Tough Fed Decisions

by
Marc Chandler
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Overview: The market has concluded that the Fed will hike rates today. The US two-year yield has risen from about 3.63% at Monday's lows almost 4.20% yesterday. It needs to rise to 4.35% to recover half of its decline since March 8 but has come back softer today. Meanwhile, the banking crisis continues to ease, and Europe's Stoxx 600 bank index is up 1.5%, its third consecutive advance. The US KBW bank index rallied almost 5% yesterday.

Still, while the dollar drew support from the adjustment of Fed views yesterday, it is mostly softer today, ostensibly on ideas that today's hike could be the last in the Fed's cycle. That said, we suggest below that the median forecast by Fed officials will likely see a terminal rate a little higher than it had in December. Today's sterling is leading the move against the dollar on the back of a stronger-than-expected CPI report, which has bolstered the confidence of a quarter-point hike tomorrow. Norway's central bank is also expected to hike by 25 bp tomorrow, while the Swiss National Bank is seen delivering a half-point hike. Asia Pacific and European equities advanced, but US equity futures are narrowly mixed. European benchmark 10-year yields are mostly 2-3 bp higher, though the strong CPI figures are lifting the 10-year Gilt yield by nearly seven basis points (to 3.43%). The US 10-year Treasury yield is three basis points softer at 3.58%. Gold is consolidating yesterday's sell-off that saw it extend its retreat from Monday's high near $2010 to almost $1935. The softer dollar and softer US rates may be helping it stabilize today. May WTI extended its recovery from below $65 on Monday to about $69.80 yesterday. It is in a narrow range below yesterday's highs ahead of the North American session.  

Asia Pacific

Japan returned from yesterday's holiday amid an easing of financial stress in the US and Europe. The recovery in US rates helped lift the dollar against the yen. While Japanese equities were lifted, with the Nikkei gaining nearly 2%, Japanese bonds softened. The benchmark 10-year yield rose eight basis points to 0.32%. The Topix bank index jumped 2.2% (after falling 1.9% on Monday), the biggest gain in two months. Japan reports national CPI figures on Friday. Tokyo's CPI points to a large drop as government subsidies kick in. Reports suggest that another JPY2 trillion (~$15 bln) of aid with be spent to cushion households from the higher prices ahead of local elections next month.

South Korea's trade figures for the first 20-days of the month are notable. While the traditional chronic trade surplus is understood as reflecting an imbalance (including the exchange rate). However, the collapse of exports (-17.4% year over-year, and -23% on a workday adjusted basis). Two numbers stand out. Chip exports were off almost 45% year-over-year, and exports to China fell by 36%.

After closing strongly yesterday, the dollar edged up to almost JPY132.80, the high for the week before finding new sellers. The dollar was pushed to about JPY132.25. The low in North America yesterday was around JPY131.80. The market may bide its time until the outcome of the FOMC meeting is announced, which is likely to inject fresh volatility. The Australian dollar is consolidating quietly within yesterday's (~$0.6650-$0.6725 range). It looks poised to test that high in North America today, though Monday's high (~$0.6740) may be safe, at least until the Fed's decision.  Initial support is around $0.6680. The greenback is steady to a little firmer against the Chinese yuan. It has remained below Monday's high by CNY6.9035 and held above yesterday's low near CNY6.8700. The PBOC set the dollar's reference rate at CNY6.8715. The median projection in Bloomberg's survey was for CNY6.8721.

Europe

The strain in eurozone and Swiss banks was an arising from the lack of access to dollars. The second day of the Fed's daily 7-day currency swaps so little interest. There was one taker yesterday as was the case Monday for $5 mln. There was also one bidder in Switzerland. It was also for $5 mln and down from $101 mln on Monday. There has been no interest from the other central banks. A few things can be deduced from weak participation. There is no demand. Dollar funding markets are working. It would therefore be likely to have been proposed by the US. There are two reasons why the US would have proposed increased frequency of the seven-day swap operations. It could have been out of concern to get ahead of a potential problem and/or as a signal of official coordination to boost confidence that the financial stress will be contained. 

The UK's February CPI surprised on the upside. The month-over-month rate jumped by 1.1%, nearly twice the median forecast in Bloomberg's survey. This lifted the year-over-year rate to 10.4% from 10.1%. The survey showed an expectation for a decline to 9.9%. The core rate rose to 6.2% from 5.8%. Core goods prices edged slightly higher (5.7% from 5.6%). Services were the main culprit. Services prices peaked in December at 6.8% and fell to 6% in January before snapping back to 6.6% in February. This was primarily driven by core services (excludes education, package vacations, and airfares), and adjusted for changes in the value-added tax, rose to 6.5% from 5.8%. The net impact of the CPI figures was to boost the market's confidence that the Bank of England will deliver a 25 bp hike tomorrow. It is now nearly fully discounted from a 50/50 proposition on Monday. It also lifted sterling to nearly $1.2300, its best level since February 2. 

The prospect of a Fed hike today, and possibly a higher dot plot for the terminal rate than in December has not prevented the euro from edging higher. It neared $1.08, which it has not traded since February 14. Above $1.08, the next chart area is around $1.0835, which corresponds to a (61.8%) retracement objective of the euro's decline since the year's high was set near $1.1035 on February 2. Initial support is seen near $1.0750-60. Sterling approached $1.23 on the back of the higher-than-expected CPI figures after consolidating with a heavier bias yesterday. Still, the intraday momentum indicators are stretched and gains much above $1.23 are likely to be limited until at least after the FOMC announcement.

America

This is arguably among the toughest FOMC decisions in several years. The extraordinary measures take to contain a banking crisis, which was evaluated to pose sufficient systemic risks as to justify the invocation of a clause that allowed noninsured depositors at two banks to be fully protected, prior to the sales of the banks' assets. Former Vice-Chairs Clarida, Ferguson, and Lindsey, and former NY Fed President Dudley have all argued that a pause now would be potential more disruptive than a hike. 

There are four components of today's decision. First is the target rate itself. It looked rather dicey a few days ago, but the market is feeling more comfortable with a quarter-point hike (that puts the upper band of the target range at 5.0%). The logic is like the ECB's:  As officials have shown, there are other tools for managing the banking crisis. Interest rates are about managing the business cycle. While the global increase in rates provided a challenging environment for holders of long-term bonds, the vast majority of banks have been able to cope. The key difference appears to be about idiosyncratic risk-management decisions.

Second is the ongoing process of not rolling over all the maturing Treasury and Agency bonds ("quantitative tightening). Despite allowing $7 bln Treasuries and $2 bln Agency bonds to roll-off last week, the Fed's balance sheet expanded, not via purchases but lending operations. However, some observers are concerned that given bank practices, reserves may be growing scarce, and there is speculation that the Fed could stop its QT operations.

The third element of today's decision are an updated Summary of Economic Projections. The "dot plot" has evolved in in recent years. Bernanke and Yellen had seemed to play down the significance, while under Powell, the dot plot has become an important signaling tool. In testimony earlier this month, Powell intimated that rates may to go higher than previously thought. He was referring to the 5.1% median forecast for the end of 2023 that was in the December 2022 iteration. Around then, the Fed funds future strip implied a terminal rate near 5.50%. With no desire to be more dovish than the market, and seemingly increasing concerns over the cumulative and lagged effect of the tightening, we had expected the Fed to validate market expectations. Now the futures curve sees a peak close to 5%. Fed officials will likely want to preserve some optionality (flexibility) and it might be best secured if the median dot looked for 5.25%.

The fourth element is the press conference, which often has often stirred dramatic price action throughout the capital market. Powell is likely to stress the economic uncertainty while recognizing the resilience of the US economy and the labor market. The Atlanta Fed's GDPNow sees the economy tracking growth above 3% this quarter. The Chair also may be a bit more confident that with the help of restrictive monetary policy, price pressures are likely to continue to moderate. Powell will likely be peppered with questions about regulatory oversight and may defer to the ongoing investigations. He will be optimistic that a systemic crisis had been averted. Powell can be counted on to refute claims that the Fed has resumed QE, drawing a distinction between purchases and loans, as well as intent. Perhaps, Powell can be asked how much tightening the Fed expects to emanate from the regional banking crisis.

The US dollar has been recording lower highs against the Canadian dollar for the past four sessions and is looking to extend it for a fifth session today. Yesterday's high was a little north of CAD1.3735. Today's high so far is about CAD1.3720. The greenback recovered smartly yesterday after approached CAD1.3645 and US two-year yields surged, but initial support today is probably around CAD1.3680. The US peaked on Monday near MXN19.2320 and settled near its session lows yesterday slightly below MXN18.60. It is in a narrow range today near yesterday's lows, which coincides with about a (50%) retracement of the greenback's rally from the March 9 low near MXN17.90. There are two sets of expiring options of note. The first is for about $810 mln at MXN18.50 and the other is for $350 mln at MXN18.85.