Market prices in more aggressive Fed tightening, 75bps this week and a likely follow-up move next month. US Treasury yields continue rise across the curve; 10-year rate approaching 3.5%

Global rates continue to soar as the market prices in more aggressive policy tightening ahead, with a 75bps hike by the Fed this week now seen as a shoo-in, and now a good chance priced that the RBNZ does the same next month. US equities have been choppy, trading in and out of positive territory. The USD DXY index has traded up to a fresh 20-year high. The NZD traded down to a fresh 2-year low just above 0.62 but GBP has performed worse, taking a peek below 1.20.

Soon after we went to print yesterday, WSJ Fed-watcher Nick Timiraos published an article stating that “A string of troubling inflation reports in recent days is likely to lead Federal Reserve officials to consider surprising markets with a larger-than-expected 0.75-percentage-point interest rate increase at their meeting this week.” What was remarkable was that less than nine hours earlier he had contributed to an article saying that “The Federal Reserve is likely to raise interest rates by a half percentage point this week, as anticipated…”.  The market put two and two together and immediately moved to price in a high chance of a 75bps hike, feeding through into a further ramp up in Treasury yields, and US equities closing on an even weaker note, with the S&P500 down 3.9%.

Other media copied the WSJ’s lead, and a 75bps hike would no longer surprise the market as it is now fully priced, with a follow-up 75bps hike in July given about a 95% chance. The market has woken up to the idea that with a 1% Fed Funds rate (upper bound) and 8.6% inflation, an aggressive normalisation of monetary policy is required and rates will have to quickly move above neutral to bring inflation sustainably lower. The Fed Funds rates is now priced to peak just above 4% in Q2 next year.

The more aggressive and front-loaded tightening cycle priced has fed through into the US Treasuries curve, with the 2-year rate up 6bps to 3.42% and the 10-year rate up 10bps to 3.46%. The re-pricing of rate expectations has been a global phenomenon, with rates much higher across Europe and elsewhere. Germany’s 10-year rate rose 12bps to 1.74% while, for a change, peripheral spreads to Germany have been relatively steady. ECB GC member Schnabel said “how we ultimately react to risks of fragmentation will firmly depend on the situation we are facing”, signalling that a new crisis tool is unlikely to be presented until it is considered necessary.

Closer to home, RBA Governor Lowe sounded a bit more hawkish in a media interview last night, saying that it would be “reasonable” to expect the cash rate to climb to 2.5% at some point.  He seemingly upgraded the inflation outlook, saying it could accelerate to as much as 7% by year-end, while the recent May MPS had inflation tracking up to “only” 6%.

The domestic rates market continues to be driven by global forces, with a massive lift in yields across the bond and swaps curve yesterday, to reach fresh multi-year highs. Curve flattening was evident, as short-end NZGBs rose as much as 22-23bps, while the 10-year rate was up 17bps to 4.23%.  The 2-year swap rate rose 27bps to 4.40%, while 10-year swap rose 16bps to 4.45%. July OIS closed at 2.68%, implying a 72% chance that the RBNZ lifts the OCR by 75bps at that meeting. The March 2023 90-day bank bill future rose a massive 35bps in yield terms, to 4.82%, equivalent to the OCR peaking at 4.5% or higher.

Overnight, the UK was an exception to the global rates move, with its 2-year rate actually down slightly and the 6bps lift in the 10-year rate being less than other key markets. As we noted yesterday, the UK might become the first major developed economy to enter economic recession and this could tame the BoE from adopting the US-style rate hike path. 

The UK labour market report was a mixed bag, with strong payrolls figures but an unexpected lift in the unemployment rate to 3.8%.  Average earnings ex bonuses rose a healthy 4.2% y/y, but plunged by 3.4% y/y when measured in real terms, the worst in two decades. In other economic news, US small business confidence barely fell in May. PPI inflation data were on the lower side of expectations but remained too strong for comfort, up 10.8% y/y for the headline and 8.3% for the core.

In currency markets, the USD has maintained its safe-haven bid and with the added benefit of surging rate hike expectations. The DXY index is trading at a fresh 2-year high of 105.4. GBP has been the weakest performer, given less interest rate support. GBP fell below 1.20 for the first time since the March 2020 liquidity vacuum at the height of the COVID19 scare.

Commodity currencies are all weaker, with the NZD printing a fresh 2-year low just above 0.62. The AUD is trading down at 0.6865. At the stronger end of the leaderboard, EUR has been surprisingly resilient holding its ground against the USD and trading at 1.0415.

The BoJ ramped up its bond buying activity yesterday to keep yields suppressed and even buying longer dated 30-year JGBs are they were showing signs of dislocation. The central bank bought 2.2 trillion yen (USD16.3b) of bonds in the operation, a record amount of bond purchasing in a single day, underlying the BoJ’s commitment, for now, in maintaining its aggressive policy stance. This policy continues to undermine the yen and USD/JPY has been hovering close to the 135 mark.

The economic event calendar in the day ahead is full. REINZ housing market data are expected to portray ongoing weakness in NZ’s housing market, with weak sales and falling prices, while NZ’s current account deficit should blow out further to 6.3% of GDP for the year to March. China monthly activity data for May will continue to be weighed down by lockdown restrictions in some cities.

Tonight, US retail sales is the key economic release, where the market expects a pullback in sales growth in May. The Fed’s latest policy update comes at 6am NZ time, where anything other than a super-sized 75bps increase in the Fed Funds rate would now be a surprise. Fed Chair Powell can’t possibly deliver anything other than a hawkish message, given the strong inflationary backdrop and the Fed’s determination to get on top of the problem. The market will be very jumpy in the hour or two after the release. Also watch out for headlines from ECB President Lagarde speaking, in the wake of a more hawkish pivot by the central bank and widening peripheral bond spreads.