Fed – Brace for larger hikes.
This week, the Fed is set to lift off rates for the second time this year. Since the first 25bp hike in March, inflation is up 60bp and it is now running at 8.5%. Moreover, the Ukraine war has impacted commodities strongly, adding to inflationary pressures. As a result, the Fed has guided for a change of pace in recent weeks and a 50bp hike is now a given. Some Fed official have pointed to the possibility of a 75bp move, but it does not seem in the cards for the time being. The market is pricing 52bp for the meeting, so bolder moves are largely discounted. Quantitative tightening is also set to start, but the trajectory for balance sheet reduction was already telegraphed in the March minutes. The Fed balance sheet will be reduced by $95bn a month, to achieve a 50% drop over three years, to about $6tn. The real focus of markets will be on future pace. Rates futures now price 10 hikes in 2022, and more than 2 hikes per meeting over the next 3 meetings. The March inflation print included many elements pointing to a potential peak, including negative energy contribution and a marked drop in used cars prices. As such, the Fed may remain hawkish but not enough to surprise the market on the upside.
EUR/USD – Sell parity.
Over the past week, the Euro is making new lows (and the US Dollar new highs). EUR/USD is now flirting with 1.05, the lowest level since 2002. We believe we may be close to the lows in the currency pair. First, the US-EU spread in short-term rates has accelerated meaningfully in 1Q22, moving from 1% to 2.3%. As the Fed is now very hawkishly priced, a relaxation in the spread appears most likely in the next few months, potentially via a re-pricing of ECB expectations. Second, recession fears in Europe have stepped up meaningfully. Our models point to an over-pricing of recession fears in Europe vs what economic dynamics suggest. Third, risk aversion has kept the USD in good demand. Over the past week, volatility and credit spreads are making new highs, and cyclical equities are close to new lows. As a result, investors accumulated dollars over the past quarter, making it a crowded currency now. A relaxation in risk aversion would thus help some dollar weakening, while investors seem already positioned for the increasing downside. As a result of these factors, there may be good upside and limited downside in EUR/USD over the next few months.
China – Lockdown fears.
In China, the zero covid policy continues to weigh on economic activity. Retail sales and employment indicators have slumped massively in March, and PMIs continue to surprise on the downside. The service sector is particularly affected: on Sunday, non-manufacturing PMIs for April moved in full recessionary territory, despite only “moderate slowdown levels” were expected. Beijing remains in semi-lockdown mode, with school having started holidays a few days ahead of schedule. Authorities have started supporting the economy more meaningfully, with a step-up of dovish monetary action. Still, RRR for banks remain at elevated levels, and rates have not been cut despite lagging inflation. Signals of policy support could thus be stronger, especially as the 5.5% authorities target for the year is now clearly outdated. A protracted lockdown could weigh on 2Q numbers, as 1Q data held up decently thanks to good performance in January and February. We believe concerns on a China slowdown are better placed than the ones on Europe and remain cautious on CNH and regional currencies.
Algebris Investments’ Global Credit Team
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