As the virus outbreak spread to new countries and hopes of containment faded last week, the US dollar finally began to weaken against certain currencies, including low yielding G10 partners like EUR, CHF and JPY.
Last week’s price action in global macro markets was consistent with intensifying risk aversion, coupled with increasing expectations of rate cuts from the FOMC.
The strong performance of the euro in particular may have been also driven by the unwinding of carry trades funded in the single currency.
- To illustrate the importance of market expectations of Fed easing as a trigger for last week’s limited USD sell-off against EUR and JPY, we point to forward pricing of overnight index swaps dated for the second future Federal Reserve meeting. The current contract indicates the effective forward rate available after the April FOMC meeting – an effective guide to market expectations of Fed policy.
- For most of February, the dollar continued to appreciate, particularly against EUR and JPY. Over this time period, no rate cuts were priced from the Fed as US data remained firm despite the worsening global shock. The 21st of February offered the first signs of the global shock affecting US producers, with the US Markit Composite PMI contracting for the first time since October 2013. Pricing of the April FOMC meeting began to show some hints changing expectations shortly after the PMI release.
- The following Monday the 24th, US equity markets began to sell off rapidly, and the US yield curve became significantly more inverted over the 3 month 10 year horizon. Over the course of the following week, market expectations for a rate cut from the FOMC began to build rapidly and are now pricing in more than a full rate cut as early as March.
Dollar Strength Eases as Markets Price FOMC cuts
February 21st – the date of the Markit Flash PMI release – marked by vertical orange line
When viewed in the context of a growing and worsening global virus outbreak, we believe the inversion of the US yield curve points towards a rate cut from the FOMC either at the March or April meetings.
With markets fully pricing a rate cut as early as March, failing to deliver would represent a marginal tightening in financial conditions.
This is something the FOMC will likely shy away from given the worsening global macro risks of coronavirus and the sudden cooling in US data. The prospect rate cuts has not yet showed up in Fed speak, although last week’s comments from Fed Governor Lael Brainard in support of flexible inflation targeting added to the dovish atmosphere.
US Yield Curve inverts over 3m-10y horizon
This week’s US data offers further information on the extent to which virus fears are affecting US confidence and may potentially add to further volatility in markets given heightened sensitivity to data showing the effects of the coronavirus of late.
- Final Markit PMIs on Monday 14:45 will offer a revision to the disappointing flash figures released on the 21st. ISM PMIs will also be released the following day.
- The US labour market has been robust to multiple confidence shocks over the past decade, and so it’s unlikely Friday’s non-farm payrolls report will offer much for USD bears, although as always the release is a red-letter event for the dollar.
Author: Ranko Berich, Head of Market Analysis at Monex Canada.