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Financial markets were a bit nervous last week, after the Federal Reserve on Wednesday sent an unexpected message.
Policymakers have set two interest rate increases by the end of 2023 and are starting to talk about the eventual need to slow the central bank’s monthly asset purchases.
Read: Barclays raises Fed tapering forecast after FOMC meeting
But reading the reaction across financial markets could indicate that investors don’t believe the Fed will have room to raise rates very far once the hiking cycle begins, George Saravelos, currency strategist at Deutsche Bank, said in a note on Friday.
But first, how excited was Thursday’s session?
The ICE DXY US Dollar Index experienced its biggest one-day jump since the March 2020 pandemic that forced a global scramble for green currencies as the economy shut down. Long-term Treasury yields tumbled to their lowest since February as investors snapped up maturities that fell in commodities, and some saw the biggest one-day drop since March 2020. The high-tech Nasdaq Composite Index rose -0.92% while other indicators indicated, ending shyly from the registry. The Dow Jones Industrial Average DJIA, fell -1.58%, while the S&P 500 SPX, -1.31% suffered a partial loss.
Short-term yields continued to rise in tandem with the dollar on Friday, while commodities saw a mixed performance and stocks extended losses until the closing bell, albeit the Nasdaq underperformed its peers.
Saravelos sought to tie it all together.
Dollar Rise
Of the individual moves, the dollar’s rally was the easiest to explain. This move, he wrote, “was fully consistent with our framework that what matters for the dollar are real front-end rates.” Real rates are returns adjusted for inflation. The short end of the yield curve rose sharply in response to the Fed’s shift, while the longer maturities fell.
“It should come as no surprise that the dollar has risen strongly even if 10-year yields have not made new highs,” the economist said.
Read: Why the US dollar is rising – and what next – after the Fed change
sell goods
“The role of the Fed in commodity price inflation should not be underestimated,” Saravelos said, noting a “very high” inverse relationship between the dollar and base metal prices. In other words, when the dollar falls, prices rise and vice versa.
The data showed a “very strong link” between the Fed’s balance sheet, commodity prices and inflation expectations, he said, noting that the Fed’s reference to plans to reduce bond purchases in 2013 also represented a peak in inflation expectations. Economists at Deutsche Bank also found a significant correlation between survey-based measures of consumer inflation expectations and commodity prices as well.
Long-term bond yields
OK, but what’s the deal with the uptick in 10-year Treasuries TMUBMUSD10Y, 1.438% and 30-year Treasuries TMUBMUSD30Y, 2.015% sunk in yields? Shouldn’t the Fed’s “phasing out” threat drive yields higher?
“The market has gone through a significant development in the past 48 hours,” Saravelos said, with Treasury yields rising with maturities to 2024, while other yields declined (see chart below). This also coincided with lower inflation expectations in the market.
German Bank
“This is very unusual considering that the Fed hasn’t even started raising rates yet,” Saravelos said.
follow the star
He said market actions are in line with the pessimistic attitude by investors about expectations for what is known as the natural rate – the real or inflation-adjusted interest rate expected to prevail when the economy is operating at full steam. In economic terms, the normal is denoted as r* or r-star.
Saravelos said the market’s message is that if the Fed decides to start raising rates early, “it won’t be able to go very far before inflation and growth hit a blip, driving down post-initial hike yield expectations.”
The pessimistic view on r-star is also in line with the behavior of the market outside of bonds, the economist said.
The dollar’s sensitivity to smaller shifts in the Fed’s stance reflects pent-up demand for yield from investors. He said that forces a stronger dollar, which in turn has a greater effect in lowering inflation on the economy more quickly than expected.
But for the dollar to see a significant “bullish cycle”, the Fed “needs to be able to go very far. The market is not sure about that,” he said.
The lower price is also in line with the resilient stock market, especially the developing stocks that are more sensitive to interest rate movements, consistent with the Nasdaq rotation.
Saravelos acknowledged that investors shouldn’t read too much into one-day price action, but cautioned that “the market is sending out some strange signals to watch.”
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