Nibbling Away at Fed Rate Cut Expectations

Debt limit optimism and decent data are nibbling away at pricing of Fed rate cuts and dollar shorts are feeling the squeeze. It’s “just a correction” but it’s painful all the same.

The comments coming from Washington and President Biden's choice to abbreviate his G7 trip have raised expectations in the markets for a potential solution. As a result, there has been a positive shift in market sentiment, leading to increased equity prices and a decrease in bond volatility. In terms of future expectations, there is growing speculation regarding potential Federal Reserve rate cuts in the second half of the year (If that really happen would be very damaging for the US Dollar), which is influencing the market's pricing. Consequently, certain risk-sensitive currencies are experiencing increased demand this morning, while others are not.

The Korean won stands out as the top-performing currency, while the Chinese yuan continues to weaken. Additionally, disappointing Australian jobs data has put downward pressure on the Australian dollar. Although there was a decrease of 4.3k in employment following two months of gains totalling 113k, it's crucial to focus on the underlying trend. This trend reveals a monthly average increase of 28k jobs during the first four months of the year and an average gain of 32k jobs over the past 12 months. The steady growth in employment is gradually slowing down, approaching an annual rate of just under 3%, a rate that most countries would envy. However, as the likelihood of further rate hikes by the Reserve Bank of Australia diminishes, the Australian dollar is expected to test the lower end of its current range, around 0.6560.

The initial chart depicts the Dollar Index's response to diminishing expectations of interest rate cuts. When the regional banking crisis emerged, the market briefly priced end-year rates below 4%. However, the rates have now climbed back above 4 ½%, leading to a gradual upward movement of the dollar. Although it seems unlikely that we will reach the levels observed in early March, the market's short position on the dollar coupled with this persistent upward trend can be quite challenging. Regarding EUR/USD, the long-term rate trends indicate substantial potential for further gains. The current correction is merely a temporary setback, even if it persists for several more weeks and causes additional discomfort.

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