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Mounting Fed Bets Cannot Propel Dollar Higher

ByXM Group
AuthorTrading Point
Published 02/20/2023, 05:55 AM
Updated 05/01/2024, 03:15 AM

    • Dollar unable to capitalize on ‘higher for longer’ Fed bets

    • Yen and gold feel the heat of rising US yields instead

    • Stocks remain resilient, but risk/reward is unattractive

  • Dollar lethargic despite Fed speculation
  • A series of powerful US economic data releases this month dispelled concerns about an economic slowdown, engineering a massive repricing of Fed policy. Incoming data revealed the labor market is still booming, consumer demand is resilient, and inflationary pressures are not abating fast enough - fueling speculation that the Fed needs to roll out bigger guns to win the war against inflation.

  • Fed officials have long argued they care most about services inflation excluding shelter, as they are confident that goods prices are cooling and that declining house prices will ultimately feed into rents. This inflation metric rose by 7.2% from last year, supporting the notion of a ‘higher for longer’ Fed.

  • Market participants responded by pushing up the expected ‘peak’ in Fed rates to a new cycle high of 5.3%, and by pricing out most of the rate cuts that were anticipated later this year. This repricing helped propel US yields higher, with the one-year US Treasury bill now yielding 5%.

  • Yet, the dollar’s advance was not impressive. Despite the quality of US data and the seismic moves in bonds, the dollar was lethargic, barely gaining any ground against the euro or pound. It’s an ominous sign when a currency cannot rally on good news, although in this case, the sluggishness might reflect the cheerful mood in stock markets instead of outright pessimism towards the dollar.

  • Yen and gold feel the heat

  • In the FX arena, the real victim of the Fed pricing and the resulting spike in yields was the yen, which continues to be shackled down by the Bank of Japan’s strategy that enforces a ceiling on domestic yields. Since the central bank does not allow longer-dated Japanese yields to trade above 0.5%, the yen mechanically weakens whenever foreign yields edge higher, as rate differentials widen against it.

  • Nonetheless, this dynamic is not necessarily a death sentence for the yen. With Japanese wage growth firing up and inflation already hot, there’s growing speculation the BoJ might raise the yield ceiling again next month - a farewell gift from outgoing Governor Kuroda at his final meeting. Such a move would alleviate some of the pressure on the yen, especially if global growth concerns resurface moving forward.

  • Gold prices have also been feeling the heat of rising yields. Bullion now has to compete with a risk-free rate of 5% on short-term Treasury bills, which has siphoned demand away from the precious metal that pays no interest to hold. That said, the Chinese central bank continued to raise its gold reserves in January, making it difficult to be bearish on gold while there are such whales active in the market.

  • Stocks claw their way back

  • Wall Street had a volatile session on Friday, with indices like the S&P 500 erasing some early losses to close nearly unchanged. It’s difficult to pinpoint exactly what triggered the turnaround, with one theory being that monthly options expirations helped contain the decline.

  • The meteoric rise of short-term options among retail traders has marked a regime shift for equity indices, as almost half of options volume is now on contracts that expire the same day. This has profound implications for markets. When options flow is net bullish, as was the case lately, it helps suppress volatility and put a floor under markets. However, this dynamic works in both directions - it can also amplify market sell-offs if sentiment turns bearish.

  • These flows help explain the sanguine mood in stocks, because the fundamentals are not very encouraging. Valuations remain expensive, with the S&P 500 trading above 18 times this year’s estimated earnings. Against a backdrop of negative earnings growth and yields marching higher, this is a dangerous cocktail for equities.

  • As for today, US markets will remain closed for Presidents’ Day.

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