- Hawkish Fed comments continue to roil the rates markets; Fed tightening expectations remain heightened; U.S. yields continue moving in the dollar’s favor; the 2- to 10-year curve is no longer inverted; FOMC minutes will be released
- As we warned yesterday, default risk has risen for Russia; eurozone reported February PPI; ECB tightening expectations remain heightened; Poland is expected to hike rates 50 bp to 4.0%.
- BOJ is likely to be tested again on its YCC; RBA officials are sounding more hawkish; RBA tightening expectations continue to rise; Caixin reported very weak China March services and composite PMIs
The dollar is firm as U.S. rates continue to move higher. DXY is up for the fifth straight day and is trading near 99.55. The March 2020 high near 103 is the next big target. The euro remains heavy after breaking below last week's low near $1.0945, which sets up a test of the March 7 low near $1.0805. That this is happening despite heightened ECB tightening expectations will be disappointing for any euro bulls out there. The relentless rise in USD/JPY has resumed and the break above 123.65 sets up a test of last week’s high near 125.10. Sterling had an outside down day yesterday that points to further losses ahead. We still look for an eventual test of last month’s cycle low near $1.30. After that is the November 2020 low near $1.2855 and then the September 2020 low near $1.2675. Between the likely return of risk-off impulses and the even more hawkish Fed outlook for tightening, we believe the dollar uptrend remains intact.
Hawkish Fed comments continue to roil the rates markets. Vice Chair Brainard said that getting inflation down is the Fed’s most important task, adding that the Fed will continue tightening policy “methodically.” Markets were taken aback when she said rapid balance sheet runoff could come as soon as May. Brainard added that the Fed is watching the yield curve for signals of downside risk. Brainard is typically on the dovish end of the spectrum so her comment about QT coming as soon as May is noteworthy. Elsewhere, George said the Fed may have to go above neutral to bring inflation down, adding she wants to watch how much traction they get with rate hikes. She said conditions easily argue for going faster than before as there’s no question that its accommodative stance has to be removed. George is a voter in 2022.
Fed tightening expectations remain heightened. Fed WIRP suggests nearly 85% odds of 50 bp hikes at both the May 3-4 and June 14-15 FOMC meetings. Looking further out, swaps market is pricing in a terminal Fed Funds rate near 3.25% while the Fed Funds future strip suggests a terminal rate of 3.25%. It’s unclear what the neutral rate is exactly, though most feel it is somewhere in the 2.5% area. Given this uncertainty, we believe the Fed will front-load much of its tightening to get above 2% quickly and then slow down to see how things develop. We do believe that the Fed may have to go a bit into restrictive territory given how high inflation is and we see risks of a terminal Fed Funds rate between 3.25-3.50%.
U.S. yields have resumed moving in the dollar’s favor. The 2-year yield is trading at a new cycle high near 2.60%. This led the 2-year differentials with Germany, Japan, and the U.K. to also make new cycle highs. This of course argues for further dollar strength against the euro, yen, and sterling. Elsewhere, the 10-year yield is trading at a new cycle higher near 2.64% while the real 10-year yield has risen to a new cycle high near -0.23%.
It’s worth noting that the 2- to 10-year curve is no longer inverted. Even though the 2-year yield has risen to a new cycle high near 2.60%, the 10-year is underperforming and trading near 2.64% and so the 2- to 10-year curve is no longer inverted. We suspect it will continue to flirt with inversion but for us, it's more important to look at the 3-month to 10-year curve. That stands at a whopping cycle high near 200 bp and is nowhere near inverting. Please see our recent piece here to see why we are not yet concerned about yield curve inversion in the U.S.
FOMC minutes will be released. At the March 15-16 meeting, the Fed started the tightening cycle with a 25 bp hike. The one dissent was from Bullard, who favored a 50 bp move. The Fed also delivered a very hawkish shift in the Dot Plots, with the median Fed Funds rate seen at 1.9% at end-2022 vs. 0.9% in December and 2.8% at both end-2023 and end-2024, up from 1.6% and 2.1% in December, respectively. Lastly, the Fed said it would start reducing its balance sheet at a “coming” meeting. Chair Powell later confirmed that an announcement could come as soon as the next meeting May 3-4. Now, Brainard’s comments suggest implementation could come as soon as May. Look for these minutes to tilt hawkish. There are no U.S. data reports today but Canada reports March Ivey PMI.
As we warned yesterday, default risk has risen for Russia. Today, Russia said foreign banks declined to process $649.2 mln of coupon payments after the Treasury Department banned Russia from making any debt payments through U.S. banks. We warned that this latest sanction was a risky one. While Russia has so far remained current on its external debt, this move will make it harder to continue doing so and so the odds of technical default are not insignificant. We say technical because we have a debtor that is willing and able to make the debt payment but is being prevented from doing so by sanctions. The good news is that there has been little contagion to other EM credits. Yes, frontier markets like Sri Lanka and Pakistan are teetering on the brink but the EMBI spread is the tightest it’s been since February.
Eurozone reported February PPI. Headline rose 31.4% y/y vs. 31.6% expected and 30.6% in January. This suggests pipeline pressures remain high and that CPI is likely to continue accelerating. Elsewhere, Germany reported weak factory orders. Orders plunged -2.2% m/m vs. -0.3% expected and a revised 2.3% (was 1.8%) in January. Therein lies the problem for ECB policymakers; inflation continues to rise even as the real sector data show signs of weakness. Given that the ECB has a singular focus on inflation, it has been painted into a corner.
ECB tightening expectations remain heightened. WIRP suggests liftoff July 21 is fully priced in. Swaps market is pricing in 125 bp of tightening over the next 12 months vs. 100 bp at the start of this week, with another 70 bp of tightening priced in over the following 12 months. This seems way too aggressive to us, especially in light of recent weakness in the real sector data. Since the last meeting, inflation data have missed to the upside while real sector data have missed to the downside. Next ECB decision is April 14 and the forward guidance then will be key. Guindos and Lane speak today.
National Bank of Poland is expected to hike rates 50 bp to 4.0%. However, nearly half of the 28 analysts polled by Bloomberg look for a larger 75 bp move. CPI rose a whopping 10.9% y/y in March, the highest since July 2000 and further above the 1.5-3.5% target range. Minutes for the March 8 meeting will be released Friday. At that meeting, the bank delivered a hawkish surprise with a 75 bp hike to 3.5% vs. 50 bp expected. Swaps market sees the policy rate peaking between 4.75-5.00% over the next 12 months but we still see upside risks.
The Bank of Japan is likely to be tested again on its Yield Curve Control. The 10-year yield is back trading near 0.23%, just below the 0.25% limit under YCC. We have warned that the struggle to contain JGB yields is by no means over, not when bond yields in the rest of the world continue to march higher. That said, BOJ divergence with the Fed and other major central banks will continue to widen in Q2 and that should continue to weaken the yen. For USD/JPY, the march higher has resumed after the modest correction lower. Last week’s high near 125.10 is likely to be tested and a break above would target the June 2015 high near 125.85. After that, there are no major chart points until the January 2002 high near 135.15.
RBA officials are sounding more hawkish. Deputy Governor Bullock said the bank is seeing signs of businesses passing along higher costs to consumers which in turn is leading to signs that workers are starting to look for wage increases. She noted “I think the issue going forward is that we have a very tight labor market evidenced by low unemployment rate, very high vacancy rates and you’re starting to see wages outside of enterprise bargains in the public sector rise a bit more quickly.” Bullock added “So these are the sorts of things that would suggest that there is some underlying inflation pressure in the economy and it isn’t just purely a level shift in costs.” Elsewhere, Assistant Governor Kent said that the bank is hearing of wage pressures building.
RBA tightening expectations continue to rise. WIRP suggests liftoff is fully priced in for the June 7 meeting, with nearly 25% odds of a 50 bp move. At the beginning of March, liftoff was priced in for the August 2 meeting. Swaps market sees 250 bp of tightening over the next 12 months and another 100 bp over the following 12 months that would see the policy rate peak near 3.75%, up from 3.5% at the start of the week. After spiking to .7660 yesterday on the RBA’s hawkish hold, AUD has succumbed to broad-based USD strength and is trading back near .7580. Despite the correction, the clean break above .7540 sets up a test of the May 2021 high near .7890. AUD remains the best performing major, up 4.3% YTD.
Caixin reported very weak China March services and composite PMIs. Services PMI came in at 42.0 vs. 49.7 expected and 50.2 in February. Last week, Caixin manufacturing PMI came in at 48.1 vs. 49.9 expected and 50.4 in February and so the Caixin composite PMI fell sharply to 43.9 vs. 50.1 in February. This is the lowest composite since February 2020 but given that the lockdowns have spread and intensified, we expect the April readings to get even worse. Of note, the Caixin reading is much worse than the official composite PMI, which came in at 48.8 vs. 51.2 in February. The growth target for this year of “around 5.5%” looks increasingly difficult to achieve and should bring more stimulus measures soon, both fiscal and monetary. We believe central bank divergence and narrowing interest rate differentials will continue to weaken the yuan.