Effective Fed funds was 2.44% on Friday for the sixth straight day on tight USD liquidity.
Next round of further tightening of USD liquidity likely to come in mid-June.
We still see value in hedging further out the FX forward curve, i.e. out to 6M-1Y.
Over the past two weeks, USD money-market conditions have tightened pushing up short-term USD rates. The effective Fed funds rate was 2.44% (6bp below the Fed's upper target bound) on Friday for a sixth straight day. The main cause of the upward pressure on short-term USD rates has been further tightening of USD liquidity. USD liquidity is primarily tightening due to the Fed's quantitative tightening (QT) but in April it was a significant rise in the US Treasury's cash balance that tipped the scale. The ongoing tightening of USD liquidity since Q4 17 when the Fed initiated its QT programme has also pushed up the implied O/N USD rate in EUR/USD FX forwards.
It is now evident to the market that reserve supply around USD1,600bn and an interest rate on excess reserves (IOER) at 2.40% do not necessarily produce an effective Fed funds rate close to the mid-point of the Fed's current 2.25-2.50% target range.
Looking ahead, we see three important events to keep an eye on with respect to USD liquidity. (1) From 17 June (when corporate tax payments are due) and until a resuspension of the debt ceiling, USD liquidity is set to tighten around USD100bn from the current level. (2) We expect the debt ceiling to be resuspended sometime around the end of Q3 (but we stress a high degree of uncertainty about this time). This would give rise to a large fall and subsequent rise in the US Treasury cash balance. (3) USD liquidity is set to be around USD300bn tighter when we come to year-end compared with the current level. See Chart 1 for our projection of USD liquidity towards year-end.
All other things being equal, we should see a further rise in the effective Fed funds rate above the current 2.44% level, which should also push up EUR/USD FX forwards. EUR/USD FX forwards were not priced for a tightening of USD liquidity in April. The market is likely to be alert ahead of the next round of tightening coming in June, which could push, for example, the 3M (NYSE:MMM) EUR/USD FX forward higher over coming months via a widening of the 3M EURUSD OIS basis. Note though that the Fed could try to mitigate such a rise by cutting the IOER 5bp (or more) at the 19 June meeting. The circumstances around the resuspension of the debt ceiling likely to take place in September and October are set to lead to a temporary easing of USD money-market conditions but this would be only short-lived and upward pressure on short-term USD rates should resume towards year-end.
We stick to our view expressed in FX Strategy - EUR/USD FX forwards: one down, three quarter turns to go , 2 April. Hence, we see value for EUR- and DKK-denominated investors in hedging USD assets further out the FX forward curve: out to 6M to gain the 12bp Fed cut priced at the September meeting and hedge the planned USD liquidity tightening or out to 1Y to hedge the year-end effect, further tightening in USD liquidity and gain from the additional 23bp Fed cuts priced on 1Y.
To read the entire report Please click on the pdf File Below..