The federal reserve interest rate predictions for the 2nd quarter is that we will see the Fed interest rate peak. Using the Fed Watch tool (https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html), we can see that holding rates at 5% is the most probable path.
| MEETING DATE | 375-400 | 400-425 | 425-450 | 450-475 | 475-500 | 500-525 |
| 03/05/2023 | 0.0% | 0.0% | 0.0% | 0.0% | 56.2% | 43.8% |
| 14/06/2023 | 0.0% | 0.0% | 0.0% | 9.2% | 54.2% | 36.6% |
It is important to understand what the expected scenarios are beyond this quarter in order to take advantage of price movements. The expectation is that a cutting cycle will begin in Q3.
| MEETING DATE | 375-400 | 400-425 | 425-450 | 450-475 | 475-500 | 500-525 |
| 26/07/2023 | 0.0% | 0.0% | 7.1% | 43.8% | 40.7% | 8.5% |
| 20/09/2023 | 0.0% | 6.1% | 38.6% | 41.1% | 13.0% | 1.2% |
However, it is important to keep inflation in mind as if there is any uptick in inflation readings then the peak funds rate may not be seen this quarter. In reality, it is only since the SVB issues that the funds rate was seen peaking this quarter. Following the SVB situation the Fed has suggested that tightening credit conditions may be a proxy for 50bps of hikes. Something which may be key to watch are things such as
Consumer Credit – if credit conditions tighten then the Fed may be correct and this is acting as a proxy rate hike – if there is no tightening of credit then the previously protected peak of 5.5% may be back in play – leaving two 25bps hikes possible.
Also, on the back of a huge upside miss in the NFP figures Powell has said that job numbers didn’t impact the Feds path. But he did say that if similar employment prints show the same, the Fed could act and raise rates – however the early data in April have shown that the labour market is cooling. If we see a strong labour market and inflation remains sticky, then this may result in more hawkish comments from the Fed.
The hard data (data which is not survey based) such as CPI, PPI, employment and retail sales will all be triggers and give good indications on the likely Fed path. As we have seen inflation cooling recently coupled with the Fedwatch probabilities we can use this as our base case, but what does that mean for the USD?
A fund manager called Stephen Jen coined the term ‘the Dollar smile’. A very simple picture taken from Babypips.com shows it in its basic form.
A strengthening dollar generally happens in two different scenarios but for vastly different reasons; risk aversion (running to a safe haven) or a booming US economy. In the middle the USD tends to underperform. The data over the coming months will likely determine where we are on the smile. I feel it is increasingly unlikely that the US will land straight into the right hand side of the curve so what does the middle and the left hand side look like?
Left hand side: Certain cracks have started to appear in the form of SVB and other banks collapsing. Moving to the left hand side of the smile is characterised by bigger risk-off sentiment.
A global recession or an escalation of the banking crisis, especially one which spreads globally will drive this risk-off sentiment resulting in funds flowing into safe havens – one of which COULD be the dollar.
How can we spot this? Risk sentiment indicators are a good signal. The VIX is the most well known indicator. As fear goes up, it is likely that the VIX will rise and vice versa. A major event like a banking collapse is pretty clear and will be heavily reported on the news. On the global recession front, global PMI readings showing all the major economies in contraction, poor employment figures and negative (and worsening) GDP readings and poor (and worsening) retail sales are all things which could see a run into safe havens.
Middle of the smile:
The US economy entering a period of sustained slowing and possibly into a local recession with declining interest rates, worsening GDP and poor US PMI and soft data will all see money flow out of the dollar looking for yields, especially if there is growth elsewhere in the world.
Another potential scenario is a kind of soft-ish landing. As interest rates begin to fall, inflation continues to fall but key metrics (GDP, PMI, Retail sales, employment) all remain steady. Money may flow out of the dollar and into equities – this would see a strengthening of indices such as the S&P, Russell, Nasdaq etc. However there are other factors such as money supply and credit conditions which are important factors. A slight tightening of credit conditions may not be a bad thing and will keep inflation under control, but an extreme tightening of credit conditions, especially globally, may cause an extreme risk off scenario.
Technicals:
The DXY has been within the 101 – 105 range since the start of the year. A clear break out of this range will be significant and represent a potential longer term trend beginning to form. At the time of writing it is currently sitting at the lower end of the range.
The EMAs on the shorter timeframe (Daily) are bearish, with price being below the 55ema which is itself below the 200ema. The Weekly is mixed, with price being below the 55ema but above the 200ema.
| EMA | DAILY | WEEKLY |
| 55 | Below | Below |
| 200 | Below | Above |
| 55/200 Cross | Bearish | Bullish |
