Fed to Deliver a Telegraphed, But Still Hawkish Skip

Markets

The recent build-up toward a hawkish Fed skip at today’s meeting resulted in an interesting technical positioning. US yields added another 6.2 (5-y) to 3.6 bps (2-y). This bring yields across the curve with striking distance of cycle peak levels. The 5-y and 10-y yield at 4.52% & 4.36% even temporarily hit a new top, reaching levels not since 2007. A higher real yield again was the main driven. It’s up to the Fed whether the market will continue a journey in ‘uncharted territory’, at least since before the financial crisis. Even after the ECB last week signaled a pause, the picture in the EMU, especially Bunds, isn’t that different. Yields also added between 3.5 bps (5-y) and 2.3 bps (30-y). Especially for longer maturities the peak levels from March are not that far away. Global bond investors continue to adapt positions for a period of policy rates to stay higher for longer, combined with an expected further reduction of global (excess) liquidity. Higher (real) core yields only had a modest negative impact on equities (S&P 500 -0.22%, EuroStoxx -0.07%). The picture for the dollar was fairly neutral. DXY closed (105.15) well off the intraday lows, but daily gains were negligible. EUR/USD failed to hold an early jumped north of 1.07 to close slightly in red at 1.0678. USD/JPY continues to challenge the 147.95 resistance, even as US Treasury Yellen indicated that any intervention in the yen aimed at smoothing volatility would be understandable. Brent oil after the recent run finally corrected back below $95 p/b (currently $93.5 p/b).

The Fed is expected to deliver a telegraphed, but still hawkish skip (5.25%/5.50% target range). However, with the decline in headline inflation at risk of slowing down, amongst others, due to a higher oil price and US economic growth holding up well, there is little reason for Fed governors to change the dot plot signalling an additional 25 bps step later this year. The higher for longer mantra might be reinforced by a further scaling back of rate cut expectations for end 2024 (4.6% in June). Fed governors also might raise their standing assessment on the 2.5% long term equilibrium rate. If so, it would be a clear confirmation that monetary policy has entered a new era. At the press conference, we don’t expected Fed Chair Powell to change its message from June in a profound way. From a bond market point of view, question is whether the tone of the Fed will be hawkish enough to force a break beyond recent cycle yield peak levels. At least the downside in yields should stay well protected. The dollar likely will stay in the drivers’ seat. We especially watch for a break higher in USD/JPY. For EUR/USD 1.0635/32 remains first reference. A strong dollar and the prospect on ongoing tighter global liquidity also gradually could put some more pressure on risky assets. Decision CET 20:00. Press Conference CET 20:30. Both UK headline (0.3% M/M; 6.7% Y/Y from 6.8%) and core inflation (6.2% vs 6.9% and 6.8% expected) this morning printed sharply lower than expected, fueling the debate on a pause within the BoE for tomorrow’s policy decision. Sterling tumbles with EUR/GBP at 0.8655 from 0.8320 before the release.

News and views

The Institute of International Finance published its quarterly debt monitor yesterday, titled “in search of sustainability”. Total debt (sovereigns, corporates and households) rose from $306.2tn in Q1 to $307.1tn in Q2, setting a new high. Total debt to GDP rose from 335% to 335.9% (vs 361.5% peak in Q1 2021). The lead author of the report, Tiftik, is concerned that countries will have to allocate more and more to interest expenses which will have long-term implications for countries’ funding costs and debt dynamics. He is especially concerned about a rise in interest expenses for local currency emerging market debt: “The traditional (debt restructuring) tools that we have are largely designed to address external debt vulnerabilities, leaving emerging markets in the middle of the vicious cycle of debt and inflation at the cost of a sharp decline in potential growth.”

Polish newswire PAP quoted National Bank of Poland governor Glapinski as saying: “After this adjustment, the room for further interest rate cuts has narrowed considerably, although it will continue to be there with incoming data”. Glapinski thus aligns with earlier comments from both government officials and other central bankers that the NBP needs to be careful with shocking rate cuts like the 75 bps move earlier this month as it leaves the Polish zloty extremely vulnerable. EUR/PLN surged from 4.45 to 4.70 in the aftermath of that decision. At the next October meeting – ahead of elections – a status quo or a max 25 bps rate cut is the likely outcome.