Powell Sends the Two-Year Yield above 5% and Ignites Powerful Dollar Rally

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Marc Chandler
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Overview:  Federal Reserve Chair Powell's comments to the Senate Banking Committee were seen as hawkish by the market, even though it has been clear to most observers that the 5.10% median terminal rate that the Fed projected in December would be increased. Also, it seemed well appreciated a few Fed officials support a 50 bp hike at the February 1 FOMC meeting, two days before a "hot" jobs report that showed over 500k jobs were filled. It would just seem to go without saying that given the strong data, there is little reason for them to raise the issue again.  US short-term rates rose, and the two-year yield rose 12 bp poke move above 5%. Asian and European stocks were mostly lower with the weaker yen arguably helping the Japanese stocks resist the pull. US futures are flat to slightly firmer. Ten-year yields are mostly steady, but two-year rates are firmer.

Important technical damage was inflicted on the foreign currencies as the greenback rallied on Powell's comments. The euro fell through last month's low (~$1.0535), and our $1.0460 target is back into view. The dollar rose to nearly JPY138, its best level since mid-December. We have warned of the risk of a move toward JPY140. Sterling fell to new lows for the year, below the $1.1840 low seen in early January and could mark the breakout of a large topping pattern. The greenback also set a new high for the year against the Canadian dollar near CAD1.3775. There is not much that stands in the way of the last October higher near CAD1.3980. The dovish hike by the RBA and hawkish talk by Powell sent the Australian dollar to its lowest level since late last November. It is approached a key retracement of the rally from the low in mid-October that is found near $0.6550. The dollar's surge proved too much for even the high-flying Mexican peso. The peso fell by about 0.55%, its largest decline in a month.

Asia Pacific

Japan reported a record trade deficit for January (~JPY3.2 trillion, or ~$23.7 bln) on a balance-of-payments basis. This drove the current account into a JPY1.9 trillion deficit, which was more than twice the median forecast in Bloomberg's survey. In January 2022, Japan reported a JPY580 bln current account deficit on a nearly JPY1.6 trillion trade shortfall. Next week, Japan will report the Fed trade balance. It has always (since at least 1975) improved from January, which has for just as long worsened from December. January and February have the strongest seasonal regularities. Japan's current account surplus was 3.5% of GDP in 2018 and 2019 and last year slipped below 2% and this year is expected to be closer to 1.6%.

The governor of the Reserve Bank of Australia suggested that while a pause in the tightening cycle is coming, it may not be quite here yet. Lowe said he has an "open mind" toward next month's meeting, citing the upcoming inflation, jobs, sentiment, and consumption data as key. A pause, he noted, would not preclude additional hikes if necessary. At the same time, Lowe pushed back against ideas that Australian rates would have to match the US. He argued that the moderation in Australian wage growth amid expanding supply, while households wrestled with variable rate mortgages will allow for a lower peak. After yesterday's RBA meeting and the tenth consecutive hike, Lowe noted that additional tightening will be needed. Australia's February jobs data are due next week. In January, full-time employment fell by 43.3k.  

The dollar closed above JPY137 yesterday for the first time since mid-December and pierced the 200-day moving average (JPY137.45) to approached JPY138.00. There does not appear to be formidable resistance until closer to JPY140. Initial support is seen around JPY137.40. The Australian dollar extended yesterday's decline as well, falling slightly through $0.6560 before rebounding to resurface above $0.6600. The $0.6620 area may offer the nearby cap. Note that it settled below the lower Bollinger Band yesterday, which is found near $0.6590 today. The greenback rose to nearly CNY6.9775 today, its highest level since late December. The CNY7.0 is the next key area. The PBOC seemed to signal caution as it set the dollar's reference rate at CNY6.9525, considerably lower than the CNY6.9581 median projection in Bloomberg's survey. Exporters were also reported to have been dollar sellers.

Europe

The increase in US short-term rates had a knock-on effect on the outlook for the European Central Bank. A 50 bp rate hike next week is baked in the cake, as they say. The swaps market shows greater confidence (85%+) of a 50 bp hike in May, which would bring the deposit rate to 3.50%. The market is more confident a 4.00% rate by the end of Q3. The implied policy rate at the end of the year rose to 4.03% from 3.95% on Monday. Still, the German two-year was practically flat yesterday and the US two-year note yield jumped 10 bp. The two-year rate differential to which the exchange rate seems sensitive to recently jumped to almost 170 bp. On Monday, as the euro approached $1.07, the US premium had slipped below 160 bp for the first time since before the US jobs report in early Feb.

German data were mixed today. On the one hand, industrial output jumped 3.5% in January, more than twice the gain expected, and the December series was revised to show a 2.4% decline rather than 3.1%. On the other hand, January retail sales disappointed, falling by 0.3%. Economists had looked for an increase. The sting may have been lessened by the sharp upward revision to December's slide. The 5.3% decline was revised to -1.7%. Note that yesterday Spain reported industrial output fell by 0.9% in January, while economist had projected a 0.2% increase. Today, Italy, reported its January retail sales jumped by 1.7%, well above the 0.2% expected increase and the largest monthly gain since last May.

The euro edged lower to $1.0525, a new low since early January. It has stabilized but has been unable to push above $1.0560, where options for 2 bln euros expire today. We note that the $1.0460 area corresponds to the (38.2%) retracement of its gains from last September's multi-year low near $0.9535. Sterling approached $1.18 today, its lowest level since last November. It has not been able to re-enter its Bollinger Band, where the lower end is about $1.1855. There are about GBP530 mln of options struck at $1.1870 that expire today. The $1.1650 area is sterling's (38.2%) retracement of its rally off late September's record low (~$1.0350).

America

Federal Reserve Chair Powell's comments sparked in increased in the swaps market expectation of the terminal rate from slightly less than 5.50% to a little above. The pricing in the futures market suggest about a 20% chance of a 5.75% terminal rate. By confirming that the Fed is prepared to speed up the pace of hikes, if necessary (depending on the "totality of data" and there is "significant data" before the March 22 meeting), the market upgraded the chances of a 50 bp hike from about a 25% chance to about a 45% chance. Even before Powell spoke, we thought it reasonable to expect the median forecast in the Fed's next Summary of Economic Projections to be lifted from 5.10% in December to 5.50%. While we argued in favor of a 50 bp hike at last month's meeting, we are concerned that a half-point hike now would be to panic in the face of a string of data that seems unrepresentative. We expect the February data will show a slower pace of job growth, less retail sales, and slower manufacturing output. However, because last February, average hourly earnings were flat, the year-over-year pace will likely accelerate to 4.7% from 4.4%, which may spook the markets but the monthly increase of 0.3% for the second consecutive month (after 0.4% average monthly increased last year).

Today's JOLTS report on job openings is more important than the ADP private sector jobs estimate. The JOLTS report is expected to show a reduction in January that does unwinds the lion's share of the December increase (572k). That said, the JOLTS report includes annual benchmark revisions and updated seasonal adjustments. The US also reports the January trade balance. The advanced merchandise balance was reported in late February, and it widened by about $2 bln, which may overstate the case a little for the final report that includes services. Recall that net exports were a drag on US GDP in H1 22 and a net contributor in H2 22. The January shortfall is expected to be in line with the $68.6 bln deficit average in Q4 22.

Shortly before the Bank of Canada's announcement Canada's January merchandise trade balance will be reported. The Covid-related improvement (rising commodity prices) that produced trade surpluses for Canada peaked around the middle of last year. It recorded small deficits last November and December, and likely did so again in January. In January 2022, the monthly surplus was about CAD$3.3 bln. Meanwhile, the conditions for the Bank of Canada's "conditional pause" announced at the last meeting (late January). The market is not convinced that the 4.50% current overnight target is the terminal rate. There is about a 50% chance of a hike in Q2 and is fully discounted by the end of Q3, though by the end Q4, it is slightly less than 80% priced into the swaps market.

The US dollar extended its gains to almost CAD1.3775 today to knock on the upper Bollinger Band. Recall that the US dollar settled last week slightly below CAD1.3600. The greenback reached its best level in four months as it approached the CAD1.3800 level. It has steadied after the initial gains in early Asia Pacific turnover. Initial support is seen in the CAD1.3730-40 area. The US dollar rose to almost MXN18.18 yesterday before settling near MXN18.1050. Again, the market has bought pesos on the pullback and the greenback has returned to almost MXN18.00 today. However, the intraday momentum indicators are stretched, and the market may be reluctant to extend the peso's gains independently of the dollar's overall performance.