general account with the Fed.

Explaining the JPY if we can. The JPY was overdo for a correction coming into the FOMC meeting and saw a sharp one on the JPY-supportive combination of the longest US yields falling post-FOMC, while risk sentiment cratered on the recognition that the Fed has lurched ever so cautiously into a tightening regime. But since then, US longer rates have shifted back higher to where they were pre-FOMC, more or less, while perhaps the market’s pricing of a lower terminal Fed rate despite brining rate hikes forward and a huge new boost in risk sentiment, not least in EM, is renewing interest in carry trades funded by JPY back into anything with a yield on it. As well, the theme of smaller central banks already beginning to tighten policy and hike rates leaves the “forever 0’s” like Japan at a disadvantage. USDJPY has traded above 111.00, possibly opening the path to the big 114.50 area if this backdrop continues, though the progress higher in USDJPY has been a choppy affair since the April lows, and it is hard to argue for steep additional upside here if 10- and 30-year US yields don’t pick up and post new cycle highs.

Chart: USDJPY
The yen has weakened sharply across the board as the Fed rate hike cycle is seen as likely to prove benign and shallow if we are to believe the market’s pricing of the yield curve. This has encouraged yield chasing and carry trades funded in yen over the last few session after the knee-jerk reaction to the FOMC meeting and generally, the Japanese currency can only thrive on global risk off and falling safe haven yields. The most important USDJPY pair is clearing the previous cycle highs just below 111.00 today, and as we discuss above, the progress higher may slow unless us longer yields stretch to new cycle highs.

Source: Saxo Group

Hungary hikes and guides for more to come. Czech central bank to follow suit today. The Czech central bank will likely hike rates 25 bps today after the Hungarian central bank hiked 30 bps yesterday and offered guidance on monthly hikes that caught the market by surprised and help drive a chunky repricing of EURHUF back lower, with the ongoing unwind of FOMC reactions offering a supportive backdrop. Interestingly, the 2-year Hungarian yield was unchanged yesterday after chopping around after the central bank announcement. The Czech central bank was more credible on inflation fighting in the pre-pandemic bout of inflation that was felt across CEE countries, and the currency has outperformed it CEE peers since the pandemic lows, but could underperform for a bit in the short term if yield chasing prevails again for a time.

BoE: Taper anticipation and Haldane’s last hurrah. Tomorrow’s Bank of England meeting is expected to see Bailey and company sharpening their message on an eventual taper and a likely dissent from the exiting Chief Economist Haldane, who is attending his last meeting tomorrow and has been shouting inflationary warnings from every rooftop of late, hoping to burnish his legacy. The wild card is the current acceleration in Covid cases from the delta variant despite the UK’s extensive vaccination rollout. From a rate spread perspective, the recent GBPUSD melt-down looks overdone, as UK vs. US 2-year spreads are the same place they were as far back as late May, 1.4000 is the key resistance there, while in the crosses, interesting to see if more hawkishness than expected can take EURGBP back toward the cycle lows below 0.8500, given the backdrop of normalizing central banks, while the ECB is clearly dragging its feet on rolling out any indication of a tightening move in the works.

Table: FX Board of G10 and CNH trend evolution and strength
The JPY is on course for a full reversal back to negative soon if JPY crosses fully erase the sell-off that developed on the back of the FOMC meeting. The USD uptrend, meanwhile, needs new fuel or it will also merely look like a knee-jerk reaction to the market’s so far one-off adjustment to forward Fed rate expectations.

Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs
In the individual pairs, the EURCHF rally is gaining credibility, while GBPJPY is the first JPY cross to reverse higher (USDJPY never went negative) as sterling has rallied in anticipation of a more hawkish message from the Bank of England at tomorrow’s meeting.

Source: Bloomberg and Saxo Group

Upcoming Economic Calendar Highlights (all times GMT)

  • 1230 – Czech Central Bank Repurchase Rate announcement
  • 1230 – Canada Apr. Retail Sales
  • 1345 – US Jun. Flash Manufacturing and Services PMI
  • 1400 – US May New Home Sales
  • 1600 – ECB's Lagarde to speak
  • 2030 – US Fed’s Rosengren (non-voter) to speak on economy

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