FX Update: Could the Fed change its tightening approach?

FX Trading Focus: Headline risk very much a two-way affair. Yields in focus. ECB jawboning QE end.

Headline risks are very much a two-way affair. What one headline giveth, the next headline can taketh away, as we discovered yesterday when purported Russian troop movements away from Ukraine and signs of a more diplomatic tone from Russia were seen as a de-escalation of conflict risks of sufficient magnitude to trigger a significant risk-on rally. The US dollar reversed back to weakness, the JPY reversing harder so in the same direction, and gold and crude dropping sharply as well. IT doesn’t seem to matter much that NATO’s general secretary has stated that the Russian presence close to Ukraine’s border continues to build and that Ukraine’s president Zelenskiy said Ukraine saw no signs of Russian withdrawal. Today, Russia insisted again that it seeks reassurances that Ukraine will not be allowed to join NATO. The situation looks far from resolved and could go anywhere next. Meanwhile…

Yields in focus again as the next hurdle for global markets. We had a robust discussion of the outlook for the Fed and the implications of rising yields on this morning’s Saxo Market Call podcast which featured Saxo CIO Steen Jakobsen. We noted that the Fed will have to continue hiking and staying at or ahead of market expectations for policy tightening “until something breaks” with that something being the economy and the breaking being a recession. The latter could be incoming as soon as late 2022. And as I hinted at between the lines in a tweet today, it is difficult to determine whether this cycle will resemble previous ones in terms of requiring an actual yield curve inversion for heralding an incoming recession in a year’s time or more, give that the yield curve is so low and that its’ peak steepness (of just above 150 bps) before the aggressive flattening that has unfolded since last spring was far below any prior cycle (the steepness reached over 260 basis points in 2003 and 280 points post-GFC). Those steepness levels were made possible by a 10-year rate that was above 400 basis points in the earlier example and above 350 basis points at peak steepness in 2010. In Japan’s experience, the JGB yield curve has never inverted since 1991, only approaching an inversion in 2016 before the BoJ implemented yield-curve-control.

In any case, the political backdrop requires that the Fed cannot surprise on the dovish cycle until inflation has fallen very significantly. This should mean that the market’s pricing of over 40 basis points of tightening at the March meeting essentially requires that the Fed move 50 basis points at that meeting unless it chooses to surprise with an intermeeting hike.

For next steps for the US dollar and Fed expectations, watching today’s US Retail Sales data for January with interest after a bad miss in December (which was probably part omicron, part forward pulled holiday shopping into October and November because of widely covered shortages of popular gifts?). But the January number may also be omicron-impacted as we possibly need to wait for March-April data for a full read on “post-covid” levels of economic activity.

And later we have the FOMC minutes, which could feel a bit stale given we have seen Fed jawboning from voting members since then, unless the minutes show clearly that the Fed is considering doing more than is already baked into expectations (quantitative tightening schedule, size and pace of hikes, etc.)

ECB members buying “optionality”. The Bank of France’s Villeroy (also of the ECB governing council) joined his colleague Klaas Knot in seeing an end to ECB QE by the end of Q3 this year, with this move not necessarily indicating that the ECB should immediately then look to lift rates. As someone on Twitter suggested, this looks like some on the ECB wanting to buy some “optionality” in the event that inflation remains embarrassingly elevated over the coming six to nine months and requires a more resolute shift into tightening mode.  Villeroy is normally a rather middle-of-the-road voice on the hawk-dove spectrum at the ECB, relative to the pronounced hawk Knot, so this looks like a slight hawkish shift, all other things equal.

Chart: GBPUSD
We discussed yields and the yield curve this morning on the Market Call podcast as noted above, and a comparison of selected yield curves shows that the UK yield curve is the closest of the major DM yield curves to achieving an inversion, with the 2-10 Gilt yield spread at sub-10 basis points this week. Indeed, the forward economic outlook for the UK looks dim, given the incoming fiscal impulse cliff and supply constraints there. Sterling showed signs of turning lower versus the Euro as the ECB finally signaled that it will review its stance on inflation at the March ECB meeting, but there has been no follow through lower for sterling. The GBPUSD chart is stuck in limbo after a significant rejection of the bear trend in December that has yet to resolve higher still or back lower – watching 1.3750 to the upside and the sub-1.3400 pivot to the downside for next steps, only preferring the downside if risk sentiment continues to deteriorate significantly again.