US bond yields & the dollar advance as pricing firms for a 25bps Fed hike. Is Powell or bond market right – will the Fed be forced to cut rates in 2H?

By Stuart Talman, XE currency strategist

As this is our first update following the Easter break, let’s look back to the conclusion of last week’s action.

Friday’s headline event for last week – US jobs numbers, whilst mixed, continued the theme of a resilient and tight labour market yet to display material softening as the Fed has raised rates at the fastest clip in over 40 years.

Jobs growth (non-farm payrolls) of 236,000 (vs expected 230K) and the unemployment rate ticking down from 3.6% to 3.5% (vs 3.6% expected) does provide enough ammunition for the Fed to implement another 25bps hike, however there are signs that US corporations’ demand for labour is cooling.

The ADP Employment change, JOLTS Job openings and weekly jobless claims data points dropped earlier in the week, all delivering downside misses. In addition, forward looking indictors of business sentiment and hiring intentions also signal the US labour market is tipping over under the weight of the Fed’s tightening.

Nevertheless, market pricing favours Jerome Powell and his FOMC colleagues lifting the Fed funds target rate to 5.00% – 5.25% on 03 May, now close to a 70/30 call in favour of a quarter-percent hike.

US bond yields have pushed higher over the past four trading days, delivering broad based US dollar strength and a basing pattern forming for the dollar index (DXY). A measure of the US dollar against a basket of six currencies (EUR has the largest weighting at ~58%), the DXY had fallen from the 105.80’s below 102.00 over the past 4 weeks, driven lower by falling yields as the market moved to dramatically reprice US rates amidst turmoil in the US banking sector.

Now that this crisis has been averted (for the time being), some of the re-pricing has been unwound, leading to rebounding treasury yields and a recovery in the dollar.

Following last Wednesday’s RBNZ induced false breakout, the New Zealand dollar continues to ease back into the range that has contained price action from mid-February. Spiking near 64 US cents following the RBNZ’s shock 50bps hike, Tuesday’s decline of around half-a-percent pushes the Kiwi back below 62 US cents.

Marking an early morning low a few pips above 0.6180, NZDUSD now trades near a 0.6140/80 support zone that, aside from the few days following the SVB headlines (08–10 MAR.), has buttressed the Kiwi throughout February and March.

The Kiwi benefitted from the US dollar failing to attract safe haven flows as turbulence in the US banking sector increased contagion risk, NZDUSD ascending through 63 US cents as the second quarter commenced.

The other catalyst – the bond market shifting to price in a Fed pivot for the second half of 2023. At their March lows, the Fed funds futures curve was calling for ~100bps of cuts before year-end…..current pricing now assigning a large probability that the Fed eases by circa half-a-percent.

This is at odds with the Fed, Jerome Powell commenting at his 22 March FOMC presser that the Fed does not expect to cut rates this year.

Should Powell prove the bond market incorrect, the US dollar will strengthen, the DXY will re-test critical resistance at 105.60/80 and the New Zealand dollar likely trades below the year-to-date low at 0.6084.

If the bond market is right, the Fed cuts rates in 2H, what then, for the dollar?

Well, that depends on the contours of the inevitable recession and whether the dollar attracts safe-haven flows.

Despite US equities rallying on Fed easing expectations, this is not a good scenario for the stock market and broader economy as rate cuts are required due to either a US recession, financial crisis or both.

A deep and protracted recession in addition to a widespread crisis (banking, credit and/or confidence) – the dollar likely remains bid.

A mild US recession followed by a rapid recovery, pro-cyclical currencies, including the New Zealand dollar likely hold up as the dollar weakens into a period of improving global risk sentiment.

Of course, this is a simple binary view that fails to account for a myriad of outcomes…..the outlook remains murky!

Shifting our focus back to the upcoming 24 hours, the week’s major event occurs overnight. US CPI for March is released, core inflation is expected to print at 0.4% month-on-month, still more than double the required reading to return inflation to the Fed’s 2% target.

An in-line or upside beat, resulting in the annualised core inflation rate printing above 5.5%, very likely locks in a 25bps hike.

The downside trajectory for inflation will be critical in the months ahead.

Should prices remain sticky, failing to meaningfully recede, the Fed may not be done hiking, or, at the very least, will hold the policy rate higher, for longer. This is bad news for US equities, the Kiwi and other risk sensitive assets.

The surprise production cut announcement from OPEC+ (weekend before last) propelling WTI crude back through US$80/barrel, provides the inflation fearmongers with a plausible scenario whereby inflation does not ease relative to current expectations.

The other market moving event for Wednesday is the Bank of Canada’s interest rate decision – widely expected to keep rate on hold at 4.50% having paused at the 08 March meeting.

It’s a quiet day for local/regional data releases, devoid of tier 1 data points.

Our near-term NZDUSD level to monitor is 0.6191, the 23.6% Fibonacci retracement of the February to March sell-off. Should price action fail to find a footing around this level, the odds increase that the year-to-date low at 0.6084 is tested through April.

Stuart Talman is Director of Sales at XE. You can contact him here.