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USD

King USD dethroned

Chris Weston
Head of Research
Jan 11, 2022
It’s been another day of Fed chatter, with several speakers hitting the market, where the fear of inflation was a clear and predictable thematic – it’s not often Chicago Fed president Charles Evans (a known dove) talks up the prospect of 4 hikes in a calendar year, but he suggested this could play out “if inflation doesn’t improve”.

Again we see this view of four hikes in 2022 as hypothetical and aligned with the newfound vision of the Fed offering maximum optionality.

Fed member Harker commented in late US trade, suggesting “the Fed won’t ignore the performance of financial markets”. Bingo, the Fed’s undisclosed mandate has once again been cemented in the notion of keeping the NAS100 and S&P500 from falling too far, subsequently impacting the wealth effect too greatly – hence, if equities and credit move too intently then the market knows the Fed will pivot the stance hard….once again.

The ‘Fed put’ is there, we just think the strike price (for a pivot to a more dovish stance) is 10-15% lower.

However, despite this endless cycle of news on Fed hikes and balance sheet reduction, the fact that the USD has simply not responded to hawkish comments from the Fed has come up time and again from clients, and the broader market - and there are many theses flying around about this negative USD flow.

Daily chart of the USDX

(Source: TradingVIew - Past performance is not indicative of future performance.)

First – price is true – it is what we trade and is the aggregation of flow and all behaviours. For traders, especially those using leverage, moves in price need to be respected and while we can argue that “the market is wrong”, if the trend is down then it really doesn’t matter what you or I think, the broad flow of capital needs to be respected. Traders control losses.

One aspect behind the weakening USD theory is the already rich interest pricing and the fact that the markets have already discounted much of the expected heavy lifting from the Fed. For discretionary traders who are taking a view on the USD, or any of the second derivatives of rates (gold etc), we need to understand what’s already priced in, as that can play a key role in our risk to reward trade-off.

I also think we can add the idea that 7% US CPI inflation is no longer a surprise, and the market needs to see something that now shocks. A steeper yield curve would be a USD positive, as the Fed are just not going to hike 4 times this year into a flattening curve – in fact, the yield curve will be the beacon of the Fed in 2022. There have also been mentions of equity flow, with a huge, concentrated position of global investor capital in US tech, and as this being unwound much of this capital is being repatriated to Asia, Europe and alike, presumably unhedged.

How to view interest rate expectations

One way we can look at expected interest rate pricing is by assessing the Fed funds future or Eurodollar futures. I tend to look at the fed funds future for pricing over a 1–2-year view, as the open interest is poor further out.

For a short-term visual, those out there using TradingView can type in this equation into the search function - 100-CBOT:ZQH2022 – to get the number of basis points priced for the March FOMC meeting. By simply dividing this by 0.25 (central banks tend to hike in increments of 25bp) we get the probability of a hike at the March FOMC meeting, which in this case is 80%.

(Fed pricing - Number of basis points of hikes priced for March)

(Source: TradingView - Past performance is not indicative of future performance.)

We can choose the December fed funds future contract and work the equation - 100-CBOT:ZQZ2022 – which we see at 90bp. Subsequently, we can see the market has priced in 3.6 hikes (90/25) by the end of 2022.

This is where we ask whether that is a real possibility and what could spur on more hikes to push the USD higher.

This is where we ask whether that is a real possibility and what could spur on more hikes to push the USD higher.

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