Risk assets remain under pressure post-FOMC. Yield curves continue to flatten hard as markets pull forward rate hike pricing. Market now pricing almost 70% chance of Feb-22 RBNZ hike

Last week’s hawkish FOMC meeting continues to reverberate in financial markets.  Reflationary sentiment continued to unwind on Friday, with equities and commodity prices moving lower again, the US Treasury curve flattening hard and the USD strengthening.  In Australia, the market brought forward the expected timing of the first hike by the RBA to late 2022 while in NZ, the market now prices an almost 70% chance of a Feb-2022 hike. The NZD remained under pressure amidst the reversal in commodity prices and risk-off backdrop, making a fresh year-to-date low on Friday and ending the week around 0.6935.

The only real news on Friday night was St Louis Fed President Bullard’s interview with CNBC, in which he said his personal forecast was that the Fed would start raising interest rates in late 2022.  Of course, the Fed’s ‘dot plot’ indicated seven officials thought it would be appropriate to start raising interest rates in 2022 so it shouldn’t have been a complete surprise that Bullard, whose views have fluctuated between very dovish and very hawkish during his time on the FOMC, was one of them.  Nonetheless, the immediate market reaction was to take the USD and US rates higher again.  Bullard added that it would likely take “several meetings” to sort out the details around tapering.

In the bond market, yield curve flattening was the key theme again on Friday.  The 2-year US rate increased 5bps, to 0.25%, with the market bringing forward the first Fed hike to December 2022.  In contrast, the US 10-year rate fell 6bps, to 1.44%, below where it was before the FOMC meeting, while the 30-year rate fell 8bps, to just above 2%.  At face value, the yield curve flattening, in conjunction with further declines in inflation expectations (US 10-year ‘breakeven’ inflation -5bps to 2.24%), suggests investors have grown less concerned about the risk of high inflation.  Unwinds of positions are almost certainly exacerbating the market moves though and it remains to be seen how long this might take to play out.

Equity markets were down across the board on Friday, with the S&P500 losing 1.3%, the NASDAQ 0.9% and the Eurostoxx 600 down 1.6%.  Sector rotation continues, with the ‘reflation trade’ favourites (including banks, energy and materials) underperforming and tech stocks outperforming.  Likewise, commodity prices (ex oil) remain under pressure with, for instance, copper falling 1.8%, bringing its loss on the week to 8.6%.

The resurgence in the USD continued Friday, with the BBDXY making a two-month high.  Higher US short-term rates and rising risk aversion were part of the story behind the big move higher in the USD last week (+2% on a BBDXY basis).  There has also undoubtedly been position squaring as well, with investors unwinding popular short dollar trades after the Fed meeting.

Commodity currencies underperformed again on Friday, with both the NZD and AUD printing fresh year-to-date lows.  Both currencies were off around 1% on Friday, and close to 3% on the week, while the NOK and CAD were also off sharply (-1.4% and -0.9%) despite oil prices holding up.  The NZD ended the week around 0.6935 and the AUD around 0.7480.  The NZD/AUD cross remains tightly rangebound and ended the week around 0.9270.

JPY was the best performing of the majors, flat against the USD on Friday, at 110.20.  The EUR was off a relatively modest 0.3%, but that still left it to a two-month low of 1.1865.

Turning back to interest rate markets, Australia saw further upward pressure on short-end interest rates on Friday, with the market starting to increasingly challenge the RBA’s assertion that rate hikes were unlikely until 2024 “at the earliest ”.  The move gathered momentum after Westpac economist Bill Evans brought forward his call for the timing of the RBA’s first hike to early 2023.  The market has moved to price the first hike for the RBA by late 2022, with a further two 25bp hikes priced in by the end of 2023.  Australia’s 3-year swap rate increased 7bps on Friday, to a more-than-12 month high of 0.51%, following on from the previous day’s 7bp increase.  It seems likely the market will again start to challenge the RBA’s commitment to its 3-year yield target, by pushing the yield on the April-2024 bond above 0.1%.

With the market bringing forward rate hike expectations for the RBA and the Fed, New Zealand short-to-mid curve wholesale interest rates remained under upward pressure.  The 2-year swap rate increased 4bps on Friday, to 0.68%, taking its move on the week to +16bps.  Market pricing for the February meeting has shifted up to 0.42%, indicating around a two-thirds chance of a rate hike.  The market even prices a non-negligible 8bps for a November 2021 hike.  Like other markets, the NZ yield curve saw a sizeable flattening on Friday.  The 10-year swap rate fell 3bps, mimicking the preceding night’s move in US Treasuries.  This resulted in a chunky 7bp flattening of the 2y10y swap curve, to 122bps, its flattest level since February.

On Wednesday, New Zealand Debt Management will announce the government bond tender schedule for the month of July, and we think it will likely be increased, from the current $300m/week in nominal bonds to something in the region of $500m/week.  We suspect the RBNZ will keep its QE pace around what it is now ($200m this week), which would let it see how the market adjusts to needing to take down more bond supply.  This might provide a useful ‘dry run’ for when the RBNZ decides to stop the programme altogether.

Besides the NZDM announcement, there is little on the agenda for domestic data this week.  Offshore, attention is likely to return to Fed commentary, with 14 speeches lined up this week.  The highlight is Fed Chair Powell’s testimony to Congress on Wednesday morning.  Elsewhere, the ‘flash’ European PMIs on Wednesday night while the Bank of England monetary policy meeting is Thursday night.