Eugene Leow, Rates Strategist
DBS Group Research
Rates: Staying the course for higher USD rates
· While the ongoing US-China trade war will overshadow sentiment today (the US is poised to slaps tariffs on another USD200bn worth of Chinese imports by noon while China is poised to retaliate with tariffs on USD60bn of American imports), we should not ignore the fact that US economic fundamentals remains firm. With US growth and inflation dynamics still running above trend, arguments for a slower pace of rate hikes do not hold. Our view for one hike per quarter till the Fed funds rate ceiling hits 3.50% (put in place since April) still holds. The market has gradually gravitated closer to our view as trade war noise gets filtered out. Notably, the implied Fed funds rate now stands at 2.82% in end-2019 (pricing in slightly over four hikes), compared to 2.65% at the start of the month.
· Longer-term USD rates were not spared with 10Y UST yields back above 3%. The pricing in of more Fed hikes, rising inflation expectations (10Y US breakeven rose to 2.15%, from 2.09% at the start of the month) and higher German Bund/JGB yields led to the sizable upward adjustments in US yields. At 3.06%, 10Y UST yields are close to our forecasts (held since April) of 3.10% and 3.20% for 3Q and 4Q respectively. While we still think that USD rates are biased higher over the coming few quarters, we are getting even more wary of market positioning. Over the past few quarters, the net short non-commercial futures positions have been steadily building in the 5Y and 10Y tenors. This phenomenon has since spread to the 2Y tenor. Net shorts increased to 246k contracts, from close to zero in July.
FX: European currencies under political pressure
· European currencies are facing political challenges from Brexit and Italy. Last Friday, we warned against optimism for any deal on Brexit and Italy looking to respect EU budget rules. The British pound plunged to 1.3072 from 1.3265 last Friday after UK-EU talks hit an impasse, followed by the opposition Labour Party looking to push for a second referendum. Expect EU leaders and officials to start talking tough on Brexit and Italy this week. Overall, the inability of the governments in UK and Italy to agree amongst themselves, and with the EU, is likely to see the pound and euro giving up this month’s gains.
· Against this background, USD bears hoping for the Fed to signal a pause in its hike cycle will be disappointed. Forward guidance and not the fully discounted rate hike at the FOMC meeting on September 26, however, will be needed to lift the US dollar. Fed Governor Lael Brainard supports the Fed’s dot plot to gradually increase rates into 2020 to more than 3%. Brainard’s comments are important because she is sensitive to global economic developments; she was the Undersecretary of the Treasury for International Affairs during the Eurozone sovereign debt crisis.
· Brainard, however, made these comments before US President Trump announced tariffs on an additional USD200bn worth of Chinese goods into America. These tariffs are set to come into effect today, starting at 10% before they rise to 25% on January 1, 2019. China has also withdrawn from trade talks with the US. With US stocks at record high and the US 10Y bond yield above 3%, and Fed officials downplaying the possibility of yield curve inversion, the Fed is unlikely to deviate from its gradual rate hike stance.