- US yield curve 'continues to flatten'
- Interest rate hike hopes diminishing
- Soft risk appetite to weigh on EM currencies
After the May nonfarm payrolls print showed an eerily quiet US jobs market,
Fed-watchers were spooked and USD bulls fled the scene. Photo: iStock
By John J Hardy
My favourite headline to emerge in the wake of last Friday’s disastrous US jobs report was Bloomberg columnist Lisa Abramowicz proclaiming that “The Fed is as clueless as you are
” on the trajectory of the US economy.
Sure, it’s an easy task to point out the inaccuracy of the Federal Reserve’s prior economic forecasts. But this time around, the Fed has a particularly acute case of egg-on-the-face due to the timing of its recent attempt to talk up the potential for two to three rate hikes this year when the market was reluctant to even price in high odds of one.
Given the very clear indication that the Fed was itching to hike, the market decided to push the US dollar a bit higher in recent weeks, figuring that positive data releases might allow the Fed to move at the June, or certainly the July, Federal Open Market Committee meeting.
But even with the market reluctantly marching to the tune of the Fed piper, interest rate expectations never priced in a full two rate hikes, and farther out the curve, the market continued and continues to believe that US rates will go absolutely nowhere. This remains the case even as FOMC rate projections from the March meeting suggest a normalisation of the policy rate to 3.0% by the end of 2018, based on the median projection, with the most dovish FOMC prognosticator at 2.0% for the same timeframe.
The market, however, says about 1.0%. And the US yield curve, even as the market remains reluctant to price in rate hikes, continues to quickly flatten as low yields drop and drop. No signal is more associated with a recession risk than a flat or inverted yield curve and this latest batch of data, together with weak growth in Q1, weak corporate profits, and anaemic expansion in the US services sector have raised the profile of recession risk.
Developments from here will be tough for USD traders and currency investors in general. Some further dollar weakness may be on the cards, but given how little the market invested in the Fed’s attempt at hawkish guidance in the first place, there may be little fuel to drive such a move.
The US dollar has to rally against something, but what? Normally we would look to the higher yielding and especially emerging market currencies, but these tend to be correlated with risk appetite, which can hardly be expected to flourish if the US is seen as dipping into recession.
Even if global markets maintain a relatively even keel, the highest yielders among the developed market currencies – the Australian and New Zealand dollars – have seen their rate advantages collapsing in recent months as inflation levels drop in the wake of decelerating commodity-linked economies.
The Reserve Bank of New Zealand is likely to cut its interest rate at its Thursday meeting to a record low 2.00%, with further cuts by the RBNZ and likely Australia’s RBA at future meetings further eroding the interest rate, or carry, advantage of holding these currencies to a mere fraction of the carry available in markets past.
As for the other major currencies, Europe is in the thrall of the UK referendum vote on June 23 and Japan will inevitably clamour for new policy measures to fight the deflation risks if USDJPY dips to new lows on the year.
Optimists will point out that the US economy suffered a couple of ugly soft patches in recent years without fully dipping into recession and this one bad jobs report will quickly be brushed aside if the June and July reports show a resurgence in the numbers, allowing the USD to rally again.
But if the US is dipping into a recession, we could be looking at a whole new chapter of the global currency wars, with less at stake for the US than most other major currencies, especially as the US might be more than distracted by the most contentious US presidential election in modern memory.
"It's gonna be YUGE!" Photo: iStock
— Edited by Michael McKenna
John J Hardy is head of FX strategy at Saxo Bank