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Steepening Fed Expectations Curve Buoys US Dollar, US Equities...For Now

Steepening Fed Expectations Curve Buoys US Dollar, US Equities...For Now

2016-11-15 12:47:00
Christopher Vecchio, CFA, Senior Strategist

Talking Points:

- Rates markets now pricing close to three Fed rate hikes over the next three years; before election, barely two were priced in.

- Rising US yields lifting sentiment - for now. At a certain point, rising yields will dent equity market sentiment amid US debt sustainability concerns.

- See our weekly data preview for outlooks on the remaining key data this week, including US Advance Retail Sales (OCT) due this morning at 08:30 EDT/13:30 GMT.

The juice has been squeezed out of December rate hike odds. At 92%, barring a significant economic shock over the next month, markets feel the Fed is certain to raise rates. Yet this isn't an appreciable difference from where odds stood before the election, at 84%.

Instead, you have to look down the Fed funds and overnight index swaps pricing curves for answers. The US Dollar's source of strength has that markets are now pricing in a faster pace of tightening by the Fed in 2017 and 2018. Prior to the US Presidential election, markets were pricing in one rate hike in each of the next two years, in December each year (rather conservative).

Now, after the Republican's wave election that seems poised to end gridlock in Washington, rates markets see hikes in September 2017, June 2018, and December 2018. In the near-term as the US Dollar Index (DXY) contends with its highs from March and December 2015 that have thus far defined the top of the two-year plus range, it wouldn't be a surprise if there were a near-term pullback. However, as long as the Fed expectations curve continues to steepen, the US Dollar will have a source of strength to rally from.

There is one caveat, however, to the rising yields picture: US debt sustainability. If you recall August 2011, this was a major problem for markets. The US government has been on the path of cutting the deficit almost every single month over the past half-decade, perhaps the only reason why Fitch and Moody's have yet to join Standard & Poor's in their downgrade of the US.

As such, while President-elect Trump's plans for his first 100 days in office may boost the economy in the short-term - reduced taxes and infrastructure spending seem like a sure bet to do so - reducing the government's revenue and increasing its spending in such a dramatic fashion is a sure way to catch the ire of ratings agencies and upset sovereign debt markets. At some point, we'll pass through the threshold where rising US yields are seen as a buoy for US equities and the US Dollar to where they're seen as a burden.

See the above video for a technical review of the DXY Index, EUR/USD, GBP/USD, AUD/USD, USD/JPY, USD/CAD, USD/MXN, and Crude Oil.

Read more: US Dollar, US 2Y Yield at New Highs as Trump Reflation Trade Rolls

--- Written by Christopher Vecchio, Senior Currency Strategist

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com

Follow him on Twitter at @CVecchioFX

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