USD TWI 0.6% lower despite Yellen's nod to March rate hike, suggesting exhaustion of buying pressure; NZD did not gain from USD fall, still at 0.7040 despite higher risk appetite, also weaker against the AUD at 0.9275

By Jason Wong

USD buying became exhausted, ending the week on a soft note, despite Yellen strongly signalling that a March rate hike was likely.  The NZD ended the week on an inexplicably weak note.

Friday’s trading session was all about waiting for Fed Chair Yellen and Deputy Chair Fischer to give the nod to a March rate hike after their fellow FOMC voters provided the same guidance earlier in the week.  They didn’t disappoint.  Yellen said that if inflation and employment data continue to meet the central bank’s expectations, “a further adjustment of the federal-funds rate would likely be appropriate” at this month’s gathering.

Fischer chimed in with “If there has been a conscious effort” to boost expectations of a rate rise, “I’m about to join it”, adding. “I think the advice that has been given by a large number of members of the Fed, of the FOMC, is correct, and I strongly support it.”  Yellen indicated that the process of raising rates “likely will not be as slow as it was during the past couple of years”.

Our calculations show that just over an 80% chance of a 25bp rate hike by the Fed mid-month is now priced, up from 25% a week ago.  Over the course of the week, an extra 13bps of tightening is now priced into the Fed Funds curve by the end of the year (around 2½ rate hikes now priced) and an extra 24bps by the end of next year (almost 4½ rate hikes priced between now and then).

It was a case of buy the rumour, sell the fact, with both the USD and US Treasury yields falling after Yellen’s speech was published. The USD major currency TWI ended the day down 0.6%, unwinding nearly half of the gains since NY Fed President Dudley’s mid-week nod to a March hike.

The NZD was surprisingly weak in the face of the USD reversal and higher risk appetite.  The VIX index fell 7%, taking it back down to a sub-11 level and helping the BNZ Risk Appetite index lift to a fresh 2½ year high of 81%. The NZD closed the week around 0.7040, some 6% below our short-term fair value estimate of 0.7470, which is about as stretched as it typically gets.  Traders might well be nervous ahead of an expected weak GDT dairy auction this week, where prices could easily fall 5-10%.  We think there is good support for the Kiwi at the 0.70 level and, to the extent that recent weakness might reflect a positioning shake-out, we wouldn’t be surprised to see some sort of recovery in the week ahead.

The soft NZD saw NZD/AUD close the week around 0.9275.  Since May last year, the cross has bounced off this similar level at least seven times.  A further break down from here would be very bearish from a technical perspective, but fundamentally we don’t see any good reason for the cross to fall much further.

EUR was one of the strongest majors, rising by over 1% to 1.0620.  This could reflect two factors – reduced perceived political risk in France, as Le Pen’s support slips in the polls, and some closing of short positions ahead of the ECB meeting later this week, where inflation forecasts are expected to be revised higher.  Reduced political risk is evident on the France-Germany 10-year bond spread, which has narrowed from 80bps to 59bps over the last couple of weeks.

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