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.
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.