This morning the London session opens with the forex markets positioned for a risk-on day. There are some flows to the higher-yielding currencies and out of the safe-haven yen and Swiss franc but with risk events still on the agenda the market is not clear cut in which direction it is traveling just yet. What we do know is that the Fed has not derailed the markets and trends remain intact.
This is a quick recap of the big announcement made by the Fed last night: starting in mid-November, the Fed will reduce the pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities. The move was widely anticipated by the markets, so there were no surprises.
According to the central bank, inflation is also elevated due to supply and demand imbalances related to the pandemic and the reopening of the economy. At the following press conference following the statement release, Fed Chair Powell deflected any questions regarding whether the FFR would lift off but insisted that a rate hike cycle can only take place once they have reached their maximum employment mandate.
Powell added that the central bank can be patient on rate hikes, but it will not hesitate to act if necessary, and because the Delta variant set the economy on a different track, the Fed would act to new developments by speeding up or slowing down the asset purchase taper.
Many market watchers believe that the taper should conclude in H2 2022 with the reduction of $15bln in asset purchases and that rate hikes could begin as early as then. Getting a precise measure of full employment is not a simple equation with defined inputs. Instead, it is more of an ephemeral judgment call, so this leaves the door open for a very cautious Fed and possibly disappointment for those looking for rate hikes sooner than later.
The US 10-year – US 2-year spread is a long way from being in the danger zone (at or below 0%) and is definitely not steepening. The chances of the yield curves flattening are higher but there is little chance of market disruptions like we had in 2013 and 2018.
After the FOMC announcement, there was a slight uptick in the longer-term notes and bonds as the Fed is buying fewer securities now. And clearly, since the June 16th FOMC this year, the focus has been on the 2-year yields rising in line with expectations of a rate hike. After listening to Chair Powell answer questions about the jobs markets and the framework used to measure full employment, it is hard to judge how they are going to match the market expectations of a rate hike to curb inflation with a jobs market that is so different from pre-pandemic days. Full employment could take years to work itself out. Watching the participation rate may give the first clues.
The TLT tracks the 20-year Bond in an ETF and yesterday that came back to a well-trodden line on the chart. The pullback in bonds etc. is in-line with the Fed reducing their asset purchases but looking at the RRP market there is clearly a very large need for this collateral and now there are $15bln more Treasuries in the markets for the banks to scoop up. It will be interesting to see if the RRP auctions come down from their $1.3trln levels. Another signal to the markets when TLT comes down is a sense of risk-on. So, we should see equities and commodities have an even better day today too.
The US dollar has caught a bid in the run-up to the London session open but it is still trading in a well-defined range. If the US 2-year yield continues to rise today and is supported by rising longer-term yields, we could see the US dollar pop higher.
With a rising US dollar and a risk-on sentiment in the markets, the USDJPY can continue following the US rates higher. Today could be the day that we get a breakout of the bull flag pattern, so traders should be prepared for an aggressive trade to the upside. Unfortunately, the majority of traders on the ActivTrader platform are bearish in this pair.
Today, the British pound could go against the grain and appreciate against the US dollar. As a result of the Bank of England's bank rate decision today it will definitely have a price move. A hike of 15bps is expected and the BoE will signal it is looking to tighten monetary policy further. GBPUSD is likely to go sideways until the announcement, so prepare for some pound volatility around midday today.
We should also expect a close vote (5-4 or 6-3), reflecting concerns about persistent inflation shocks affecting inflation expectations. In the Bank's forecast, inflation will reach 5% in spring 2022 and remain above target into 2023. Though the tone is likely to remain cautious, a subsequent hike is anticipated in February, not December. Any pushback against raising rates further to combat inflation will be a problem for the markets.
Currently, the Aussie is caught between a bullish US dollar, a risk-on sentiment in the markets, and weakening Iron prices from China. The fact that the RBA was not Hawkish shows how the currency can be dumped by the markets when a central bank doesn’t do what the market expects.
We also need to be aware of the OPEC+ meeting conclusion, though they are unlikely to surprise the markets today.