G10 FX Weekly: What’s Next for Central Banks and Yields?

Summary

• February and March saw outsized volatility in G10 interest rate markets, especially in the short ends of the curves.
• This has seen expectations for pricing central bank policies swing wildly, especially considering the turbulence in the US and European banking sectors.

Market Implications

• Overall, the volatility has rendered central bank expectations considerably more dovish now than last month when at their most hawkish.
• That said, expectations have withdrawn from peak dovish levels a week or two ago when fears about the global banking sector were at their highest.
• Expect the wild volatility of February and (especially) March to abate in the coming weeks, with a return to the trough in yields seen in March more likely than a return to peak yields seen that same month.

Introduction

After roughly one year of tightening monetary policy, expectations for G10 central banks now see policy rates either at or very near their peak.

Following a volatile February and March, traders price less hawkish policy for the coming year. In many instances, policy rates are expected to be lower by year-end than now.

The past couple of months witnessed a tug-of-war between too-high inflation and fears of a material economic slowdown in the developed world.

The former had seen central bank pricing initially tack hawkishly, with traders initially pricing much tighter policy. Fears of the latter, however, have superseded inflation fears, with traders generally now seeing the rate hiking cycles in the G10 at or near an end.

After the wild volatility seen in recent weeks, we expect markets to settle down, with the peak in short-end yields already in place. We believe that the recent lows in these yields will be revisited.

The State of Play in G10 Short-Ends

The past month or so has seen volatility ramp considerably higher in the short end of the G10 interest rate curves.

This time last month, before volatility exploded, we saw value in the short end of the US and German curves, arguing that elevated yields on both sides of the Atlantic would attract buyers.

Admittedly, the subsequent violent moves surprised us, and you can never be certain of any catalyst(s) for a big move. But the result, one month later, is that those US and German yields are considerably lower.

Below, we will look at the state of play in five major interest rate markets and provide a prognosis for the coming months.

The US Federal Reserve

The US Federal Reserve (Fed) hiked by 25bps on 22 March, a compromise from the extremes seen in the 2-year UST yield in the weeks before the rate decision.

In the first week in March, markets had been pricing a ~70% probability of a 50bp hike. Roughly a week later, after the turmoil in the banking sector, a 25bp hike was seen as a coin toss.

The resulting 25bp rate rise came with a statement containing language that acknowledged the impact of recent issues in the US banking sector, highlighting the resulting elevated economic uncertainty.

Markets currently place a ~50% probability that the Fed raises rates by 25bp at its next policy announcement on 3 May. Beyond this, though, pricing takes a decidedly dovish turn.

By year-end, the Effective Fed Funds rate is expected to be at ~4.2%, about 65bp below the current level and roughly 75bp below the expected peak in the Fed Effective rate near 5%.

Recent price action showed the weak side of the market (lower yields), with traders clearly having a ‘buy dips’ bias in the US 2-year.

With this dovish backdrop in place, expect the recent low in the US 2-yr yield just above 3.5% to be revisited in the coming weeks.

The European Central Bank

The European Central Bank (ECB) raised rates by 50bp at its most recent policy announcement on 16 March.

Since the announcement, both the hawks and doves from the ECB Governing Council have been out in force. Yet both sides say the central bank’s policy action is ‘data dependent’.

Unlike the Fed, the market expects the ECB to continue raising rates this year, with roughly another 55bp of rate hikes priced by the autumn. Rates are not expected to be reduced until next year.

As in the US, the volatility in recent weeks is evident in the German 2-year yield, which has gyrated wildly.

Despite the lack of easing priced for ECB policy this year, we do not expect the 2-year German yield to climb back to last month’s peak near 3.4%.

Instead, as with the US market, traders are still in a ‘buy dips’ posture and, as a result, expect the German 2-year yield’s recent low near 2.1% to be revisited.

This may seem challenging, given the market’s expectations of further ECB policy tightening. Nonetheless, if markets are right about the Fed, expect this dovishness to also feed into the German curve.

The Bank of England

The Bank of England (BoE) raised rates by 25bp on 23 March, in a split vote of 7-2 on the Monetary Policy Committee (MPC).

In its statement, the MPC highlighted the unexpected increase in the latest CPI release as a reason for hiking, although it expects inflation to fall sharply the rest of this year.

Last month, as in the US and euro area, the 2-year UK yield was also incredibly volatile. Unlike in the US and euro area- however, that yield did not push to multi-decade highs. That happened last autumn due to the Truss/Kwarteng mini-budget debacle.

Ahead, the market prices another ~40bps of rate rises from the BoE, with rates expected to peak in the summer.

And, as with the ECB, while this is not as dovish as Fed pricing, we still see scope for the UK 2-year yield to challenge the recent low near 3%.

The Bank of Canada

The Bank of Canada (BoC) held rates steady on 8 March, the first of the major central banks to pause its tightening cycle.

Last month, we wrote the BoC’s overall message was that although inflation remained too high, it had probably peaked and is heading in the right direction.

We also wrote that actions spoke louder than words, and the BoC’s pause spoke volumes. The urgency was gone, and, according to market pricing, Canada’s rate hiking cycle has ended.

In the weeks that followed the BoC’s pause, the 2-year Canada yield was also volatile, as was the case with its G10 peers. At the time, market pricing suggested that the BoC’s hiking cycle was completed, and that the next move would be a rate cut.

The market’s view hasn’t changed on the BoC – the next move is expected to be a cut, probably at the September meeting.

Canada 2-year yield’s recent low near 3.25% will probably be revisited in the coming weeks, with the 3% level (last seen in the summer of 2022) probably in play in the coming months.

The Swiss National Bank

The Swiss National Bank (SNB) raised rates by 50bp on 23 March, matching the ECB rate hike from the previous week.

This is an important point to consider in Swiss monetary policy. The Swiss currency, the franc (CHF), is central to the SNB’s monetary policy approach.

When Switzerland was fighting deflation/disinflation after the GFC and the European sovereign debt crisis, the SNB sold the CHF in unlimited quantities for several years, fighting against imported disinflation.

Over the past year or so, the SNB has done the opposite – it has sold foreign currencies, supporting the CHF in the FX market, to ward off imported inflation.

Going forward, the SNB will probably match the ECB’s monetary policy stance, wanting to keep interest rate differentials steady and avoid conditions where the CHF would weaken against the euro. The market now prices about 75bp of further tightening by year-end from the SNB, implying that the Swiss central bank will keep pace with its euro-area counterpart.

The 2-year Swiss yield is roughly in the middle of the 0.75%-1.6% range seen last month. Should yields in the other developed markets fall as we describe above, expect the Swiss 2-year to also fall back to its recent low near the bottom of this range.

Conclusion

The G10 interest rate markets have seen wild price swings in the past month or two. And, while market initially tacked hawkishly in pricing central bank expectations, fears of a material economic slowdown has seen that pricing tilt dovishly in recent weeks.

A ‘buy dips’ bias in the 2-year part of the various interest rate curves has developed, catalysed by turbulence in the banking sectors in the US and Europe. Traders are now betting that the global tightening of the past year is either at or near the end of the cycle.

This means that we have probably already seen the peak in 2-year yields across the developed market curves. We expect the recent lows seen in these short ends to be revisited in the coming weeks and months. Markets have tipped their hands, and lower yields beckon.

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. 

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(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.)