The Trade Week Ahead - Rate Determinants

All macro-economic currency movements of late lead back to one source – US rate hike trajectories.

Whether it’s be emerging markets and the issue of USD-denoted debt, or the central bank differential of the ECB to the Fed for example or the ‘flight to safety’ on geo-political risks.

All, ultimately lead to the Fed and the US bond markets.

Fundamentally:

• Bond yields are driven by the expectation of monetary policy rates and just as importantly, ‘duration’ sometimes referred to as term premium. Expectations of policy are macro-economically driven and through central bank communication. Duration premium is a harder to quantify. Duration premium overall tends to be countercyclical – falling on growth, rising on recessions – which is another way of say it’s a ‘fear trade’. The bigger the risk the more demand for term premium. It also depends on inflation expectations even more so on when there is uncertain around future inflation. Now in the main inflation is the main driver however right now that doesn’t appear to be the case. The best example currently is the US 10 year, rates are rising but duration premium from global risk has pushed the rate but below 3%.

Bringing this back to the USD, US inflation has returned to the Fed’s second mandate of 2% inflation rate, the interesting risk here is the speed at which it has done this suggests inflation might not just ‘overrun’ (Fed’s jargon) the second mandate it could completely over shoot.

The consensus on US core-PCE come December is 2.2% and 2.4% come December 2019 as higher wages, energy and general cost lift core US inflation. Couple that with employment rates not seen since the 60’s (unemployment) and 70’s (employment change) and rate expectations jump significantly. Currently the Fed is forecasting 4 rates rises in 2018 (2 of which have already occurred), 3 in 2019 and 1 in 2020.

What is interesting is that short duration bonds like the 2 and 3 year are moving up and quick – even to the point that they are suggesting that ‘why wait to 2020’ idea is a real possibility – and I would agree. (i.e. If inflation does overshoot the speed at which the Fed hikes will come into question and 3 in 2019 could become 4 in 2019 instead of 1 in 2020).

This should attract carry trade investment and USD flows, the EUR, AUD and GBP cross are all facing weakness off the back of this point and something I see continuing in the coming months.

The Bank of Canada and the ECB meet this week and although neither are likely to move rates or even shift general communication – further confirmation that the Fed is really the only central bank to be actively shifting rates will see DXY continuing its match back to 100.

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