USD Rates: Skip or pause?
The front of the USD curve continues to reprice and is now entertaining the possibility of a Fed skip in June. This is a relatively new development, with the market only very recently assigning a higher probability of a July hike (37%) compared to a June hike (20%). Note that the front of the USD curve has been volatile in recent weeks. Between pricing in the risks of a banking crisis (odds of a June cut) just a few weeks ago to factoring in a pause and now into a skip, expectations have proven to be very fluid. The arguments for a skip are as follows. Inflation still looks sticky but the Fed might want more time to assess the impact of the hikes already delivered. Accordingly, keeping the option open for further hikes might make sense. Note that the RBA already delivered a skip so this is a plausible scenario for the Fed if certain conditions come into play (very firm economic indicators and limited financial market stress). However, this makes forecasting the terminal Fed rate much more difficult as the string of hikes would be broken. A skip is not our base case.
The key question lies with whether the Fed would be satisfied with cooling inflation or must the labour market show meaningful cracks before the Fed is willing to cement a pause. Aside from watching data, we would also be looking at financial conditions. When yields go up too swiftly, there tend to be stresses on the market. Thus far, markets have been calm as yield levels are not quite close to levels seen in early March (before the collapse of regional lenders). Rate pricing out through this year is more reasonable now, factoring in about 1.5 cuts from current levels. We reckon that the market will want to protect against some downside risks (commercial real estate and the banking sector) and keep some rate cut pricing in. These might be faded in time, but it is probably too early to conclude that the US economy will be fine out to the end of the year.
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