G10 FX Weekly: Our Favoured H2 Trades After the Central Bank Deluge
By Richard Jones
Summary
Market Implications
Introduction
June has seen a flurry of central bank rate hikes. And as a volatile quarter for markets ends, we examine the monetary policy landscape and the market implications for H2 2023.
For us, the standout trades in FX and rates are bullish 2-year bonds in both the US and Germany and bearish the pound.
We think yields are near their peaks in both markets, inflation is subsiding, and that both the European Central Bank (ECB) and the US Federal Reserve (Fed) have almost finished tightening.
Therefore, we like to scale into long positions in the short end of both markets. Deeply inverted yield curves in the US and Germany, pointing to recession, underscore our conviction.
The Bank of England (BoE), however, is in a much trickier situation. UK inflation is still rising, and an economic slowdown looms. The market prices significant additional BoE policy tightening to tame inflation. Hiking rates into a recession will undermine the UK economy, and stagflation is a real threat.
We think this macroeconomic backdrop will hurt the pound and, therefore, that sterling will underperform most G10 counterparts.
The G10 Central Bank Landscape
US Federal Reserve (Fed)
The Fed has tightened policy aggressively over the past 12-15 months, raising the Fed Funds Target Rate (FFTR) from 0.00%/0.25% to 5.00%/5.25%. The FFTR is at the highest level since 2007.
Despite this concerted tightening cycle, the Fed paused earlier this month.
The?Summary of Economic Projections ?(SEP) accompanying the Fed’s decision called for another 50bp of tightening, a message Fed Chairman Jerome Powell?underscored ?in his Congressional testimony last week.
Although many have characterised the Fed’s messaging as hawkish, given the SEP, my colleague Dominique Dwor-Frecaut?argued ?that the meeting produced a dovish outcome.
The market seems to agree, pricing the Fed hiking cycle very near its end. There is a ~78% probability of another 25bp hike at next month’s Fed meeting, but very little expectation beyond this for additional tightening. Markets see the FFTR peaking at 5.25%/5.50%.
Powell and other central bankers attended the?ECB’s Forum on Central Banking ?in Sintra, Portugal, this week. The Fed chair?reiterated ?that the SEPs call for at least two more rate hikes this year.
European Central Bank (ECB)
Like the Fed, the ECB has tightened policy materially over the past year or so, raising its Deposit Rate from -0.5% to 3.5%. At its most recent meeting on 15 June, the ECB hiked 25bp.
Since the rate decision, ECB messaging has tilted slightly hawkishly.
Last week, the ECB’s Isabel Schnabel?said ?the Governing Council should err on the side of raising rates too far rather than too little, adding that inflation risks are tilted to the upside.
In contrast, ECB Chief Economist Philip Lane?said ?he expects inflation to fall ‘fairly quickly’ to the central bank’s 2% target. Lane also said much of the ECB’s hiking is already done and struck a non-committal, wait-and-see tone regarding the September rate decision.
In Sintra, Christine Lagarde?echoed ?Schnabel’s messaging. She said it is too soon to declare victory over inflation and that another rate hike is coming next month, with further tightening afterwards also likely.
This messaging validates market expectations for a hike next month, with another in September or October.
Bank of Japan (BoJ)
Unlike its US and Eurozone counterparts, the BoJ has kept monetary policy steady. Its policy rate has been stuck at -0.10% since 2016.
In April, Governor Kazuo Ueda assumed leadership of the BoJ. Despite this change, the accommodative monetary policy mix of a sub-zero policy rate and?yield curve control ?has remain unchanged.
At its most recent meeting on 16 June, Ueda?repeated ?that he expected core inflation to slow below 2% towards the middle of the current fiscal year ending in March.
Market pricing foresees no change in BoJ monetary policy. In Sintra, Ueda?flagged ?sub-2% underlying inflation in Japan as justification for keeping rates on hold.?
Bank of England (BoE)
The BoE is among the most aggressive G10 central banks in tightening monetary policy, with its policy rate rising from 0.1% to 5.0% since November 2021.
Last week, policymakers surprised markets by raising rates by 50bp, against a consensus expectation of 25bp.
Unlike most of its G10 counterparts, the BoE faces rising inflation. The most recent headline and core CPIs were both higher than the previous readings, forcing BoE aggression.
The market also expects more tightening in the UK than the US and Eurozone. It currently prices another ~120bp of rate rises in the next six months or so, with the policy rate set to peak above 6%.
Problematically, the current UK macroeconomic backdrop undermines BoE credibility, as investors fear the bank is falling behind the curve. Its most recent move looked panicked and reactive.
My colleague Henry Occleston?described it best : BoE credibility is ‘in the dirt.’
Swiss National Bank (SNB)
The SNB has also tightened considerably, abandoning its negative interest rate policy in the process. The SNB Policy Rate has risen from -0.75% roughly a year ago to now 1.75%.
On 22 June, Swiss policymakers hiked 25bp, matching the ECB the preceding week.
Last weekend, SNB President Thomas Jordan?said ?the central bank will probably have to raise rates again to combat inflation.
This is a key dynamic for Swiss monetary policy. As a small, open economy where trade is critical, the exchange rate is a central part of SNB monetary policy. As such, the SNB will be keen to match any further ECB tightening.
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Jordan emphasised this in his most recent comments, saying that the SNB can also influence consumer price growth by allowing the Swiss franc (CHF) to strengthen.
The SNB has sold foreign currencies in the market to support the CHF, with Jordan asserting that this ‘protected us from imported inflation.’ At 2.2% YoY, Switzerland has the lowest headline inflation reading in the G10.
Ahead, the market prices a high probability of an additional 25bp of tightening by year-end, with the Policy Rate currently expected to peak at just above 2% early next year.
Bank of Canada (BoC)
The BoC has hiked nine time since March 2022, taking its policy rate from 0.25% to 4.75%.
The most recent hike was 25bp this month, which was a surprise, as the markets priced a ~45% probability of a rate rise of this magnitude.
In?the accompanying statement , the BoC said ‘[o]verall, excess demand in the economy looks to be more persistent than anticipated’ and ‘that monetary policy was not sufficiently restrictive to bring supply and demand back into balance and return inflation sustainably to the 2% target.’
Policymakers also noted the slight uptick in YoY headline inflation, from 4.3% in March to 4.4% in April. This was the first time since June last year that inflation edged higher than the previous reading.
A further 25bp of rate increases is fully priced for this year, probably at the September meeting, with the BoC policy rate priced just above 5% by year-end.
Three Favoured Trades for 2H 2023
Given the central bank landscape, three trades stand out to us for 2H 2023. These trades are long US 2-year bonds, long German 2-year bonds, and short GBP.
Long 2-Year US Bonds
The 2-year US Treasury (UST) yield peaked on 8 March, at ~5.08%. It then collapsed in the weeks that followed, printing an intraday low of 3.55% on 24 March.
The retracement off that low has seen the yield return to ~4.75%, erasing a large chunk of the fall in the past three months or so.
On an outright basis, as?we have argued before , this yield is attractive. We like to?scale into ?a long position.
The shape of the UST curve also supports this view.
Yield curves are one of the most?reliable predictors ?of recession. When long-term yields start to fall towards or below short-term yields, the curve flattens or inverts. This has often predicted a recession in subsequent months.
Using the yield curve, the Macro Hive?recession model ?currently assigns a 93% probability of a recession in the US within the next 12 months.
The US 2s10s calendar spread is now at -100bp, very near its multi-decade extreme seen in early March.
The strong likelihood of a recession in the coming year, combined with already appealing outright yields, means that long fixed income positions will become increasingly attractive to investors.
We therefore expect the US 2-year yield to generate material downside momentum in the coming months.
Long 2-Year German Bonds
The arguments for owning 2-year USTs also apply to German 2-year bonds.
The 2-year German yield peaked on an intraday basis at ~3.38% on 9 March, the highest level since 2008.
In the following days, price action was like that in the US, with yields falling sharply and quickly. The 2-year German yield printed an intraday low on 20 March at ~2.1%.
Since bottoming out, German short-end yields have retraced a large portion of March’s fall, with the 2-year now trading back at ~3.15%.
As in the US, this outright yield level is attractive, and we like scaling into a long position from current levels.
The shape of the German yield curve also supports our bullish view. The German 2s10s spread is at its most inverted in ~30 years, currently trading at about -80bp.
The tempting outright 2-year yield level, together with the shape of the German yield curve and the elevated probability of recession it implies, points to material downside for the yield in the coming months.
Short GBP
The macroeconomic backdrop facing the UK in H2 2023 is very challenging.
The combination of tepid growth and the highest inflation in the G10 makes stagflation a real possibility for the UK economy. This grim prognosis will weigh on the pound in the coming months.
So far this year, the pound’s resilience has?surprised us and others . And, while interest rate differentials are expected to continue to favour GBP, the damage to the BoE’s credibility from too-high inflation, forcing the central bank to continue hiking aggressively into a recession, will be negative for the currency going forward.
We expect the Deutsche Bank GBP trade-weighted index to trade back to its YTD low, a little over 4% below the current level.
In terms of specific GBP pairs, one of our favourite shorts is in GBP/CHF.
With the SNB committed to, and achieving, notable success in reducing domestic inflation, together with Swiss policymakers seeing a stronger CHF as a key tool in their policy mix, we see the CHF as a potential standout in the G10 in 2H 2023.
When coupled with the potential for stagflation in the UK and the BoE lacking credibility, a short GBP/CHF position looks particularly attractive.