Latest Insights on US Rates Outlook and USD Implications

The “US exceptionalism” narrative has regained some support recently through resilient economic data prints versus the rest of world (in particular China and the Eurozone). Along with steady progress on disinflation, markets are cautiously adopting the idea that the Fed has been largely successful in tempering price pressures, while avoiding a harder landing.

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Markets are currently pricing a September pause whilst remain more split (c. 35% hike probability*) on a final hike in November given initial mixed labour market data despite Fed hawkish comments at Jackson Hole. Indeed, stronger than expected August NFP has come against a moderation in wage gains, tick up in unemployment and JOLTS miss, with early signs of labour market softness adding further uncertainty around a November hike. Ultimately, rate cuts are expected to start sometime in mid-2024, with June Fed dot plots also placing peak rates in 2023, though policymakers are still communicating open-ness to further data-dependant rate rises.

*CME FedWatch Tool places c. 50% November hike probability on 30/08/23

Investors continue to calibrate terminal rate trajectories and in doing so are also considering the factors (as well as uncertainties) that change the path towards rate cutting:

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Increased uncertainty around monetary policy lags

Popular estimates (including from the Fed) indicate a 12 – 18 month lag for monetary policy actions to affect the economy. However, initial ultra-loose policy, offsetting pandemic fiscal stimulus, and COVID-related labour market and spending distortions have created great uncertainty around traditional pass-through mechanisms.

Markets are hence generally in the dark on how potential drag, both in speed and size, from tighter monetary policy will materialise (if at all). The main risk here remains the Fed overshooting a soft landing, underestimating transmission mechanisms and running the risk of a material macroeconomic contraction, even if inflation reaches its target sooner — i.e. a hard landing.

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A growth scare could speed up rate cuts: Factors that have supported growth and lengthened pass through may begin to fade, particularly consumer demand (excess COVID savings/firm jobs markets and wage growth) whilst real activity begins to decline, all whilst fiscal support remains relatively moderate. Indeed, research from FRB of San Francisco suggests Americans have burned through c. 90% of pandemic excess savings, with full depletion expected by end of 2023.

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As could further disinflation: Fed officials have increasingly emphasized inflation data dependency in their monetary policy reaction function. Disinflation/deflation risks particularly around a housing market slowdown and definitive labour market rebalancing could turbo-boost ongoing moderation in prices. Notably in the case of the former, rental prices have steadily declined (YoY, Zillow Observed Rent Index) since Feb 22’ as post pandemic rental premiums have unwound - though very lagged pass through to shelter inflation, a key inflation component, makes pinpointing the timeline and degree of eventual disinflation dynamics difficult.

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Meanwhile a “Goldilocks” scenario could delay the eventual cutting path: A sweet spot scenario of ebbing consumer prices, strong growth momentum in addition to a resilient labour market (at current rates) could see the Fed pause and sit on elevated rates, noting that initiating a cutting cycle could further stimulate the economy and introduce unnecessary risk.

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Implications for the USD?

• As we approach the final stages of the tightening cycle, the timing around peak rates will remain sensitive to key data prints which if become more ambiguous and difficult to interpret could see shorter term volatility and repricing, with USD fluctuating in line with market calibration of peak rates.?
• In the more medium term, a Fed pause into 2024 could incite some USD weakness as other DM central banks remain in their final tightening phases (e.g. BoE) though USD downside would ultimately be limited in lieu of catch down of these fellow central banks. If global growth also stalls as monetary policy effects pass through across the board, then this creates a favourable USD environment, further boosted if the domestic economy retains an edge vs RoW.
• The longer term outlook remains contingent on structural factors affecting R*, the real neutral interest rate equilibrating the economy. Increasing market chatter places this long run estimates higher, citing green energy transition investment, AI led productivity boost, reshoring and deglobalisation trends supporting the upwards shift in neutral rates. The US remains at the forefront of trends vs other DM’s, which could point to a fundamentally strong dollar longer term.