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Fed leans against near-term cuts

• Fed focus. No change from the Fed. Tone was more ‘neutral’ & while Chair Powell pointed to easing later this year he also watered down odds of a March cut.
• Market vol. Another burst of volatility as markets digested the US data & adjusted near-term Fed expectations. AUD whipped around (now ~$0.6560).
• AU CPI. Q4 inflation slowed more than forecast. Markets are pricing in a chance of a RBA rate cut as soon as next week. We don’t see this happening.

Another burst of market volatility overnight with the latest Fed meeting and Chair Powell’s press conference center stage. As expected, rates were kept on hold for the 4th straight meeting with tweaks in the Fed’s guidance in focus. Prior rhetoric keeping alive the possibility of “additional policy firming” was discarded with the Fed adopting a more ‘neutral’ footing (i.e. “in considering any adjustments” the Fed will assess the “incoming data, the evolving outlook, and the balance of risks”). That said, the Fed also leant against calls looking for imminent easing by stressing it needs to have “greater confidence” inflation is on a sustainable path to 2%pa before it starts to reverse course. This more balanced message is also something Chair Powell tried to get across. As he outlined, while the Fed believes rates are likely at their peak and policymakers think it “will be appropriate to dial back at some point this year” they don’t think it’s likely the process will begin in March, and they are “prepared to hold rates” higher for longer if needed.

The push back on the prospect of a March cut rattled a few optimistic cages given markets were penciling in a ~40% chance of a move. US equities, which had already been on the backfoot due to weakness across the tech-sector and renewed concerns about regional banks following a plunge in New York Community Bank, extended their slide. The S&P500 fell 1.6%, the biggest one-day drop since September with the NASDAQ falling 2.2%. Bond yields declined with US rates ~10-11bps lower across the curve (US 10yr yield is now 3.93%). Wobbles in US regional banks compounded softer US labour market data released earlier in the day, with longer-term bond investors more focused on the upcoming easing cycle rather than comments cuts probably won’t start in March. US ADP employment undershot forecasts with only 107,000 jobs added, while the Employment Cost Index (a broad wages gauge watched by the Fed) slowed, another sign inflation pressures are cooling.

In FX, the USD whip-sawed around with early losses unwound as odds of a March Fed rate cut sank. This was in line with our expectations. On net, EUR is a little lower (now ~$1.08) as is GBP (now ~$1.2665). By contrast, the dip in bond yields and shaky risk sentiment helped the JPY outperform. USD/SGD tracked the swings in the USD and is a touch higher compared to this time yesterday (now ~1.3405). The backdrop has also seen the AUD trade in a ~1% range over the past 24hrs (now ~$0.6560).

Eurozone inflation (9pm AEDT) and the Bank of England decision (11pm AEDT) are due tonight, with the US jobs report released at the end of the week (Sat 12:30am AEDT). While the paring back of near-term Fed rate cut pricing may keep the USD supported today, we feel a softer US jobs report (which is where we think the risks reside) could see the USD lose ground once again.

AUD corner

The short-term gyrations in the AUD have continued with the currency trading in a ~1% range over the past day as domestic/global releases and swings in risk sentiment washed through. As discussed above, after losing ground early in the night on the back of softer US labour data the USD bounced back as Fed Chair Powell watered down prospects of a March rate cut. As a result, the AUD is tracking near the bottom of its recent range (now ~$0.6560). The negative risk environment has also seen the AUD underperform on the crosses. AUD/JPY (-0.9%) has slipped below ~97 with the AUD also declining by ~0.2-0.4% versus the EUR, GBP, NZD, and CAD relative to this time yesterday.

Also exerting downward pressure on the AUD was yesterday’s lower than anticipated Q4 Australian inflation print. Positive base-effects in things like food and petrol as last year’s larger increases rolled out of calculations, coupled with disinflation across ‘goods’ prices (thanks to weaker global demand and repaired supply chains), and government subsidies designed to hold back rents and take the heat out of electricity costs pushed CPI lower. Headline inflation decelerated to 4.1%pa, its slowest since late-2021, and trimmed mean (the RBA’s preferred core inflation gauge) slowed to 4.2%pa. The RBA was forecasting headline and core inflation to come in at ~4.5%pa in Q4 (see Market Wire: Inflation moving in the right direction).

The pull-back in inflation is welcome relief for indebted mortgage holders and the RBA as we think it opens the door slightly more to the start of a gradual and limited easing cycle later this year. However, we believe markets may have been too quick to factor in a RBA reversal. Interest rate futures are now discounting a ~20% chance of a rate cut by the RBA next week with a 25bp reduction fully priced in by June. We don’t think this will occur given inflation is still a long way from where it needs to be. Indeed, we doubt the RBA is likely to change its rhetoric too much due to lingering domestic inflation pressures. If realised, much like the reaction in the USD post this mornings Fed meeting, a paring back of near-term rate cut pricing could see the AUD rebound. This may compound our thoughts that the USD’s upturn may run out of steam if the upcoming US labour market report underwhelms, and markets focus more on the looming Fed rate cut cycle rather than the chances of a March move (Sat morning AEDT). As our chart shows the AUD already looks to be trading below levels implied by the Australia-US two-year yield spread.

As a reminder, we feel the bout of AUD volatility observed over January might be an example of what may be in store over coming months with macro turning points normally associated with twists and turns given visibility of how things are travelling often murkier at this part of the cycle (see Market Musings: AUD volatility: a taste of things to come?).

AUD levels to watch (support / resistance): 0.6500, 0.6530 / 0.6620, 0.6660

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