Market Brief: Soaring US Yields Set Stage for Fed's 'Hawkish Hold'
The dollar is trading near a five-month high after data showed US wage growth accelerating, further reducing market odds on rate cuts this year. Yesterday’s update in the Federal Reserve’s preferred measure of wage growth saw the Employment Cost Index accelerate to the fastest pace in a year, adding to last week’s inflation data in forcing markets to question whether the central bank will be able to lower interest rates from what it currently sees as restrictive levels.
Two-year Treasury yields are holding above the 5 percent threshold and traders are now pricing in just a single rate cut in 2024, widening already-yawning interest differentials relative to other major economies.
With markets in Europe and Asia closed for holidays, the euro, British pound, Chinese yuan and Japanese yen are all trapped in relatively narrow trading ranges. This morning’s data releases could see volatility recover, with the Institute for Supply Management’s manufacturing gauge and the Job Openings and Labor Turnover Survey both set to land in thin liquidity conditions at 10:00.
The Canadian dollar is still on the defensive as yesterday’s disappointing gross domestic product print translates into wider rate differentials across the curve. Although the exchange rate has now breached our year-end target, we’re not sure losses will extend as far as some observers seem to fear. Although a slew of recent economic data releases have shown the economy slowing relative to its US counterpart, this has long been priced in, and the performance gap could narrow in the months ahead as real estate activity rebounds and exogenous demand helps boost Canadian exports and investment. Expectations for divergence between the two North American central banks might narrow over time as growth trajectories are revised toward more moderate levels, and a recovery in the loonie remains distinctly plausible.
On the face of it, this afternoon’s Fed decision should be a snoozer. The statement is likely to remain essentially unchanged, and Chair Powell’s data-dependent reaction function is already well understood. The rate-setting committee said last month that it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent”. Speaking at an event with the Bank of Canada’s Tiff Macklem in March, Mr. Powell said “The recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence. Given the strength of the labour market and progress on inflation so far, it is appropriate to allow restrictive policy further time to work and let the data and the evolving outlook guide us”. We expect similar messaging to emerge in today’s post-decision press conference.
But there’s a non-trivial chance of a dovish surprise. With investors crowded into long-dollar positions and braced for a hawkish shift, any hint of an easing bias from Powell could spark a reversal. Our assessment of the US economy points toward a loss in momentum, and the Fed chair could easily highlight any of a wide range of indicators that are showing signs of weakness as he argues for taking more time to assess underlying trends.
And an adjustment in balance sheet policy might trigger a Pavlovian response from markets. Like its major counterparts, the Fed has been winding down its assets at a fairly aggressive pace over the last year, but officials are becoming concerned that pace of “runoff” - currently set at around $60 billion per month - could ultimately lead to disruption in funding markets. Beginning with a speech from Dallas’ Lorie Logan in January and culminating in Chair Powell recently saying “it will be appropriate to slow the pace of runoff fairly soon,” policymakers have prepared markets for an imminent decision. A lower runoff cap might theoretically subtract from the tightening impulse in liquidity conditions, leading investors to take more risk, but there’s not a lot of evidence that global balance sheet reductions have negatively impacted markets - under most calculation methodologies, financial conditions are now easier than before the Fed began raising interest rates.
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