US dollar
MARKET UPDATE
In March the US dollar weakened against the Euro in terms of London closing rates, moving from 1.0612 to 1.0863. In addition, the dollar weakened versus the yen, from 136.15 to 132.90. The FOMC, at its meeting in March hiked the fed funds rate by 25bps to 4.75%-5.00%, following 450bps since March of last year. The FOMC has also continued with its policy of reducing its securities holdings with QT ongoing at a pace of USD 95bn worth of UST bonds (USD 60bn) and MBS (USD 35bn) of balance sheet reduction each month. However, this was dramatically offset by balance sheet expansion to provide loans and liquidity for the banking sector.
OUTLOOK
After advancing by 2.7% in February, the US dollar (DXY) depreciated in March by 2.3% fuelled a huge shift in rate hike expectations triggered by the collapse of two regional banks in the US.
When Fed Chair Powell presented his semi-annual testimony to Congress, the message was more tightening would be needed, which prompted the markets to price in a total of 100bps of more tightening this year. After the bank failures and the delivery of a 25bp rate hike, the markets now expect nearly 50bps of easing by year-end.
This pricing suggests to me that markets are positioned for another bout of market turmoil. Some of that easing may come out of the market over the short-term although it does seem quite likely that we will see further market volatility of some kind before the end of the year.
The Fed’s action in creating a liquidity window to accept US Treasury securities, Agency securities and MBS at par value in exchange for cash has cut off the risk of deposit flight based on these securities being held at a loss after the huge sell-off over the last year.
But even with no renewed turmoil, I believe there is a good chance the FOMC will now pause. The updated dots profile implies one further 25bp rate hike which is still a clear risk. If the jobs and inflation data remain firm and we see no additional turmoil, the FOMC could hike. But there is less justification now for further action. Financial conditions have tightened – the St. Louis Fed Financial Stress Index jumped to its highest level since the GFC when the Covid period is excluded.
Lending by banks could now slow as banks ensure they reduce the risk of deposit flight. Inflation is also set to slow with services (rents in particular) looking likely to slow over the coming months to add to slowing goods inflation. Wages have also slowed with signs of a pick-up in the supply of labour. The labour force increased by 1.7mn in the three months to February, which will help curtail wage growth going forward.
The developments in March reinforce my view of a weaker US dollar going forward. Our profile is relatively conservative to reflect the likely bouts of risk-aversion that lie ahead that will see increased volatility and corrections stronger for the dollar, in particular versus the higher-beta G10 and EM currencies. The potential for greater caution over extending credit will likely add to disinflationary pressures and reinforce the likely move lower in inflation from here.
INTEREST RATE OUTLOOK
“We have taken back our extra hike that we put in last month. We are entering the period where the data (a quick CPI slide in Q2/Q3 plus job losses will likely start to stack up) will give the Fed cover to pause. Either way we are relatively indifferent if the Fed hikes one more time or not. In our view the cycle is coming to an end. The credit tightening along with ongoing QT will feel like a few hikes over the course of 2023.
That said, as we saw in March, if it’s a close call, but markets have a hike priced in, the Fed will likely deliver on it in May. Yet the risk that other rate sensitive sectors (CRE, PE/private credit etc) start to see cracks in Q2 is also high. We have moved our first cut to September (with the first cut at 50bps not just a 25bp adjustment) and then see scope for more cuts into year-end.
Overall, we view what happened in March as having a lasting effect on general credit conditions. Where the rates shock turned into a potential credit crunch as banks become risk averse (along with slower economic activity turned recession) will likely hit cashflows and loan holdings (and eventually lead to defaults)” - (George Goncalves, US Macro Strategy)
DXY VS. SHORT-TERM YIELD SPREADS
SIZE OF FED’S BALANCE SHEET
By Luca Santos.
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