Risk sentiment positive on improving debt ceiling narrative, equities climb. Hawkish Fed-speak supports higher bond yields and a higher US dollar. Market re-thinking the probability of a Fed pause; odds for 25bps growing

By Stuart Talman, XE currency strategist

The improving narrative around a debt ceiling deal has been the key driver of sentiment this week, however whilst the Nasdaq logs fresh 13-month highs and the S&P500 approaches an important test of 4200 resistance, the equity sensitive New Zealand and Australian dollars have failed to capitalise.

The Kiwi’s rebound from the heavy selling across the final two days of the week has stalled at the 100-day moving average, reversing from Wednesday’s high in the 0.6270’s, falling around two-thirds-of-a-percent through Thursday to trade within a few pips of 62 US cents.

Whilst NZDUSD price action continues to be described as choppy and range-bound, there are signs that the Kiwi may be setting up for a re-test of the lower bound of the 0.6100 – 0.6300 range that has contained much of the past three months trade.

So, why is the Kiwi struggling to perform in a risk-on environment amidst positive dent ceiling news flow?

US bond yields are on the rise.

The yields on both the Fed policy sensitive 2-year bond and the benchmark 10-year bond have both climbed for a fifth consecutive day, poised to break-out of the upper bound of respective two-month ranges.

In turn, this has supported recent US dollar outperformance – the dollar index (DXY) testing key 101.00 support on multiple occasion over the past few weeks to ultimately base and now ascend back to the mid-point of the 101.00 – 105.80 range that has evolved from late December.

Why are bond yields rising?

It may have been premature to call a Fed pause following the Fed funds target rate been lifted for a 10th consecutive meeting to 5.00% - 5.25% on 03 May.

The market has been subjected to a torrent of Fed-speak over the past half-dozen trading days.

The key takeaway – most Fed officials are still uncomfortable with the mix of elevated inflation and a resiliently tight labour market and clearly do not subscribe to an imminent pause nor the bond market’s pricing of multiple rate cuts through the latter stages of the year.

The Wall Street Journal’s Nick Timiraos, widely regarded as the mouthpiece of the Fed, released an article Thursday following interviews held with Dallas Fed President Lorie Logan and newly nominated Fed Vice-Chair, Phillip Jefferson.

In reference to Logan’s comments, Timiraos writes:

….a key centrist on the Fed’s policy-setting committee, suggested that barring further weakness in the economic outlook, she would be prepared to lift the benchmark federal-funds rate by a quarter-percentage point at the central bank’s June 13-14 meeting.

Timiraos later comments:

Ms. Logan said she didn’t see enough evidence that inflation was firmly on track to reach the central bank’s 2% inflation target because much of the recent improvement has come from falling energy prices and because tight labour markets could continue to support income and spending growth that fuels higher inflation.

Fed Governor Jefferson struck a more balanced chord, presenting arguments for both a pause and further tightening, referencing the long and varied lags of monetary policy’s impact on economic activity.

 A week ago, market pricing assigned a ~10% probability of the Fed hiking for an 11th consecutive meeting. Now, this has risen to almost 40%. 

This is the primary reason why US bond yields are stronger…..a lack of additional US banking sector stress a secondary factor.

Against its other major peers, the Kiwi’s net movement through Thursday has been modest, gaining less than a quarter-of-a-percent against the EUR, GBP, JPY and AUD.

Yesterday’s local session brought the release of the Treasury’s budget and across the Tasman, April employment numbers.

With a focus on cost-of-living relief and reconstruction spending following the severe weather events, the budget will deliver a larger deficit. Add in increased migration and tourism, the New Zealand economy may be better placed to avoid a recession as higher borrowing costs impact households and businesses.

This likely prolongs inflation pressures requiring the RBNZ to keep the foot on the tightening pedal in the short to medium term.

A 25bps hike to lift the OCR to 5.50% at the 24 May meeting is a forgone conclusion.

This is one factor that has supported NZD strength versus the AUD through May.

Weak Aussie jobs also assisting in driving NZDAUD back to the upper bound of the 6-week range between 0.9150 and 0.9440.

Job creation unexpectedly declined (-4.3K vs 25K, expected) whilst the unemployment rate ticked up from 3.5% to 3.7% (3.5% expected). Following on from solid wages growth earlier in the week that was not as strong as expected, the week’s data raises questions over whether the RBA will hike through 4% at its June 6 meeting.

Given the Australian Bureau of Statistics employment report utilises a flawed sample rotation model, we could very well see jobs growth rebound through May.

The monthly CPI release on 31 May will likely be the deciding factor in the RBA’s selection between on-hold or a quarter-percentage point rise. Market pricing is heavily in favour of the policy rate held at 3.85%.

The bar is set lower for a hawkish RBA surprise relative to the RBNZ….therefore we favour NZDAUD topping out somewhere in the 0.9450 to 0.9550 region.

Looking to the day ahead, local trade balance and CPI for Japan are released during the Asian session. Canadian retail sales is the sole tier 1 data point during offshore action.

More central bank speakers are scheduled for Friday, headlined by Fed Chair Powell’s participation in a panel discussion titled Perspectives on Monetary Policy. Any comments that imply it’s a close call between a pause and 25bps at the next FOMC meeting likely extends US bond yields and the dollar’s run higher.

A soft weekly close below 62 US cents could portend a re-test of the lower bound of the three-month range, next week.

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