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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This article was written by ForexLive at www.forexlive.com.
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