FX Update: Market complacent on FOMC

FX Trading focus: FOMC agenda: the SLR and the dot plot

The currency market seems to be holding its collective breath a bit more than the equity market on what the Fed will say tomorrow at the FOMC meeting, one that will include the quarterly update of economic forecasts and “dot plot” of policy rate forecasts from Fed members. Recent Fed rhetoric underlining that the Fed wants to stay the course for now and that any strong inflationary pick-up is seen as likely transitory means that we are very unlikely to see any strong upward revision in policy forecasts in the dot plot. But the Fed can still send a rather loud measure in the amount that it raises forecasts for growth and inflation and especially by lowering the unemployment forecasts. Remember that the last batch of forecasts came at the December meeting, before the Georgia Senate race results were known and before the subsequent stimulus package passed by the outgoing Trump and doubled up again by the Biden administration last week. And on the dot plot, a few more Fed members shifting to a 2022 lift-off forecast and several more suggesting that 2023 is in play could impress the market and send the US dollar and US yields higher. See the discussion of the 5-year Treasury yield below for additional thoughts on US yield moves. (For perspective, only one of the seventeen Fed members forecasted lift-off in 2022 and five in total expected a higher rate in 2023 than the current level, with three of those only suspecting that a single 25-bp hike would be likely). The market is pricing greater than even odds that the first hike comes in late 2022, with about three more priced for 2023.

The secondary issue has more to do with the hot button issue of the supplemental leverage ratio (SLR) rule and whether it will be allowed to expire at the end of this month as originally scheduled or extended for some time or indefinitely. As this article, for example, makes clear, the SLR issue is only one aspect of the overall challenging structure of the US treasury market and has little to do with what happens down the road later this year when treasury issuance will vastly outstrip the Fed’s current pace of QE purchases and likely overwhelm any domestic or even foreign buying interest. As Althea Spinozzi, our fixed income strategist, pointed out in this morning’s Saxo Market Call, the foreign interest (despite superior currency-hedged yields for US in Europe, for example), has been trending lower. For the short term, a failure to extend the SLR rule or an only temporary extension to end of Q2 or Q3 could spook the treasury market anew on the implications that banks will need to reduce their treasury holdings.

Chart: US 5-year yields and 5-to-30 yield curve slope
The 5-year yield in the US and how quickly it moves (most interesting direction is up) relative to other points on the yield curve should prove an interesting coincident indicator relative to what is going on in other markets on the other side of the FOMC decision and presser tomorrow evening. Remember that it was a multi-sigma move in the “belly” of the US yield curve of 3-7 years that generated significant volatility across global markets in late February, when everyone was looking for general yield steepening, the curve actually flattened for a few days. Certainly, yield curve steepening bets are likely extreme out there as this has been one of the “macro trades of the year” and patterns on the curve as much as and perhaps more than any shift, for example, in the nominal 10-year yield could prove the interesting plot twist tomorrow. Flattening together with risk off would be the most potently USD positive, while “nothing new” and a dovish Fed could see the USD bears trying to restart their engines for a new sell-off leg.