G10 FX Weekly: Where the Fed Goes, Its Peers Will Follow

Summary

• The outsized volatility in G10 rates markets from February and March has abated.
• Markets still price the end of the current global tightening cycle, with policy rates at or near their respective peaks.
• US pricing is the most dovish, with the Federal Reserve (Fed) policy rate expected to be lower by yearend.
• Eurozone, UK, and Swiss pricing is less dovish, with policy rates expected to be higher by yearend.

Market Implications

• Bullish 2Y USTs. Short-end rates markets remain a buy-on-dips, especially in the US. Expect a new year-to-date (YTD) low for the US 2-year yield in the coming months (perhaps weeks).
• If Fed pricing is correct and the central bank cuts rates this year, expect other G10 central bank pricing to quickly tilt more dovish.
• Bullish 2Y Bunds, Gilts, Swiss GBs. Downward pressure on 2-year yields in other G10 markets will follow the US lead, with new YTD lows across the board expected.

Introduction

After a wild end to the first quarter for short-end rates markets globally, the second quarter has been comparatively subdued so far. Outsized volatility in February, and especially in March, has given way to rangebound, choppy trading in the 2-year segment of developed rates markets.

Despite March’s volatility and challenging second-quarter trading conditions, the consensus among traders is that the Fed has finished hiking and will pivot to cuts by yearend.

Should this dynamic continue, expect not only US 2-year yields to revert to and break below the intraday YTD low (currently ~3.55%), but also short-end yields in the Eurozone, UK, and Switzerland to break sharply lower.

More tightening is currently expected in these European markets. If the Fed pivots this year, expect similar moves from the European Central Bank (ECB), Bank of England (BoE), and the Swiss National Bank (SNB) within months.

What Is Priced for Central Banks?

This month, the Fed, ECB, and BoE have all raised their policy rates by 25bp, with the SNB having hiked its policy rate by 50bp on 23 March. We now examine pricing for the remainder of 2023.

The US Federal Reserve

After hiking rates by 25bp on 3 May to 5%/5.25%, market pricing suggests that the Fed has now finished tightening and will start cutting rates this year, as early as at its September meeting.

By yearend, the Fed policy rate is expected to be about 55bps lower than now (Chart 1).

This dovish Fed pricing is primarily based on the notion that a US recession is almost certain. Macro Hive’s model, which uses the 2Y10Y part of the yield curve, forecasts an 82% probability of a recession in the next 12 months. Meanwhile, the Fed’s recession model, which uses the 3M10Y part of the yield curve, produces a 72% chance of recession.

Notably, both models are producing recession probabilities higher than that of the 2007-2008 Global Financial Crisis.

Should the current debt ceiling impasse lead to a US default, expect market volatility to jump across all asset classes. A flight to safety will also ensue. Against this backdrop, the Fed will almost certainly not hike rates in June, and US yields will slump.

Recent messaging from Fed officials has been very much ‘wait-and-see,’ with FOMC members disagreeing on the need for a rate increase next month. Fed Chairman Jerome Powell will speak tomorrow after the US equity market closes. 

The European Central Bank

The ECB hiked its Deposit Rate by 25bp to 3.25% on 4 May, the seventh hike in the current cycle, which began last year. Market pricing suggests another ~45bp of hikes before yearend (Chart 2).

The ECB’s Robert Holzmann, one of the more hawkish members of the bank’s Governing Council, said policymakers must raise the Deposit Rate above 4% to tackle inflation. The market currently sees the peak at ~3.65%.

Holzmann’s ECB colleagues, however, think the current tightening cycle is almost over. Greece’s Yannis Stournaras said on Tuesday that ‘we are close to an end’, echoing remarks from his German colleague, Joachim Nagel, last week. 

The Bank of England

The BoE hiked Bank Rate by 25bp, to 4.5%, at their most recent meeting on 11 May. This was the 11th rate hike in 15 months. Market pricing indicates that more rate hikes are expected: ~35bp by yearend (Chart 3).

Despite the market expecting a higher Bank Rate, the most recent employment data released on Tuesday was discouraging. Expectations of a 25bp rate hike next month were pared from ~85% to ~75% after the UK jobs report.

Even though nominal wages rose from the previous reading, payrolls declined by 136,000 in April – the biggest drop since the pandemic in 2020.

My colleague Henry Occleston said that the UK labour market is loosening faster than the BoE had expected in recent forecasts, although the feed through to wages is a sticking point. Nonetheless, he expects the BoE to pause its hiking cycle after another 25bp hike next month.

BoE Chief Economist Huw Pill said on Monday that he is hopeful that the bank has ‘done enough’ policy tightening, but that inflation risks must be monitored.

BoE Governor Andrew Bailey warned yesterday of inflation persistence in the UK, but also added that inflation is expected to fall sharply in the near future, and that the labour market is cooling.

The Swiss National Bank

As we wrote last month, the SNB’s monetary policy is largely predicated on that of the ECB.

This is because of the importance of the Swiss franc to SNB policy. The currency is critical to the central bank’s policy approach.

As such, the SNB wants to keep interest rate differentials versus the Eurozone relatively constant. The market is acutely aware of this dynamic and is currently pricing about 40bp of further tightening (Chart 4). This, unsurprisingly, is roughly in line with ECB pricing.

Recent messaging from SNB President Thomas Jordan is consistent with market expectations. Last week, Jordan said that ‘monetary policy is still not restrictive enough to anchor inflation in the area of price stability,’ adding that the SNB ‘cannot exclude that we have to further tighten monetary policy.’

This echoed messaging from the week before, where Jordan said that further tightening of monetary policy could be required.

What Is Next for 2-Year Yields?

Across the US, Eurozone, UK, and Swiss rates markets, 2-year yields made their YTD lows in late March, following the tumult in the banking sector on both sides of the Atlantic.

Since then, yields have been choppy and rangebound. Looking ahead, though, we expect those YTD lows in each of these markets to be revisited.

In the US, we expect a new 2023 low to print sooner rather than later – perhaps as early as the next few weeks. Much depends on the US debt ceiling negotiations.

Failure to reach an agreement will put acute downward pressure on US yields, as investors will almost surely flock to havens. Yields in the Eurozone, UK, and Switzerland will follow the US lead.

US 2-Year Yields

We have written about US short-end yields twice in recent months – first on 2 March, then on 20 April.

In both pieces, we expressed a bullish view of the US short end, expecting yields to fall. The first piece, written before the banking turmoil in March, preceded a sharp, quick drop in yields, with the latter piece advocating a buy-on-price-dips approach (Chart 5).

Since the piece last month, the US 2-year yield has chopped around in a ~3.65% to ~4.25% range. Over that period, though, fading any yield spikes within the range has proven a sound strategy.

This strategy should continue to perform well, and buying price dips should produce even better results in the coming weeks.

We expect the US 2-year yield to trade back to the YTD low of 3.55% seen intraday on 24 March. The impasse over the US debt ceiling might see this happen sooner rather than later.

Beyond that, with the probability of a recession so high, we expect the US 2-year yield to trade to a new YTD low in the second half of 2023, nearer 3%.

As my Macro Hive colleague Bert Gochet stated recently in one of our weekly conference calls, the US 2-year at ~4% is not pricing a recession. That yield needs to be nearer 3% to reflect recession fears more accurately.

German 2-Year Yields

The 2-year German yield printed its YTD intraday low at ~2.1% on 20 March (closing at 2.36% that day), and currently trades at 2.72% (Chart 6).

Since that recent trough, the 2-year German yield has not traded above 3%. This is probably due to the buy-on-price dips approach that has dominated since the precipitous yield drop in March.

With the bulk of the ECB’s tightening cycle already completed, we expect that traders will continue to buy dips in German 2-year bonds. As such, any upside in yields will be limited, and any yield increases will be buying opportunities.

Moreover, if the Fed pivots to easing before yearend as the market currently prices, driving the US 2-year yield to a new low, expect the German 2-year to follow. We expect the German 2-year to retrace to the current YTD low in the coming months.

UK 2-Year Yields

We can say the same for the 2-year UK gilt yield. Having bottomed intraday at ~3.01% on 24 March (closing at 3.21%), it topped out just under 4% in recent weeks, currently trading at ~3.87% (Chart 7). We expect the current YTD low to be revisited by yearend.

Like the ECB, the BoE has already completed the bulk of its tightening cycle. And, while the UK 2-year yield has been stubbornly persistent near 4% over the past three months, it cannot buck the trend of lower yields in the US and Germany that we expect.

This is especially true if the UK data continues to deteriorate as the most recent employment figures have.

Moreover, Brexit is a drag on the UK economy, which we have written about previously. News this week added to the challenging backdrop for the UK economy, with three big carmakers warning that current Brexit rules threaten the future of the British automotive industry.

Inflation topping out, a cooling job market, and the persistent Brexit drag all point to an economic slowdown. This will weigh on UK yields.

Swiss 2-Year Yields

The Swiss 2-year yield has oscillated in a 55bp range since hitting the YTD low at ~0.75% on 20 March, currently trading near the middle of that range at ~1% (Chart 8).

As outlined above, the SNB will not be immune to monetary policy pivots elsewhere, and Swiss 2-year bonds will therefore remain a buy-on-dips. More important is the Swiss franc (CHF). As a critical input into SNB policy, the bank wants a strong CHF to offset inflation.

Given the economic uncertainty ahead, compounded by the debt ceiling impasse and a high likelihood of a US-led recession, in addition to geopolitical risks, investors can expect CHF appreciation in the second half of 2023.

As such, this may help the SNB combat inflation and lead to less urgency on hiking rates. If so, it would be another bullish driver for lower Swiss yields.

Conclusion

If market pricing for a dovish Fed pivot proves accurate, expect the US 2-year yield to plunge below the YTD low, trading very near 3% as traders price a US recession.

This will prompt similar actions from the ECB, BoE, and SNB, whose current expected rate path is much more hawkish than the Fed’s, according to market pricing.

The key takeaway is that where the Fed goes, other developed market central banks will follow. A dovish Fed will lead to lower US yields, and lower US yields will feed through to Germany, the UK, and Switzerland.

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.)