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MARKET UPDATE
In October, there was a slight, albeit minimal, strengthening of the US dollar against the euro, as observed in London closing rates. The exchange rate shifted from 1.0576 to 1.0562. On the other hand, the dollar experienced a more significant strengthening against the yen, moving from 149.37 to 151.56. During the same period, the Federal Open Market Committee (FOMC) did not convene, resulting in no changes to the fed funds rate, which continued to hover between 5.25% and 5.50%.
The FOMC has been consistent in implementing its strategy of reducing its securities holdings, with Quantitative Tightening (QT) ongoing at a rate of USD 95 billion in US Treasury (UST) bonds (USD 60 billion) and Mortgage-Backed Securities (MBS) (USD 35 billion) in balance sheet reduction each month. As a result of these efforts, the balance sheet has now diminished to USD 7,908 billion, marking a significant reduction of USD 8,965 billion from its peak in April 2022.
OUTLOOK
Throughout October, the US dollar exhibited a relatively stable performance, trading within a narrow range but ultimately ending the month with a 0.5% increase when measured against the Dollar Index (DXY). This marginal gain for the dollar coincided with a significant surge in the 10-year US Treasury (UST) bond yield, which rose by 36 basis points and briefly exceeded the 5.00% mark for the first time since 2007. The modest strengthening of the US dollar in response to the rising yields signalled a potential softening of the correlation between yields and foreign exchange (FX) movements, possibly indicating that much of the favourable news had already been factored into the dollar's value.
The surge in yields can be attributed, in part, to the ongoing resilience of the US economy, with the real Gross Domestic Product (GDP) in Q3 showing a robust 4.9% quarter-over-quarter seasonally adjusted annualized rate (Q/Q SAAR) growth. This growth was fuelled primarily by a 4.0% Q/Q increase in consumer spending. However, the growth was also influenced by inventory accumulation, which may see correction and act as a drag on growth in Q4. Additionally, factors such as fragile consumer confidence, dwindling excess savings, and the resumption of college debt servicing are expected to create headwinds for the consumer. Market consensus for Q4 and Q1 2024 indicates Q/Q real GDP growth of only 0.8% and 0.2%, respectively.
The Federal Open Market Committee (FOMC) is scheduled to meet at the beginning of November and is highly likely to announce an unchanged monetary policy stance. Federal Reserve Chair Powell is expected to emphasize the possibility of a pause, given the growing evidence of monetary policy's impact on financial markets. This is coupled with the fact that inflation remains stubbornly high, prompting the FOMC to maintain the current stance until there are clearer signs of inflation moderating toward the 2.0% inflation target. The tone of the announcement is likely to echo Powell's recent speech to the Economic Club of New York, suggesting that the Fed is becoming more aware of tightening financial conditions. "Philly" Fed President Harker also noted in October that he had heard reports of the economy slowing down faster than official data suggested. The spread in fed funds futures for December 2023 and December 2024 has fluctuated between -50 and -100 basis points, currently standing at -68 basis points. There is an expectation that markets will increasingly price in more easing by the end of the next year as US economic data begins to weaken, which could weigh on the US dollar's performance.
As previously mentioned, the opportunity for the US dollar to strengthen still exists. However, the lack of significant appreciation in October, despite surging US yields, raises concerns about the potential for dollar gains being less substantial than anticipated. As the US economy decelerates, the market is likely to factor in more Fed rate cuts, leading to a weakening of the US dollar in the first half of 2024.
INTEREST RATE OUTLOOK
My consistent perspective is that the Federal Reserve (Fed) is likely finished with raising interest rates. I consider the 25-basis point hike in July 2023, which brought the mid-point of the Fed Funds Rate Target Range to 5.375%, as probably the final rate increases for the year and possibly concluding the current phase of tightening. This distinction is essential to make. If the Fed opts not to raise rates during the December FOMC meetings, which are the remaining meeting for 2023, it will mean that the Fed has maintained the same interest rate level for over six months, until the first FOMC meeting in January 2024. While a rate hike at the beginning of 2024 is possible, it could be seen as somewhat awkward, as one might wonder why they didn't raise rates in December.
I believe that a six-month hold period would likely extend into 2024, during which the Fed would rely on forward guidance like "higher for longer," continue with Quantitative Tightening (QT), and potentially adjust the 2024 projections in the December Summary of Economic Projections (SEP) to maintain tight monetary conditions, rather than resuming rate hikes. In the meantime, my outlook is that the economy will slow down in 2024, rendering the previous considerations less relevant. Additionally, the elevated long-term interest rates are also exerting pressure on the Fed's stance. (George Goncalves, Head of US Macro Strategy)
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