Markets Keep Pricing In More Policy Tightening
The strong PMI data from China on Wednesday gave markets a substantial push as investors took on more risk. But there were two key data points that changed the narrative outside of China. The first was the release of German CPI, which came in above expectations. That was fast on the heels of the Eurozone notching record high inflation in January.
Then in the afternoon was the release of US PMI figures which disappointed. But, prices paid came in well above expectations, suggesting that inflation still has quite some time to go to get under control. US bond yields rose, helping reverse the loss in dollar strength through the Asian and EU sessions.
Higher for longer
The data played right into the hands of Fed’s Kashkari, this year a voter on the FOMC. He said he was looking to revise his outlook for rate hikes, and to support hikes even above the 5.4% level he said would be the terminal rate back in December.
The US yield curve inverted even more as markets priced in an expectation that the Fed will hike more in the near term. The longer end of the yield curve also rose, suggesting that investors not only expect the Fed to raise rates, but to keep them high for a longer period. It also means that more investors are coming to the conclusion that the Fed might be right about avoiding a recession. The Fed would be expected to cut rates during a recession, which would lower the longer end of the yield curve. As longer-term bonds see rising yields, it suggests that the market does not expect the Fed to cut rates soon.
The state of play
Since rate expectations are what drive flows between currencies, the terminal rate for different economies is pivotal for forex moves. As it stands, markets are pricing in rising rates across the three major currencies: Dollar, Euro and Pound. Those increases in expectations cancel each other out in their respective pairs. But it also implies those currencies could keep getting strong with respect to others where rates are not expected to rise soon. Such as the yen.
The market is currently pricing in a terminal rate for the Fed at 5.5%. For the BOE, it’s 5.0%. And the ECB is expected to reach 4.0% as a terminal rate before holding policy steady. Interestingly, that’s all 100bps above the current rate of each respective economy.
What are the forecasts
Both the BOE and the ECB are expected to hike by at least 50bps at the next meeting, which would eat up half of the expected hiking. Currently, the Fed is still expected to hike by just 25bps, but the majority in favor of that option keeps shrinking by the day in favor of a 50bps hike.
Overall, however, the discrepancy among analysts isn’t around where interest rates will end up, but the timing for the rate hikes. Which means that changing expectations for the next policy meeting might cause some fluctuations in the currencies. But the overall trend would likely reassert itself. That is, unless there is a major shift in the key data points coming out in the coming days that would change where the market is pricing in terminal rates.