Trader Notes: Will The Fed Pivot and How to Position for It?
Singapore Sales Trader
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.
NZD might outperform
From the list of currencies that declined the most this year, most have reasons to be there though NZD seem to stand out given that their rate hike cycle (current 3.5%) is well ahead of the rest (including the US) and terminal rate is currently above 5% expected some time next year. In addition, recent QoQ CPI data for Q3 came in hot at 2.2% vs 1.6% expected. These factors do not seem to warrant a decline of 15.4% this year relative to the USD and hints that if the Fed were to pivot, NZD could have a decent sized bounce. One possible risk to note is that the NZ current account deficit is quite negative at -7.7% of GDP as compared to the other currencies due to higher prices of machinery/vehicle/energy imports and a lack of tourism spending though these are expected to improve once supply shortages subsides and tourists return in full swing.
How About the Other Large Decliners?
JPY has good reason to be there given the BOJ’s dovish policy and commitment to yield curve control. Given that this has moved the most, any slight change in BOJ’s stance could trigger a large move in the opposite direction. However, barring that change, JPY would still be tough to hold given the huge carry cost and BOJ’s unlimited bond buying spree.
UK is going through one of the toughest times in history due to political and economic turmoil. Therefore, it is not surprising to see GBP fall 14.9% this year as the government struggles to balance growth and inflation. UK has just seen their third prime minister in 3 months and even though there has been the recent reversal of the infamous unfunded tax cuts, the current prime minister Rishi Sunak still has a lot of tidying up to do to regain growth.
Sweden Krona (SEK) has declined this year as Riksbank was known as one of the most dovish central banks before they started hiking more aggressively in September from 0.75% to 1.75%. Even then, these moves seem to be in response to the aggressive tightening central banks to prevent outflows. Sweden is also not spared from the energy crisis in Europe with 30% of its LNG imports were from Russia before the war, and thus higher rates will not resolve inflation resulting from higher gas prices (which are more supply driven).
The Chinese Yuan (CNH) has also declined quite rapidly in the recent month, reaching new lows against the USD this week as the PBOC is back on an easing cycle to support the property market. There are also concerns that the recent consolidation of power by Xi would stifle business opportunities in the country and impede growth. In addition, with the government keen to support common prosperity this year because of the zero-covid policy, the PBOC is likely going to maintain an easing bias.
In conclusion, NZDUSD seems to have the best risk-reward skew as it has the highest policy rate among G10 currencies with scope to hike further on the back of still firm inflation data and market positioning given huge declines this year, with the key risk being the current account deficit. JPY might be an attractive one to look at if BOJ tweaks yield curve control with short positioning at very high levels and recent gains due to intervention might put pressure on shorts. GBP is in a grey area as we see how the new prime minister will navigate not just the tough economic environment but to push his agenda within his own government being young and less experienced. With a new leadership in place and a government keen on supporting the economy, CNH would be quite an unlikely candidate to go long until the economy stabilizes and PBOC changes their easing stance. Finally, even though inflation is creeping higher in Sweden, Riksbank has historically been more of a follower in terms of hiking rates than a leader, and the Fed pivoting might reduce their need for staying hawkish with an energy crisis to handle.
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