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US Fed pivot has further to run

The US Fed’s ‘dovish’ turn at its mid-December meeting, where it effectively called time on the rate hiking phase and opened the door to easing down the track, has reverberated across markets. Global interest rate expectations have adjusted lower and bond yields tumbled, growth linked risk assets such as equities and commodities have risen, and the USD’s downturn took another leg lower. This mix has pushed the AUD (now ~$0.67) to the top of its multi-month range, a long way (nearly 7%) from its late-October lows.

While the Fed’s pivot looks to have stunned many, it wasn’t a surprise to us. We have progressively been dialing up our thoughts over recent months that the US Fed was at the end of its rate rise road and that the ‘overvalued’ USD should steadily lose ground (see Market Musings: AUD: Always darkest before the dawn and Market Musings: USD losing its shine).

Markets trade in themes and what happens in the US is central to the overall picture as the rest of the world is essentially a ‘price taker’. With this in mind we think the signals from the US Fed not only at the December meeting but also by policymakers over the past few weeks, coupled with a look back at past easing cycles suggest the unfolding bond yield and USD down trends have more room to run over coming quarters. Macro-wise, although US CPI is still running above the Fed’s target, there are increasing signs across the labour market and broader economy that demand and supply is moving into better balance, and this should see the inflation pulse continue to recede. Notably, we believe that based on its comments and updated economic projections, while the Fed is still alert to the inflation dangers its degree of alarm has been scaled back. And with a close eye on trying to thread the needle, limit the economic damage, and navigate a ‘soft landing’, a more forward-looking risk management approach to its policy decisions is gaining prominence.

This is something we flagged as being an important consideration for the interest rate and USD outlook in recent research which others don’t seem to have accounted for. As we noted (and as our chart above illustrates), with US inflation decelerating, by mid-2024 unless nominal policy settings are recalibrated in locked step, the Fed’s policy stance (which is measured by the gap between real interest rates and the equilibrium ‘neutral’ rate) would mechanically become progressively more ‘restrictive’, and this is something we doubt the Fed wants to happen. Indeed, Chair Powell stated as much when he indicated that the Fed is now “very focused” on not “hanging on too long” to higher interest rates, and that the discussion on when to start cutting was framed as being fixated on “when it will become appropriate to begin dialing back the amount of policy restraint that’s in place”.

Barring a surprise re-acceleration in US inflation, we believe that based on our replication of the Fed’s policy rules, and assuming the gap between the last hike (i.e. July 2023) and the first cut is a bit longer than average due to lingering inflation worries, predictions Fed policy loosening could start in May/June 2024 look about right. That said, compared to history and given how high interest rates now are, we would argue markets may still not be pricing in enough of a reversal by the Fed over future years. Over the past four cycles the US Fed has, on average, delivered 350bps worth of interest rate reductions. Even after the recent rejig, markets are only discounting ~230bps worth of Fed easing by early-2026. Interestingly, this is also a little less than what the median FOMC member is now anticipating.

In our judgement, as US growth continues to lose steam on the back of the lagged impacts to the Fed’s past aggressive actions, the labour market loosens, and inflation slows, US interest rate expectations and bond yields are biased to fall even further. The upswing in US bond yields and the US’ relative economic strength were pillars behind the USD’s outperformance a few months ago. As these fundamental supports fade, and assuming growth in China continues to pick up as policy stimulus gains traction and this spills over positively into the Eurozone, Asia, and Australia which are leveraged to its economic fortunes, we expect the USD to continue to gradually weaken over the next few quarters. It won’t be smooth sailing as markets seldom move in straight lines, but in our view, this backdrop should see the tide continue to turn more favourable for the AUD. We see the AUD edging up to ~$0.68 in Q1 and then onto ~$0.70-0.71 by Q3.

Market Retreat Continues as Yields Climb
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Market Momentum Fades After US Long Weekend
No news is good news
Dollar Cruises Toward Weekly Gain on Fading Easing Expectations
Twists & turns

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