Fed: A rate increase backed by hawkish dots and rhetoric would support short-term yields

Markets

Yesterday’s bear steepening produced some all in all modest yield gains at the long end of the curve. US rates added between 0.4 and 2.2 bps. It was enough for the US 10-yr, though, to close spot on the 5% mark on the eve of one of the most important Fed policy meetings in recent years. Rising energy prices were to blame for the move yesterday and over the past few weeks. Add a resilient economy, a stable labour market and accelerating already-above inflation, and you have markets bracing for the first rate hike today in three years. Fed chair Warsh at the Jackson Hole Symposium raised the stakes: "We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do." Economic data since then suggested the later part. Backing off now for whatever reason, especially when a hike is fully discounted, is certain to backfire at the long end of the curve through rising inflation expectations and general risk premia. Warsh undoubtedly took notice of the recent yield surge and he probably has little appetite to put fuel to the fire that eventually would end up in the Fed having to take tougher action. A rate increase backed by hawkish dots and rhetoric would support short-term yields. Money markets could for example up bets for a back-to-back October hike. A strong, decisive Fed (Warsh) should ease some of the pressure at the long end of the curve – even though that doesn’t address other root causes. We expect the dollar to show strength in such a case. EUR/USD currently trades around 1.155 with little movement shown yesterday. First intermediate support in the pair is located around the 1.15 region, followed by the 1.14 big figure.

European yield curves yesterday showed similar bear steepening with net daily changes varying between flat (2-yr) and +3-4 bps (30-yr). Credit spreads for France hit new 14-year highs. Belgium is following suit as budget-related nervousness is clearly picking up. Gilts yields added 0.2-3.1 bps across the curve going into tomorrow’s Bank of England meeting which may feature laying the groundwork for a near-term rate hike. In-line with expectations August UK CPI this morning only serves the cause. Headline inflation accelerated to 3.1% while core remains sticky at 2.6% for a fourth month straight. Japanese yields added up to 7 bps on reports that the government under US pressure would raise defense spending to 3.5% of GDP. About half of the surge has been returned in trading this morning in a generally calm session, at least compared to the previous days. Energy prices cool down a bit while the likes of Brent oil hover a few dollars below their recent $110 highs. It’s offering equity markets some support. The EuroStoxx50 tested support at 6200. The US S&P500 and Nasdaq are struggling near their respective support levels around 7600 and 26000.

News and views

The Clarity Act failed to pass a procedural vote in the US Senate yesterday. Only 49 senators voted in favor to progress the bill to the next stage where 60 votes were needed. The bill would establish a regulatory framework for cryptocurrencies and other digital assets with the Commodity Futures Trading Commission getting the authority to regulate the industry. Concerns over ethics provisions remain one the major stumbling blocks. While lawmakers have the chance to reintroduce the bill in the next session, it is uncertain whether there’s a path forward after yesterday’s defeat and with mid-term elections around the corner. The price of bitcoin hit $75k this morning which is the lowest level in around a month.

August Japanese trade data this morning showed the value of Japanese exports being 19.3% Y/Y higher. While slightly down from July’s +23.2%, it’s the 12th consecutive month of rising exports. Details showed exports of electronic components being the main driver. Car exports also increased, but the pace slowed. The value of Japanese imports rose by 28% Y/Y (+26.3% in July) with elevated oil prices driving up import costs and leading to 4th consecutive monthly Japanese trade deficit.

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