FX Update: Fed priced to reach 5.00%. USD consolidation time?

FX Trading focus: Higher US treasury yields not driving much USD strength – just about the 150 USDJPY “barrier” or a sign of USD exhaustion?

The Bank of Japan felt forced to announce an unscheduled bond-buying operation to defend the 0.25% cap on the 10-year JGB after that level was violated overnight. Meanwhile, US yields posted strong new highs yesterday near 4.15%, a move that spilled higher still in early trading today to nearly 4.18% before settling several basis points lower. The move comes as USDJPY pressed on the 150.00 level in USDJPY, managing to spill over that level for around a minute before it was bashed back below – no word on whether this was official intervention that I can see. Could the Bank of Japan take the SNB approach of defending a specific level?

With the early 2023 Fed expectations hitting 5.0% (March FOMC meeting priced at 4.99% as of this writing after yields have retreated a few basis points from intraday highs), I wonder if the JPY could catch a break for a spell here – at least from the pressure of seemingly ever-rising US yields. Whether USDJPY specifically has found a peak here, a temporary peak in US treasury yields would certainly take some of the steam out of the broad upside pressure on the greenback.

The generally downbeat Fed beige book last night also encourages the notion that the market may have reached “peak Fed expectations” in pricing near certainty of a 75 basis points hike at the FOMC meeting on November 22 and strong odds of another 75 basis points at the December meeting that would take the Fed funds rate to 4.50-4.75%, less than fifty basis points from the big 5.0% rate. Yes, the Fed has made it clear that it anticipates that it will continue to hike next year even as the labor market weakens – if only to 4.4%. A rise of 0.5% in the unemployment rate could already mean the US is in recession, while a recent paper from the San Francisco Fed estimates that the unemployment rate needed to slow inflation (NAIRU) is perhaps 6.0%, far above what the Fed forecasts suggest (And making for a very ugly outlook for markets if this is the case).

So, we know the bar is high for the Fed to actually lower rate expectations, but the bar is also high for the market to take Fed expectations higher from here as long unless wage/core inflation data continue to surprise to the upside for another couple of cycles. Even a sideways trajectory in yields could bring a bit of USD consolidation, as long as risk sentiment also finds cheer on that development and earnings season (hitting full stride next week) doesn’t surprise too negatively. It’s tough to measure how much worse things need to get to move the needle when sentiment is already terrible.

Chart: AUDUSD
The Aussie has traded weakly as commodity prices have lost their way and the RBA has turned a bit more dovish, expected to only deliver 25 basis point moves at its monthly (no meeting in Jan.) meetings from here, with soft payrolls growth data overnight encouraging that notion (caution, it’s a very choppy data series). The 2-year AU-US yield differential is at record lows of over 100 basis points. Yield differentials don’t have to prove an important driver, especially in timing terms, but as Fed expectations have been a key driver of USD strength for this cycle, a period of consolidation may set in if we have reached “peak Fed expectations” for now – especially in relative terms, as the RBA/Fed differential is currently priced at near -150 basis points by March of next year, only to tighten a bit more thereafter. That view looks stretched. As for the technical situation, not much to discourage the bears yet, but we’ve seen some choppy price action after multiple tests lower. A break above the descending trend channel and through the 0.6350-0.400 area needed to suggest a larger scale back-up to at least 0.6500 and possibly 0.6600+. All of that would need for US yields to take a breather. If US yields continue higher at anything resembling their recent pace for much longer, we are likely headed toward a liquidity crisis somewhere in global market after another aggravated rise in the US dollar.