Written by Marios Hadjikyriacos, Senior Investment Analyst at XM.com. An original version of this article can be read here.
There is a sense of caution in the air, with equities sliding yesterday and the dollar finding some demand through the safe-haven channel.
Conviction among traders seems low as several risks continue to cloud the outlook, while some classic correlations between asset classes have broken down this month.
Expectations on the Fed’s rate path have changed quite drastically, in a higher-for-longer direction. Market pricing currently assigns roughly a 50% probability for the Fed to raise rates by July, while the rate cuts that were baked in for the remainder of the year have been mostly unwound following a streak of encouraging data releases.
This recalibration of the trajectory for interest rates was clearly reflected in the dollar and US yields, which have been grinding higher in the last couple of weeks.
Above: EURUSD at daily intervals.
However, equity markets have turned a blind eye, with the tech-heavy Nasdaq rallying in unison with yields. That’s strange as rising yields are theoretically bad news for riskier plays like stocks.
It seems that stock markets are no longer trading the Fed, even though the dollar and rate-sensitive assets like gold are still tuned in.
With the dollar on the verge of making a comeback, emboldened by the rethink around the Fed’s rate path and some cheerful business surveys yesterday, traders will keep a close eye on the minutes of the latest FOMC meeting later today.
The underlying question is whether further tightening is on the table, which Fed members currently seem split on.
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In the political sphere, the debt ceiling negotiations seem to have stalled lately and nerves about a US default are rising.
Admittedly though, this might not be the true risk for markets. A catastrophic default suits neither party, so some compromise will ultimately be found even if the government shuts down. This showdown is a political game of chicken, and investors are fully aware.
Instead, the real risk is what will happen after a deal is reached. That’s when the Treasury will scramble to raise its cash levels, by sharply boosting borrowing and flooding markets with newly-issued bonds. This process can amplify the effects of quantitative tightening, draining liquidity out of the financial system and effectively ‘sucking the oxygen’ out of the room.
The bottom line is that when a debt ceiling deal is eventually reached, it might be a ‘sell the news’ event because of its negative implications for liquidity flows, leaving riskier assets such as stocks and cryptocurrencies vulnerable this summer.
In the UK, inflation numbers for April came in way hotter than expected. The core CPI rate defied forecasts that it would stay unchanged and instead stormed higher to hit a new three-decade high, reigniting concerns that the Bank of England has not done enough to extinguish inflation.
Sterling initially received a boost as traders raised their bets on continued rate increases by the central bank, but those gains quickly evaporated, perhaps on the realization that the BoE might be forced to hike the British economy into recession to squash persistent inflationary pressures.
Over in New Zealand, the local currency tanked following the Reserve Bank’s decision. Even though the RBNZ raised rates, the vote was split with some members favoring no action, and the overarching message was that this is probably the peak for rates. Zooming out, the growing signs of a slowdown in China are also detrimental for commodity-linked currencies like the kiwi.
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