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Federal Reserve Chair Jerome Powell's recent address to the Economic Club of New York (on last Friday 20/10/2023) has triggered speculation about a potential shift in the stance of the Federal Open Market Committee (FOMC), largely in response to the recent surge in U.S. Treasury (UST) bond yields. In his speech, Powell maintained the obligatory reference to persistently high inflation, emphasizing the necessity of further declines while warning that the path ahead will be "bumpy." While no one expected a celebratory announcement regarding the conquest of inflation, Powell's speech did place more emphasis on the risks arising from the tightening measures already enacted by the Fed.
This heightened caution can be attributed to two primary factors. Firstly, the surge in yields, driven by a variety of economic and geopolitical factors, has created "significant tighter financial conditions," according to Powell. Secondly, the recent uptick in geopolitical uncertainties following the Hamas attack on Israel and Israel's response has added an additional layer of complexity to the economic outlook.
Powell's speech implied that the FOMC is content with its current stance. He emphasized that "additional evidence" of economic strength might necessitate further monetary tightening, setting a particular bar that indicates November is unlikely to see a rate hike due to its proximity to his comments. While December remains a possibility, doubts persist about the sustainability of the current level of economic strength until that time. Powell also admitted to the presence of "meaningful tightening in the pipeline from past hikes," which implies that the impact of the Fed's tightening policies will become more apparent by December.
Powell's comments also suggest an impending economic slowdown. He alluded to the fact that "many indicators" are pointing to a cooling job market. Although strong GDP growth is expected in the third quarter, there are concerns that this will be followed by weaker growth in the fourth quarter and beyond into the next year.
Interestingly, the financial market reaction has been more pronounced in the FX market than in interest rates. Despite the 10-year UST bond yield finishing higher at 4.99%, the 2-year yield dropped by 6 basis points, though it remains near its cyclical high. The correlation between FX movements and interest rates has shown some weakening in recent times, with EUR/USD breaking free from a downward trend channel that has been in place since July. Within the G10 currencies, a risk-averse sentiment is evident, with the CHF, EUR, and JPY emerging as the top three performing currencies this week.
While it may be premature to declare the end of the U.S. dollar's strength, recent market dynamics strengthen the view that there may be limited scope for further dollar appreciation. This window for appreciation could close as we see more evidence of the cooling job market, as indicated by Powell. Additionally, the primary upside risk for the U.S. dollar remains geopolitical factors, such as an escalation in the Israel-Hamas conflict, which could lead to higher crude oil prices and subsequently bolster the U.S. dollar.
If you would like to watch the full speech by Powell you can click on this link:
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