USD and 5 year Inflation Swaps, AUDUSD and USDCAD
The BoC discussing the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity, provided a timely reminder that policy divergence is likely to be the theme of 2017 suggesting a higher USD. Fed’s Dudley projecting higher interest rates by the end of this year provided that US data remain on track leave the impression the Fed is running a similar formula compared to last year which we called ‘guidance toward tightening’. However, there is one important difference between last year and this year. Last year saw rate expectations for 2016 rising as markets prepared for the December rate hike. This year sees rate expectations moderating for 2017 with Fed Funds Future now pricing an additional 18bps rate hike for 2017 which compares to 65bps which was priced in for 2016 in December 2015. AUDUSD has topped out with the weak September labour market report reducing rate expectations. GBPUSD should reluctantly move into the 1.26 handle. USDJPY dips provide a strategic buy and low yield AxJ is for sell.
The flatter rate expectation curve for 2017 compared to last year’s more aggressive stance may prevent the USD rally gaining momentum in the short-term, but it lays the foundation for a more powerful USD rally later this year and especially for 2017. Money market pricing can act as speed bump as they offer implicit easy potential offered to the central bank when required. Last year, this speed bump was in good shape allowing the Fed via verbal moderation to release a dose of monetary stimulus working via the flattened money market curve and the implicit weakening of the USD. In February 2016, the Fed used this option as it recognized unwanted economic weakness and a threat of financial instability.
Nowadays, this speed bump is underdeveloped allowing us to draw USD bullish outcomes whatever the growth scenario for the US. Our base scenario suggests that economic expansions do not end due to age. Instead, economic cycles turn either by an unwanted inventory built up or the need to consolidate balance sheets. None of these two conditions fall currently into place explaining why recession probabilities have reduced. Accordingly, the economy grows moderately at the pace dictated by its (reduced)growth potential. However, the closed output gap suggests the growth–inflation trade off will shift towards the right, suggesting the Fed will either hold or increase rates while other central banks remain within easing cycles. Note, the US 5 year inflation swap has recovered towards levels witnessed in November at a time when US 10-year yields traded above 2%. Implicitly lower real yields suggest that US monetary conditions have eased over the past 11 months. Accordingly, either the USD or US-yields will rise.
What would happen if our base case does not work out and the US economy weakens from here? In this case, the Fed would have less generous room to maneuverer compared to last year when verbal interventions allowed money market rates to come down. The front end of the money market curve does not offer the same speed bump compared to last year and for the Fed to cut rates – and implicitly admit a policy mistake – it may take more than a growth blip. The point is that a bearish growth scenario will bring the equity market under selling pressure leading globally to reduced cross border flows and subsequent USD supportive repatriation flows.