US bond markets tell us the Fed will pivot

Summary of key points:

  • The US bond market votes with its feet on the economy and inflation
  • Burgernomics and purchasing power parity theory
  • Another drop in stocks remains as Kiwi dollar risk

The US bond market votes with its feet on the economy and inflation

The message coming from the US bond market on the future of US inflation trends, the timing of the Federal Reserve’s pivot on monetary policy, the direction of the US economy and therefore the direction of the value of the US dollar will not can be clearer.

The dramatic reversal in US 10-year bond yields, from highs of 3.50% in mid-June to 2.75% at market close on Friday July 22, tells us that bond investor sentiment and expectations and of borrowers are that they see lower inflation and lower interest rates in the future. The shift in focus and direction was quick, but well justified by lower oil prices and weaker US economic data.

In last week’s commentary, we mentioned that further declines in US bond yields below 2.80% (2.93% at the time) would suggest a weaker USD value on the Dixie index towards 102 The US dollar, however, has weakened over the past week. only at 106.40 on the index, so it still has a lot of catching up to do (see chart below).

US economic data released last week continues to paint the picture of a rapid slowdown in the US economy in June and July. The S&P Global Composite Manufacturing PMI for July was significantly weaker at 47.5 compared to the earlier consensus forecast of 52.1. A result below 50 signals a very negative outlook with the fall in manufacturers’ order books. Housing data earlier in the week for June was also considerably weaker than expected. The Federal Reserve may not officially temper its rhetoric on the need for higher and higher interest rates to reduce demand in the economy until it updates all of its forecasts in its September statement. . However, financial and investment markets will anticipate the pivot in advance and adjust prices now. We are already seeing this play out in the bond market as they vote with their feet and the value of the US dollar must surely follow lower bond yields (in a lagged fashion).

The Fed meets this week on Thursday morning (6am NZT) and a further 0.75% increase in its interest rate to 2.50% is already priced into the market. US GDP growth data for Friday morning July 29 for the June quarter is expected to reach an annual growth rate of between 0.40% and 0.60%. A lower-than-expected actual number, or a negative number, would cause the value of the US dollar to fall sharply as the need for further increases in US interest rates to reduce inflation fades. US employment data for July on Friday August 5 will also be a key indicator for the markets. The consensus forecast calls for a lower increase of 260,000 after the better than expected increase of 372,000 in June.

The direction of the NZD/USD exchange rate continues to be completely dominated by the USD side of the equation. Not even a 5% drop in dairy prices last week prevented the Kiwi Dollar from advancing to 0.6250 as the AUD saw gains and the USD weakened in global currency markets .

Burgernomics and purchasing power parity theory

The Big Mac Index was invented by The Economist magazine in 1986 as a light guide to whether currencies are at their “correct” level. It is based on purchasing power parity (PPP) theory, the idea that over the long term exchange rates should approach the rate that would equalize the prices of an identical basket of goods (the Big Burger Mac was chosen) in any country. two countries. It’s not precise; however, it is a standard measurement that is better than most.

According to The Economist, a Big Mac burger costs NZ$7.10 in New Zealand and US$5.15 in the United States. The implied exchange rate is therefore 0.7250. The current NZD/USD market rate is 0.6250, so the Kiwi Dollar is 14% undervalued against the USD. The Australian dollar is undervalued by 10.2% and the euro by 7.5%. The Swiss franc is overvalued by 30.3% (a Big Mac costs 6.50 SFr in Zurich) and, at the other end of the scale, the Venezuelan bolivar is undervalued by 66%.

Another drop in stocks remains as Kiwi dollar risk

Strong sell-offs in US equities in April and again in early June hit the Kiwi Dollar hard (circled areas in chart below) as investor risk aversion sentiment pushed hedge funds to sell stocks. risk-sensitive currencies (NZD and AUD). Stocks have rallied in recent days as US corporate earnings have yet to be affected by the slowing economy. The sudden reduction in yields on risk-free US Treasury bonds to 2.75% was more favorable news for tech stocks which sold off when bond yields rose sharply in April and June.

The close correlation between the Dow Jones index and the NZD/USD exchange rate cannot be ignored. Some market commentators are suggesting that stock markets could fall another 10% on top of the Dow Jones’ 20% plunge from 37,000 in January to a low of 30,000 a few weeks ago. If that were to happen, the Kiwi Dollar would be vulnerable to further selling. However, given the greater likelihood of the Fed pivoting sooner than most think on a weaker US economy and lower oil prices (now at US$95 a barrel), the likelihood of another selloff stock market massiveness seems to be shrinking. Even a modest rally in the Dow Jones Industrial Average from 32,000 to 34,000 would propel the Kiwi Dollar higher to 0.6800.

The NZD/USD rate at 0.6250 has now broken decisively higher to sit above the downtrend line it has been trading below since 0.7000 in late March (black line in the chart below). below). Our forward view remains unchanged, the NZD will follow the AUD higher over the next few months.

USD importers should be at minimum hedged levels and USD exporters continue to hold maximums replacing all maturing hedges. USD exporters facing bank credit constraints because existing hedges are in an unrealized loss position on mark-to-market revaluations are advised to purchase NZD call options (which do not use bank credit). Buying NZD call options with strike rates two cents above the spot of 0.6250 (i.e. 0.6450) has an indicative cost of 80 trading points .

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*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has been writing commentaries on the New Zealand dollar since 1981.

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