Written by Marios Hadjikyriacos, Senior Investment Analyst at XM.com. An original version of this article can be found here.
Investors continue to reassess the trajectory of Fed interest rates. Under the hood, there’s been a quiet repricing of rate expectations this week, with the probability of a June rate hike edging higher and bets of rate cuts in the remainder of the year getting trimmed somewhat.
A strong batch of U.S. economic releases yesterday put a June rate increase firmly on the map as underlying measures of retail sales exceeded forecasts, alongside industrial production and homebuilder sentiment.
Similarly, there's been a stream of Fed officials on the wires lately and the common message is that it’s way too early to even discuss rate cuts.
Cleveland Fed President Mester went as far as saying she doesn’t think the Fed has reached sufficiently restrictive rates yet, clearly throwing her weight behind another hike next month.
However, Mester is a well-known hawk and does not vote this year, so traders were reluctant to take her words at face value.
In the markets, the unwind of rate-cut bets lifted U.S. Treasury yields, which in turn boosted the U.S. dollar through the interest rate differential channel.
The probability of a Fed rate increase in June currently stands near 20% and if traders start to view it more as a 50-50 coin toss heading into the event, there's a window for the dollar to extend its latest gains.
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With the dollar and U.S. yields creeping higher, one of the main casualties was gold, which sliced below the $2000/oz region.
The precious metal doesn't bear any interest to hold, so its appeal diminishes when yields rise and investors can earn higher returns on bonds.
The correction in gold has scope to continue if the odds of another Fed hike next month keep rising or rate-cut bets cool further, although it’s difficult to envision any huge losses either as the easing cycle has merely been delayed, not derailed.
Coupled with ongoing central bank purchases spearheaded by China, demand for bullion is unlikely to dry up.
Over in the equity arena, there’s been a ‘flight to quality’ lately, with investors rotating towards mega-cap tech shares that are seen almost as safe-havens in a rocky economic environment.
A handful of tech giants are essentially holding up the entire market, which raises red flags, reinforcing the warning signals from excessively rich valuations.
Crossing into Japan, the economy expanded by 1.6% in annualised terms in Q1, far exceeding analyst estimates.
And yet, the yen is getting slaughtered on Wednesday. Since the GDP data was solid, it seems the yen’s troubles are linked to rate differentials, as US yields are on the rise while Japanese yields have been smashed lower by a strong bond auction.
Still, the stronger-than-expected GDP report enhances the case that the Bank of Japan might take the next step in its tightening campaign as early as this summer, especially if Friday’s data releases show that inflation continues to heat up.
In the political sphere, investors are grappling with conflicting signals around the debt ceiling showdown after House Speaker McCarthy said a deal is “possible” this week even though the two sides remain “far apart” in the negotiations.
Markets are laser-focused on the risk of default in June, although perhaps the true risk is what happens after a deal is found, as the Treasury floods the system with bond issuance and potentially drains liquidity out of other markets such as equities.
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