US Dollar Looks to Jackson Hole for Fed Rate Cut Clues - Central Bank Weekly
Central Bank Weekly Talking Points:
- All eyes are on Fed Chair Jerome Powell’s speech at 10 EDT/14 GMT on Friday, August 23. The July Fed meeting minutes indicated that the FOMC isn’t ready to aggressively cut interest rates.
- Fed funds are pricing in an 100% chance of a 25-bps rate cut in September and an 87% chance of 50-bps of rate cuts by the end of the year. Meanwhile, Eurodollar contracts are only pricing in a 24% chance of 50-bps of rate cuts by the end of 2019.
- Retail traders are turning more bearish on the US Dollar ahead of Jackson Hole.
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Now that the “race to the bottom” for central banks has begun as the US-China trade war weighs more heavily on global economic growth, the Federal Reserve’s Economic Policy Symposium in Jackson Hole, Wyoming carries additional weight for market participants.
With European Central Bank President Mario Draghi staying home as he winds down the final months of his term, all eyes are squarely focused on Fed Chair Jerome Powell’s speech at 10 EDT/14 GMT on Friday, August 23.
The July Fed meeting minutes indicated that the FOMC isn’t ready to aggressively cut interest rates. Based on recent moves in bond and rates markets, it appears that traders are already fully aware of the possibility of a less aggressive Fed rate cut cycle than what was previously expected a few months ago.
US Treasury Yield Curve Remains Inverted
With the US-China trade war in a state of détente, US Treasury yields have risen as market participants have lowered expectations for an aggressive Fed rate cut cycle. Indeed, much of financial media has been talking about the 2s10s spread and its flirtation with inversion territory in recent days.
US Treasury Yield Curve: 1-month to 30-years (August 22, 2019) (Chart 1)
While the 2s10s spread has flirted with inversion over the past week, the two key spreads of the US Treasury yield curve – the 3m5s and 3m10s – have been inverted for several weeks now. In turn, US recession odds are rising. The key question at the Fed’s Jackson Hole summit isn’t “will the Fed cut rates in September?”, but rather “by how much will the Fed cut rates in September?”
The Fed Rate Cut Cycle Will Not Be Aggressive
With the US yield curve inverted in the key portions, rate cut odds remain frontloaded. Prior to the July Fed meeting, Fed funds futures were discounting a 76% chance of another 25-bps rate cut in September and a 56% chance of a third and final 25-bps rate cut in December 2019.
Federal Reserve Interest Rate Expectations (August 22, 2019) (Table 1)
Now, prior to Fed’s Jackson Hole Economic Policy Symposium, Fed funds futures are discounting a 100% chance of another 25-bps rate cut in September and an 87% chance of a third and final 25-bps rate cut in December.
It is worth noting that there is only a 2% chance of a 50-bps cut at the September Fed meeting. If Fed Chair Powell fails to strike an overtly dovish tone during his Jackson Hole speech – one that would indicate 50-bps of rate cuts are coming in September – markets won’t be surprised.
Eurodollar Contracts are Less Aggressive than Fed Funds
Eurodollar contracts are not as aggressive in their dovish pricing as the Fed rate cut cycle has begun. We can measure whether a rate cut is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future.
The chart below showcases the difference in borrowing costs – the spreads – for the continuous front month/January20 (orange) and thecontinuous front month/June20 (blue), in order to gauge where interest rates are headed in the December 2019 Fed meeting and the June 2020 Fed meeting.
Eurodollar Contract Spreads – Continuous Front Month/January 20 (Orange),Continuous Front Month/June 20 (Blue) (JANUARY 2019 to AUGUST 2019) (Chart 2)
Based on the Eurodollar contract spreads, a 25-bps rate cut is fully discounted at the September Fed meeting. There is only a 24% chance of seeing two 25-bps rate through the end of 2019 and a 32% chance of three more 25-bps rate cuts coming by June 2020.
Fed Rate Cut Odds are Frontloaded Due to US-China Trade War
This point bears repeating time and again. Traders should continue to appreciate the fact that if Fed rate cuts are coming, they’re going to come over the next several months, a direct response to the growing threat of the US-China trade war. It thus stands to reason that if a US-China trade deal materializes at any point in time there will be a repricing of Fed rate cut odds in favor of a stronger US Dollar.
DXY INDEX TECHNICAL ANALYSIS: DAILY PRICE CHART (AUGUST 2018 TO AUGUST 2019) (CHART 3)
For the US Dollar (via the DXY Index), the rebound from the uptrend from the June and July swing lows has been maintained, neutralizing bearish momentum that developed at the start of August. But price action has continued to firm up, and as a result of the DXY Index’s momentum profile has turned more bullish. Price is trading above its daily 8-, 13-, and 21-EMA envelope, daily MACD is trending higher in bullish territory, and Slow Stochastics are now above below its median line. Yet there has been a clear lack of directional movement ahead of the Fed’s Jackson Hole summit.
The big picture for the US Dollar (via the DXY Index) is potentially troublesome, particularly if the recent recovery fails. The DXY Index is again looking at a retest of the rising trendline from the February 2018, March 2018, and March 2019 low lows – the backbone of the entire bull move. Failure to retake the uptrend would suggest that the major topping potential for the US Dollar remains valid.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail at email@example.com
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