The resolution to the conundrum surrounding the US debt ceiling has had a positive impact on the US debt markets. T-bill yields for near-term maturities have experienced significant declines, while CDS on US debt have retreated aggressively. Even longer-term bond yields have dropped meaningfully as the US's sovereign risk premium diminishes. However, it comes as no surprise to participants in the FX market that the impact on FX has been almost negligible.
For instance, in major currency pairs like EUR/USD, the implied volatility over a one-month period consistently decreased throughout May, despite the widely held belief that the US would face a financial shortage in June. Even in pairs like USD/JPY or USD/CNH, where implied volatility did increase over May, the driving factor was more related to shifting perceptions and heightened uncertainty regarding whether the Federal Reserve is likely to pause or raise interest rates in June, rather than anything directly linked to the debt ceiling.
Essentially, the lack of evident FX expressions for debt ceiling risk played out as anticipated, with the FX market paying little attention. Consequently, a resolution to the debt ceiling issue is unlikely to have a direct impact on the FX market.
The noteworthy development lies in the continuous stream of positive US growth data and persistently high inflation figures, exemplified by the core PCE number from last week (0.4% m/m compared to the expected 0.3%). As a result, the market has fully priced in another 25-basis point rate hike by the July 26th meeting of the Federal Reserve. I anticipate that this final rate hike of the cycle will instead be delivered during the June 14th meeting, followed by no rate cuts in the second half of 2023. Given this context, the recent strength of the USD is not surprising.
In fact, there is still significant room for further USD strength if the market revises its expectation of relatively rapid rate cuts starting from the fourth quarter of 2023. The implied rate spread between September 2023 and September 2024 for SOFR remains wide at -160 basis points. Between mid-January and mid-March, this spread narrowed from nearly -180 basis points to around -60 basis points, but then reversed due to various shocks in the US banking sector. Notably, during that period, the BBDXY index rallied by approximately 3%, indicating a recent track record of the US dollar benefiting from such market dynamics.
The market's persistent adherence to pricing in rapid Federal Reserve cuts stems from various factors, but two key narratives dominate.
1. First, there is a belief that the magnitude of rate hikes observed thus far will eventually dampen economic activity, leading to a gradual cooling of the labour market and alleviating core inflation pressures.
2. Simultaneously, there is a separate notion that the pace of hikes is so aggressive that it risks triggering an economic and financial market collapse, necessitating swift rate cuts of 200-300 basis points. Since these narratives are challenging to disprove, the path to a stronger USD hinge on consistently robust US data that pushes these dynamics into the background, much like the prevailing sentiment observed between mid-January and mid-March.
This week is of particular significance as it holds crucial data that could potentially yield the desired outcome. The release of the JOLTS job openings figure for April, for instance, is eagerly anticipated by the market, which hopes to witness a notable decline from the 9590k recorded in March, substantiating the narrative of a "healthy" cooling in the labour market. Additionally, June 1st brings the May ADP employment data and ISM figures, while June 2nd presents the May payroll data. Collectively, these numbers will play a pivotal role in determining whether the Fed will proceed with a hike on June 14th or not. If the message conveyed by the data is sufficiently clear to warrant pricing in an imminent hike in June, it is likely that the market will have to consider the possibility of a subsequent increase in July or adjust its expectations for rate cuts in the fourth quarter.
Based on my analysis, I had advised against opposing the strength of the USD, even though my initial Q2 outlook anticipated a slightly weaker dollar by the end of the quarter. As of now, I see no compelling reason to change my stance. If US economic data proves strong enough this week to challenge expectations of future rate cuts, there is potential for EUR/USD to decline further, possibly testing the 200-day moving average around 1.0491 (and the 2023 low at 1.0486). Additionally, as the US government refills its coffers following the debt ceiling deal, a significant issuance of bills is expected, which could enhance upward momentum in US bill rates and provide additional support for USD assets through carry trades. Furthermore, the global interest in the AI theme is currently benefiting the USD, given the US's technological advantage in global equity markets. Therefore, from a tactical perspective, I would favour a short position on EUR/USD.
Certainly, this week also features important data from the Euro area, particularly the preliminary May CPI figures. Yesterday, Spain's core CPI number declined to 6.1% year-on-year, falling short of the expected 6.4%. Economists were not particularly surprised by this outcome, as their projections for Euro area CPI were below consensus. They also emphasize that wage pressures have been more pronounced in the core Euro area countries compared to the periphery, making it challenging to extrapolate Spain's numbers to larger economies like France and Germany. Nevertheless, they anticipate a decrease in Euro area core CPI to 5.4% year-on-year from the previous 5.6%, which is slightly below market expectations of 5.5%. This result would support my tactical short position on EUR/USD by alleviating the pressure for Euro area interest rates to closely track those of the US if the latter were to rise once again.
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