Mizuho Daily - Lost the (Dot) plot?

By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Lost the (Dot) Plot?

The question that begs asking with regards to last week’s FOMC’; whether the dovish plot was lost in the “Dot Plot” that flagged up two rate hikes for 2023 from none in the March edition.The rash of unexpected, and likely unintended, reactions/volatility across equities, commodities, FX and bonds not only demands reflection, but arguably warrants clarifications.

Equities wobbled at prospects of reduced policy support (cyclical-growth rotation a secondary theme); with Wall Street down 1.3%-1.6%, Nasdaq off 0.9% and EuroStoxx tumbling 1.8% on Fri.

Commodities have been knocked back in an unwind of the reflation trade, with a strong USD exacerbating the drop. Transposing this to FX markets necessarily results in USD bulls being most brutal on commodity currencies; squaring with Gold (-2.2%), ZAR (-2.2%), NOK (-2.1%) languishing the worst post-FOMC. NZD and AUD (-1.4%) are necessarily in that mix.

From 0.77 with 0.78 aspirations, AUD has flipped to desperately defending the 0.75-handle.

And this turn of USD bullishness is reflected more widely with EUR tumbling more than two-big figures (from above 1.21 to) below 1.19 from. USD/SGD up two big figures at mid-1.34.

USD/JPY by comparison appears muted at 110+; not dramatically above 109-110 pre-FOMC range. But this reflects offset from Cross/JPY drag and softer long-end UST yields.

(Not Quite) The “Real Deal”?

To be sure, we are not entirely taken aback by USD upswing although admittedly the brutality of the move was admittedly somewhat out of our ball park.Crucially, details of the drivers behind USD mechanics also differ from our expectations.

For the record, we had anticipated potential for USD rebound post-FOMC given the propensity for real (UST) yields to rise.

And indeed real yields rose. But this was not the “real deal” we had flagged. Not quite.

We had anticipated that the FOMC leaning more emphatically towards “state-dependent” policy accommodation would prompt a rise catch-up in nominal long-end UST yields to catch up with inflation expectations (break even); thereby resulting in higher real yields.

Instead, it was quite the opposite. As sharply as nominal yields fell, inflation expectations dropped even more to catch down.

So, real yields might have risen, but it got there very differently from how we had imagined it would play out.

This supposedly reflects market views that inflation expectations will be anchored, if not subdued, by the Fed shifting/signaling more hawkishly (at the margin); thereby tempering reflation trades and commodity assets/currencies in its wake.

But that appears to be unrealistic as assumptions go. After all, the Fed has committed to “flexible average inflation targeting”, which necessarily promotes inflation overshoot.

Arrested Steepening …

Another way to frame this is the “arrested steepening”. That’s to say, where a bear steepener led by rising long end nominal yields was anticipated, we were left with a bull (long-end)/bear (short-end), flattener; with 2Y yields rising sharply, but 10Y yields falling even more.

What’s intriguing about this is that markets appear to have fast-forwarded to rate hike prospects (hence 2Y yields jumping) whilst anchoring inflation expectations.

But this appears to be curtailing bear steepening (steeper yield curve driven by long-end yields rising) associated with “taper”, which is supposed to be “well before” rate hikes.

Whereas flattening (led by rising 2Y yields) is expected to follow only when “taper” is fully priced in (probably underway) and market move on to anticipate rate hikes that will follow.

So the question is whether indeed “taper” is already fully priced-in and markets have moved on; or markets caught wrong-footed by the “Dot Plot” have jumped the gun.

We are not convinced about getting past and over “taper” risks. After all, the Fed is not even “talking about talking about” this. So as “taper” reclaims the limelight from “Dot Plots” we expect “re-adjustments”. And so, two way volatility in bond markets will be a feature of this particularly clumsy transition to normalization by the Fed.

Credit: Mizuho Bank Ltd