This is an excellent research note from Kit Juckes of SocGen on how the market is pricing in Fed tightening.
Via Kit Juckes of SocGen:
Hawkish/dovish FOMC? I’d rather focus on the market move.
The US 1-year interest rate, one year forwards, has now risen to almost 1.2% from only 0.45% last autumn, well above the ‘taper tantrum’ spike last summer and to the highest level since 2011.
Meanwhile, the 1yr rate 5yrs forwards is still thoroughly anchored below 3.4%, 25bp lower than the lows of last autumn, and 8bp lower than at the start of this year. The moves we are seeing in both tell us a lot about how the market is reacting to improving economic data and the minor tweaks in the wording of FOMC dispatches.
The 1y/1y rate spiked from 2.5% to above 4% in 2004 as the start of the Fed tightening cycle approached. The move we’re seeing this summer is a little earlier than I had guessed (I have written frequently about watching for this to really start happening in September), but the market is doing what it typically does – pricing in the rate cycle aggressively once it becomes convinced that we are indeed months rather than years away from the first hike. There is further to go – the 1y/1y rate will surely overshoot, and I can easily imagine it reaching 2% by the end of the year. The 1-year in 5-years however, has been successfully anchored by the promotion of the notion that ‘new normal neutral’ rates are much lower now than in previous cycles. The market has not shifted from a view that the terminal Fed Funds rate is more likely to be 3% than, say, 4%. On yesterday’s data, Q2 US nominal GDP growth is back above 4% y/y, and the idea of a rate peak far below that is only credible on the back of inflation data remaining very well behaved. So tomorrow’s wage data will once again matter as much, possibly more than the unemployment rate or the gain in non-farm payrolls.
For currencies, the different trends at the two ends of the yield curve matter. In EM, for example, while the re-pricing of one-year forward rate expectations is causing a wobble, it is just that. The idea that the Fed will finally normalise rates to a new, super-low level on the back of stronger economic data ought not to scare asset markets overall and emerging market currencies in particular. The EMFX ‘story’ is going to be one of differentiation between scarily overvalued currencies and more competitive ones; and between economies whose growth momentum is fading fast and ones that will benefit from the US recovery. It’s a different story in G10 however, where sensitivity to small changes in Fed policy is much bigger. The jump in 1y/1y rates is very important for EUR/USD, GBP/USD, USD/JPY, as well as for AUD, CAD and NZD. If the move higher in the 1y/1y goes on, the dollar has further to go against all of these. In positioning terms, I still like being long USD/JPY much more than being short Treasuries, I like long USD/SEK most of all in Europe, and I think there’s a decent chance this is the start of a longer-term trend in AUD/USD, NZD/USD and USD/CAD.
As to the rest of the news: On the FOMC Statement itself there is agreement that the Fed is trying to be both upbeat and dovish at the same time. The hawkish read of the statement will probably win out if the data remain strong, with today’s focus on weekly claims, and the Chicago PMI (expected 64 versus 62.6 previously). Argentina was declared to be in default by S&P. UK house price inflation slowed to 10.6% from 11.8%. The FT says Londoners are cashing in and moving to the suburbs! Japanese housing starts were slightly soft, but Australian building approvals and credit growth were reasonably robust. We are expecting headline and core Euro area CPI to remain unchanged at 0.5% and 0.8% respectively. It is also, of course, month-end and the day before NFP, which makes it hard to imagine that there will be a lot of ‘dip-buying’ from yield-hunters looking to take advantage of this week’s weakness in risk assets and currencies.