The final throws of monetary tightening are near
The tightening of monetary policy by the world’s major central banks has been thrown a massive curve ball. A banking crisis in the US has threatened to develop into a much broader crisis of confidence in financial markets.
The assessment is that the financial system is experiencing a bout of significant indigestion. This is forcing central banks into a big rethink of their policy tightening. After hiking by 50 basis points on Thursday, the European Central Bank may not be able to tighten much more.
At the FOMC meeting on 22nd March, the Federal Reserve will be the next to react. It will likely be the trigger for a string of major central banks to ease back on the tightening. All the while, markets continue to trade with elevated volatility.
What we are seeing:
- The Fed pulling back on its tightening: Markets are positioned for one and done on further hikes.
- Market volatility and investor fear gauges are elevated: Indicators of bond and equity market volatility have spiked higher, but forex is more cautious.
- Positioning for safety: Expecting further swings in markets, but safe haven assets such as JPY and Gold could perform well.
Huge uncertainty into the FOMC meeting
It has been an incredible period for financial markets. Huge swings with spiking volatility will have left traders with heads spinning.
It could be a blessing or a curse that the Federal Reserve meeting is next week. It is difficult to know which at this stage.
The backdrop is that a crisis of confidence has threatened to take hold of global markets. A banking crisis in the US has resulted in three banks closing in the past couple of weeks. US Government authorities have moved fast to assure depositors that their money is safe. Furthermore, US banks have clubbed together to shore up the system, whilst also borrowing money from the Fed to improve liquidity.
However, the fragility has extended to Europe. Credit Suisse, a major bank considered to be one of the world’s 30 most systemically important, has had to tap the Swiss National Bank for a funding line of 50bn CHF (c. $54bn).
These moves are important to protect confidence. Nonetheless, confidence is fragile.
Fundamentally, these stresses are being driven by the aggressive monetary policy of the world’s major central banks. Banks are sitting on assets that were priced for far lower interest rates. As rates have spiked higher, the strains are showing.
Despite this, the European Central Bank did hike by 50 basis points on Thursday. However, it was cautious about providing monetary policy guidance on further interest rate moves. It could be that the ECB struggles to hike any further.
The Federal Reserve is next in line. The meeting on Wednesday could be crucial for how other central banks are viewed.
The feedback loop looks set to come back full circle.
The Fed is leading the way, but where to?
In the February meeting, the FOMC hiked by 25 basis points to a Fed Funds target range of 4.50%/4.75%.
With huge Nonfarm Payrolls jobs growth in February and March, and inflation still sticky in February, markets had positioned for a 50bps hike in March and the possibility of at least another 50 in the meetings to come (some had even predicted the terminal rate would be 6.00%)
The banking crisis has slashed these expectations. Fed Funds futures markets now expect the peak rate to be closer to 5.00%. This is way down from the 5.69% terminal rate from early March.
The Fed is “data dependent”
The expectations of the Fed decision have fluctuated wildly over recent days. There could still be three possible outcomes (no change, +25bps and +50bps).
However, after the ECB hiked by 25bps, the likely move is a 25bps hike bringing the top of the Fed Funds target range to 5.00%. This is where the consensus is sitting, with CME Group FedWatch prices implying an 88% probability of a 25bps hike.
However, the message that the Fed gives on future moves will be crucial.
US inflation indicators are still elevated but both the CPI and PPI fell faster than expected in March. Also, take into consideration that the US banking sector is creaking.
The Fed is “data dependent” will be the likely theme, but could also come with a dovish lean. A focus on “financial stability” would add to the cautious bias.
Another 25bps hike in May is a possibility, but markets may then see the Fed’s tightening cycle coming to an end.
Volatility remains elevated on bonds, equities
This is all impacting traders. Market volatility indicators and investor fears remain elevated across bond markets and equities. In forex, the volatility is more muted, for now.
In bonds, the volatility of US Treasuries has soared to levels not seen since 2008.
There has been more than a 20 basis points move on the US 2-year yield for six consecutive days. This is the first time this has happened in over 45 years.
This is important because when volatility in bonds is high, traders are looking for safety. Yield differentials do not drive markets, and the safety of currencies such as the JPY and USD tend to be favoured.
In equities, the VIX Index of volatility on S&P 500 options has been jagging higher and lower but remains well above 20.
This implies that options premiums are high because investors are buying puts that act as downside protection to their portfolios.
In forex, the volatility has picked up (as measured by the Deutsche Bank Currency Volatility Index). However, the increase is not anywhere near the extent of bond markets or equities.
We can see that the trading volatility of the Average True Range in major forex pairs has increased. The increase in the ATR for EUR/USD from 73 pips at the end of February to 99 pips. Although again, the increase in volatility is not too significant.
The charts of many major forex pairs such as EUR/USD, GBP/USD and USD/JPY remain in trading ranges of the past few months. This reflects continued caution, but also the push and pull of events on the USD.
Markets will be cautious into the Fed
So with uncertainty surrounding the Fed decision and volatility remaining elevated, this will leave markets cautious, at least into the Fed meeting.
Another reassessment will be needed once the Fed decision and we know more about its forward outlook. However, as things stand, it certainly looks as though the end of the aggressive monetary policy of the major central banks has been brought significantly forward.
Although conventionally this would be positive for risk appetite, the stresses in the system mean it is coming for bearish reasons.
This leaves the door open for safe haven assets such as gold and the Japanese yen to be favoured.
The near-term outlook for the USD is likely to be characterised by choppy moves higher and lower. However, as and when the dust settles, the outlook for the USD is nowhere near as positive as it was a month ago.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorised to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
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