Hawkish talk from Fed officials on Friday, several flagging a 50bps hike as a serious option. US yield curve continues to flatten. Equity markets brush off the hawkish rhetoric and risk-on tone builds

In case investors didn’t get the memo from the FOMC meeting on Thursday morning, there was a flurry of hawkish Fed speak on Friday, leading to a further lift in short-term US rates, a flattening in the yield curve and a (relatively modest) boost to the USD.  It didn’t do much to dent resurgent risk appetite though, with US equities extending their gains from earlier in the week.  The NZD closed above 0.69 for the first time since November amidst broader strength in commodity currencies.  Over the weekend, there have been reports that Russia and Ukraine “have almost reached agreement” on parts of a peace deal, which should see a risk-on tone to start the week.

Starting with the Fed, in an interview with CNBC on Friday, Fed Governor Waller put the market firmly on notice for a 50bps rate hike in the coming months, explaining it was only the uncertainty around the Ukraine war that persuaded him to vote for a 25bps hike last week.  “The data is basically screaming at us to go 50, but the geopolitical events were telling you to go forward with caution.”  Looking ahead, Waller said he was in “favour of front-loading out rate hikes…which would imply 50bps at one or multiple meetings in the near future.”  Meanwhile, Richmond Fed President Barkin said he was “very open” to a 50bps move if inflation doesn’t moderate as the Fed is expecting.  Finally, known hawk Bullard issued a statement explaining his dissent at last week’s meeting (he voted for a 50bps hike) and making his case that the Fed should hike the cash rate above 3% by the end of the year.

But perhaps the most telling comments came from Minneapolis Fed President Kashkari, long seen as the most dovish member of the committee, who has had a broader rethink about the inflation outlook and now sees another six 25bps hikes this year as a base case, in line with the median forecast on the ‘dot plot’.  Kashkari said current inflationary pressures could either be due to transitory factors persisting for far longer than originally thought or alternatively because the economy has entered a “high-pressure, high-inflation equilibrium”.  In the former case, Kashkari sees the Fed needing to take rates above neutral while the latter case would necessitate a “contractionary stance” (i.e. rates well north of neutral).

The discussion around a 50bps move shouldn’t be a huge surprise to the market given the ‘dot plot’ implied 7 of the 15 committee members saw at least one 50bps hike in their baseline forecasts for this year.  Nonetheless, the market pushed up the odds of a 50bps move at the next meeting in May to around 50%, with now 7.3 hikes priced in for the remaining six meetings this year.  The curve flattening trend continued, with the US 2-year rate rising 2bps against a 2bps fall in the 10-year rate, to 2.15%, and a 5bps fall in the 30-year rate.  We reported on Friday morning that the 5s10s US Treasury curve had briefly inverted and it was followed on Friday night by the 3s5s curve.  The market is already pricing in some modest rate cuts for the Fed beyond 2023 (the same is true, albeit to a lesser extent, for the New Zealand curve).

Equity markets shrugged off the hawkish talk from the Fed, with the S&P500 increasing 1.2% and the NASDAQ 2.1% on Friday, extending their gains on the week to 6.2% and 8.2% respectively.  Likewise, the EuroStoxx 600 was up 0.9% on Friday and 5.4% on the week, recovering all its losses since Russia’s invasion of Ukraine.  It’s still an open question why equity markets have rallied hard after one of the most hawkish Fed meetings in the past 20 years.  The passing of the event risk might have something to do with it while some commentators have suggested Powell’s message of confidence in the economic recovery was reassuring to investors, although, given the Fed’s recent forecasting track record, one should probably treat this with caution.

Instead, the improvement in market sentiment is likely related, at least in part, to growing market optimism in a ceasefire between Russia and Ukraine.  Indicative of this, Ukrainian 10-year USD bonds have rallied from around 20 cents in the dollar a fortnight ago to around 40 cents now while Brent crude oil has reversed most of its post-invasion gains.  Over the weekend, Turkey’s foreign minister said that Russian and Ukrainian negotiators “have almost reached agreement” on four aspects of a peace deal, including Ukraine committing not to join NATO and declaring itself neutral, although the future status of Crimea and the Donbass region would need to be taken up by Putin and Zelenskiy.  The US, for one, is still sceptical about Russian motives, Secretary of State Blinken saying on Friday that Russia was showing little sign of willingness to stop the war.

Late last week, Russia made $117m in USD coupon payments, with JP Morgan processing these after consulting with US authorities.  According to Bloomberg, there is a carve out in place allowing US entities to receive payments from the Russian government until May 25th, which allowed JP Morgan to facilitate the payment on behalf of Russia.  While all the credit rating agencies now rate Russian debt deep in ‘junk’ territory, news of the coupon payment has seen Russian USD bonds rally from around 20 cents in the dollar to around 50 cents now (still implying a high chance of default).

Also helping market sentiment has been the Chinese government’s midweek announcement that signals a shift away from its tough regulatory stance towards a more market-friendly policy approach.  The Hang Seng has recovered 17% from its 5½-year lows seen on Tuesday.

In currencies, the USD was stronger against the EUR and JPY on Friday but weaker against the commodity currencies.  USD/JPY hit a fresh 6-year high, closing the week at 119.16.  In contrast, the improvement in risk appetite helped propel the NZD and AUD to fresh multi-month closing highs.  The AUD was up 0.5% on Friday (1.7% on the week), to 0.7414, while the NZD gained 0.4% (1.5% on the week), closing the week above 0.69 for the first time since November.  NZD/JPY ended the week with its highest close since 2017, at around 82.30.

In central bank news, the Bank of Japan kept its policy settings unchanged, as expected, with Kuroda batting away suggestions it might consider tightening policy.

Trading activity was quieter in the domestic rates market on Friday, with the 2-year swap rate unchanged on the day, at 3.01%, and the 5 and 10-year rates increasing 2bps. Global forces continue to dominate at the longer end of the curve, amidst a very high correlation between NZ and US 10-year rates over the past few months.  The 10-year swap rate is 72bps higher this year and trading at 3.36%.

Besides developments in Russia-Ukraine talks, focus this week is likely to be on commentary from Fed officials.  Powell is speaking tonight while Williams, Daly, and Evans are among those speaking later in the week.  The European PMIs are the main data of interest in what is otherwise a quiet week for economic releases.