G10 FX Weekly: Trading the Fed Pivot Theme

Summary

• US Short-Term Interest Rate (STIR) traders are pricing a US Federal Reserve (Fed) reversal this year, with a lower policy rate expected by yearend.
• Traders see inflation already falling from its peak, wage growth decelerating, tougher credit conditions and the Fed’s cautious economic prognosis as evidence the tightening cycle is ending.
• Accordingly, traders view a US recession this year as nailed on, with the Fed to react decisively and cut rates by yearend in response.

Market Implications

• Bullish 2Y USTs. We believe the US rates market is now firmly in a ‘buy price dips’ paradigm, with jumps in yields opportunities to initiate (or add to) long positions.
• Bearish DXY, bullish EUR/USD. Conversely, the US dollar (USD) is now a ‘sell on rallies,’ with the USD looking especially vulnerable against the euro (EUR).

Introduction

US STIR traders expect the Fed’s current tightening cycle to end soon, likely at the next meeting on 3 May. By yearend, the market expects the Fed to reverse and begin cutting rates.

This market view has been consistent over the past few quarters, yet analysts and economists are unconvinced of rate cuts in 2023. While there is a growing consensus the Fed will probably stop in May, most commentators expect rates will be on hold through 2023 and into 2024.

So why are traders so much more aggressive in pricing a Fed pivot?

1. They think a recession is imminent and that the Fed will react decisively to limit the damage from the imminent economic slowdown.
2. They see a trend in inflation – that it has peaked and is beginning to decelerate.
3. They anticipate tighter credit conditions. The recent tumult in the banking sector is seen as a possible catalyst for much tighter credit conditions, which will hasten the recession.

What Does Fed Pricing Look Like Now?

Traders currently expect the Effective Fed Funds rate (EFFR) to peak at or just above 5% and for the rate to stay there over the summer. By yearend, they expect EFFR to roughly be at 4.6%, or about 50bps below the expected peak.

To learn how pricing has evolved over the past year or so (roughly since the tightening cycle began), I like to look at the December 2023 Fed Funds contract (Chart 1).

Immediately noticeable is that pricing became extremely volatile in February and March. Initially, after some strong US data and hawkish commentary from Fed officials, the implied yield on the contract peaked at about 5.6% on 8 March.

How Did We Get Here?

Traders took the combination of better-than-expected data and Fed jawboning to heart, which raised expectations to much more hawkish levels than now.

Then, only a few days later, Silicon Valley Bank (SVB) collapsed, together with the rescue of Credit Suisse. Fed expectations did a handbrake turn, and the implied yield on the December 2023 contract fell ~150bp.

After that knee-jerk reaction (and clearout of extended short positioning in the US short end), pricing has now gravitated towards 4.6-4.7%. This is where the market was pricing the Fed throughout much of Q4 last year.

This demonstrates two things.

First, the market has been remarkably consistent in its view of the trajectory for Fed pricing (and decidedly sceptical of a soft landing).

Market pricing has been more dovish than analysts and economists because the market assigned a higher probability of a recession and expects the Fed to react forcefully to prevent an overly damaging economic slowdown. 

Second, it also shows that STIR traders do not operate in a vacuum. They are very sensitive to Fed messaging and adjust pricing dynamically to reflect all available information.

That pricing has gravitated back to its position before the Fed’s hawkish jawboning in February and March, and before the banking sector turmoil, shows how robust STIR traders are in pricing Fed expectations.

Fed Tightening Is Passé – Inflation Has Peaked

Looking at a cross section of metrics, STIR traders have concluded that US inflation has peaked, implying a diminished need for further Fed tightening.

Moreover, inflation’s declining trajectory is such that easing policy this year due to an expected recession should not prevent the Fed reaching its inflation target.

Looking at year-on-year (YoY) headline CPI, consumer prices peaked in June of last year at 9.1% and have decelerated each of the last nine months to the most recent reading at 5% (Chart 2).

Core PCE is widely seen as the Fed’s favoured measure of inflation and, like the YoY CPI reading, core PCE peaked last year (in February). Back then, the reading was at 5.4%, with the latest reading (for February 2023) coming in at 4.6% (Chart 3).

As with CPI, core PCE is demonstrating a favourable inflation trajectory, indicating the end of the Fed’s tightening cycle.

Another key inflation metric is the average hourly earnings (AHE), released as part of the US jobs report every month. Like CPI and core PCE, AHE peaked last year and have decelerated considerably (Chart 4).

YoY AHE peaked in March 2022 at 5.9%. Last month’s data came in at 4.3%.

Again, the trajectory of this metric leads STIR traders to the same conclusion as the other inflation data – the tightening cycle is almost over, and the expected recession will hasten easier Fed monetary policy.

Tighter Credit Conditions Spell Trouble

A few weeks ago, Fed Chairman Jerome Powell said that the recent upheaval in the US banking sector is ‘likely to result in tighter credit conditions for households and businesses ,which would in turn affect economic outcomes.’

Similarly, a week or so later, JPMorgan Chase CEO Jamie Dimon said the impact of the banking sector turmoil is ‘not yet over’ and will be felt for years.

Additionally, Dimon added last week that ‘the storm clouds that we have been monitoring for the past year remain on the horizon, and the banking industry turmoil adds to these risks.’

Powell and Dimon’s views are borne out in the data. The NFIB Small Business Credit Conditions index printed its most negative reading last month since 2012 (Chart 5).

The catalyst for the recent bout of dovish Fed pricing was the turmoil in the banking sector.

And, while the worst of the effects from the tumult seem to have passed, Powell and Dimon’s words, plus the NFIB data, remind us that the impact could be long-reaching and important. Fed market pricing reflects that.

STIR Traders See an Inevitable Near-Term Recession

Given the above data, STIR traders logically think recession is imminent and that the Fed will ease monetary policy to minimise the impact of the economic slowdown. That is certainly the way the market is priced.

STIR traders are not alone in expecting a recession. At the close of business last week, our Macro Hive recession model, which uses the 2Y10Y part of the yield curve, assigned an 83% probability of recession within the next twelve months.

Meanwhile, the Fed recession model, which uses the 3M10Y part of the yield curve, produced a 68% chance of recession. Notably, both models are producing recession probabilities higher than that of the 2007-2008 Global Financial Crisis.

The Fed Name-Checking a Recession Matters

Alongside the Fed’s model, the most recent FOMC minutes explicitly stated that the central bank expects a recession this year.

Specifically, the minutes stated that ‘the Fed staff’s projection at the time of the March meeting included a mild recession starting later this year with a recovery over the subsequent two years.’

This is important. Before last month and the banking-sector troubles, Fed messaging was much more upbeat, with talk of a soft landing prevalent.

Seen one way, the expectation of a recession, even a mild one, acknowledges what the market has been pricing since last year. Ostensibly, pricing a Fed pivot foretells a recession.

Arguably, for the first time since the Fed’s tightening cycle began, the central bank’s messaging and models align with market pricing: all suggest a recession is coming.

What Does This All Mean for Markets?

Two markets where Fed pricing is key, which we have focussed on in recent G10 Weeklies, are US 2-year Treasuries (USTs) and the US dollar index (DXY). We look again at these markets below.

US 2-Year Treasuries

We first wrote about US short ends on 2 March, just before the big drop in yields.

We said that elevated yields in the 6-month US T-bills would attract buyers. Although we focussed on the very short end of the curve, we could have said the same for 2-year USTs. Buyers would find short end yields uniformly attractive.

And, although early March would have been the optimal time to go long US rates, the reasoning behind the preference to initiate longs is still valid. Despite US fixed income becoming more expensive since early March, yields are still at attractive levels (Chart 6).

As we outlined in a follow-up piece on 6 April, we think a ‘buy dips’ bias has emerged among STIR traders. Recent price action is evidence of traders ‘tipping their hands’ and revealing the weak side of the market (for lower yields).

We expect this dynamic to continue paying out in the coming weeks and months and the US 2-year Treasury yield to initially trade down to 3.5%.

The US Dollar Index (DXY)

We wrote about the DXY last week, and the price action since then has played out as we expected (Chart 7).

In that piece, we expected material further downside in the DXY over the medium term. However, we said that in the shorter term the dollar would remain rangebound.

After making a marginal new year-to-date (YTD) low shortly after publication, the DXY has now bounced, with several USD pairs (including EUR/USD and GBP/USD) trading back within the previous YTD ranges.

Our view remains unchanged. While the near term may see some USD consolidation within the previous YTD ranges (e.g., ~1.05/1.10 in EUR/USD), expect further downside in the USD in the coming months. This means selling USD on rallies.

In DXY terms, that could see the index trade down to the ~95 level, while EUR/USD could trade back to the ~1.13/1.15 level seen before the Ukraine war began.

Conclusion

The pricing of Fed expectations show that STIR traders are convinced that US inflation has peaked, wage growth is decelerating, credit conditions are tightening, and that a recession is almost virtually guaranteed. This has led the market to expect a Fed policy pivot this year.

With this easier Fed policy prognosis, the US rates market has entered a buy dips paradigm, while the USD is now a sell on rallies. In essence, the burden of proof for higher US yields lies with the hawks, with the onus on USD bulls to make the case for a stronger dollar.

By yearend, we expect both US yields and USD to be lower.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)