G10 FX Weekly: Three Key Trades Following Jackson Hole

Summary

• The annual gathering in Jackson Hole is over, with senior central bankers including Fed Chairman Jerome Powell and ECB President Christine Lagarde having spoken at the event.
• Although no game-changing messaging emerged from Jackson Hole, price action in reaction to subsequent data releases leave key markets at interesting levels heading into a busy September.

Market Implications

• For US 2-year treasuries, the yield has this week challenged, and pulled back decisively, from the year-to-date (YTD) high at ~5.12%. We like fading this elevated yield, as any level near 5% will prove attractive to investors, especially with market pricing suggesting the Fed tightening cycle is nearly complete.
• For 2-year German bonds, we also like fading the current elevated yield. The yield is back above 3%, similarly at a level that will also prove attractive to investors, with market expectations also pricing the ECB tightening cycle near its end.
• EUR/USD briefly traded through the bottom of the 1.08/1.13 trading range we highlighted in a recent weekly note, before bouncing robustly. We think this price action and the dynamics driving it bodes well for additional upside in the pair. 

Introduction

The key takeaway from the Kansas City Fed’s annual Economic Policy Symposium in Jackson Hole last weekend is that data dependence will be de rigeur for the Fed and ECB. Data this week has certainly driven price action in FX and rates markets.

Fed Chairman Jerome Powell and ECB President Christine Lagarde spoke at the event, with both central bankers highlighting data dependence as the critical guiding determinant of future interest rate policy in the US and Eurozone.

To underscore the importance of economic data on market expectations, releases on both sides of the Atlantic this week have led some of the bellwether markets we focus on to trade at very interesting levels. And this leaves them finely poised ahead of the busy period about to begin in September.

For 2-year US Treasuries, the yield is now trading 4.88%, after this week trading within one basis point (bp) of the multi-year high seen last month at ~5.12%.

We are still in favour of fading elevated short-end US yields, as outright levels anywhere near 5% look tempting. Additionally, with market pricing suggesting that Fed is near the end of its tightening cycle, longs become even more attractive.

We also like fading elevated short-end German yields, with the 2-year now trading at 3.07%. As in the US, this outright level looks tempting. Moreover, with the market also pricing the ECB near the end of its tightening cycle, this trade is even more tempting.

Finally, EUR/USD is also at a critical price level, having briefly traded below the bottom of the ~1.08/1.13 range which had contained the pair since mid-June.

The robust bounce in the pair this week back above 1.09, driven largely by data surprises and central bank pricing, supports EUR/USD pushing higher in the coming weeks.

Approach the three markets mentioned above cautiously, however. In recent weeks, we have liked reducing position sizes, thereby allowing traders to remain nimble, and this approach still seems sensible to us.

By doing so, it is easier to act more opportunistically and maintain flexibility into and beyond upcoming key Eurozone and US data points, including US jobs data tomorrow.

Fed Messaging

Fed Chairman Jerome Powell’s remarks at Jackson Hole were highly anticipated and closely watched. Overall, we concluded that his messaging was balanced.

Powell’s speech gave the Fed the flexibility to keep rates on hold next month while keeping its options open for the future.

On the one hand, Powell said he thinks interest rates will stay high and could rise even further if economic data warranted such a move. He added that the Fed still had more to do to combat too-high inflation. This could be interpreted as hawkish.

On the other hand, Powell also said that the Fed will proceed carefully and that the central bank will be acutely focussed on managing risks emanating from an increasingly uncertain macroeconomic backdrop.

The impact of the tightening already enacted by the Fed is a source of much of this uncertainty, as is the direction of inflation and the US labour market. This uncertainty, and the Chairman’s acknowledgement of it, could be interpreted as dovish.

Also on the dovish side, the Chairman characterised current interest rates as ‘restrictive,’ and that real interest rates ‘are now positive and well above mainstream estimates of the neutral policy rate.’

In sum, therefore, there was something for both hawks and doves in his speech. Perhaps most importantly, though, Powell reiterated the importance of economic data and how dependent the Fed’s future actions will be on the evolution of this data.

This messaging is not new. It has been the modus operandi for the Fed for several months now. As such, rather than being a game changer, Powell’s remarks were a continuation and reiteration of recent Fed communications.

ECB Messaging

ECB President Christine Lagarde’s remarks at Jackson Hole were also not earth-shattering. Much of what Lagarde said has been heard in recent communications, both from the President herself and from her colleagues on the ECB’s Governing Council (GC).

Lagarde did not give any indication, either way, when it comes to the next ECB rate decision on 14 September. Instead, she said that the ECB is ‘deliberately, decisively data-dependent’ and not pre-committed to one course or the other on monetary policy.

This should sound very familiar to ECB watchers.

And while noted ECB hawks Joachim Nagel and Robert Holzmann both made hawkish comments during and following Jackson Hole, a Reuters sources piece on the eve of the conference revealed that momentum is growing for a pause in rate hikes next month.

The Reuters piece said that members of the GC were increasingly concerned about deteriorating growth prospects in the Eurozone and suggested that the ‘pause camp’ is now growing.

My colleague Henry Occleston commented on specific elements of the Reuters story, concluding that there is a 50:50 probability that the ECB tightens policy next month.

This is roughly in line with the market, which prices a 55% probability of a 25bp rate hike (more on this below).

Fed Pricing Shifted by Data

Before Jackson Hole, the market did not expect the Fed to tighten when it next announces rates on 20 September. Market expectations are slightly more dovish today for next month’s Fed meeting.

At the close of business (COB) on 24 August, the eve of the conference, the market had priced only 4.5bp of tightening. At COB on 25 August, following Powell’s remarks, the market priced 5.3bp of tightening.

Now, after softer-than-expected US data this week, in the form of softer jobs metrics and plummeting consumer confidence, there is 3bp of tightening priced for the Fed next month.

These expectations point to a very small probability of a rate hike next month (i.e., about 12%, versus roughly 20% this time last week).

For the November meeting, and assuming the Fed keeps rates on hold next month as the market expects, the market currently prices 12bp of tightening, or a 49% probability of a 25bp hike.

On 24 August, the market priced 13.2bp of tightening, or a 53% probability of a 25bp hike in November.

Looking into next year, by the end of 2024 the market expects the Fed’s policy rate to be at 4.26%, just over 100bp below the current level.

On the eve of Jackson Hole, the market priced the end-2024 Fed policy rate at 4.37%.

Again, further out the curve, as was the case for the next two Fed meetings, the data this week shifted expectations in a more dovish direction.

ECB Pricing Shifted by Data

Similarly, Lagarde remarks at Jackson Hole did not materially shift ECB expectations along the curve.

The hawkish tilt this week was catalysed by data, namely August inflation readings from Germany and Spain, which firmed up expectations of a 25bp ECB rate rise next month.

At the close of business yesterday, the market priced a 55% probability of a 25bp rate rise on 14 September.

On 24 August, partly reflecting last week’s awful PMI numbers, the market priced a 33% probability, odds which did not change materially with Lagarde’s ‘data dependent’ Jackson Hole messaging.

In terms of pricing the ECB’s terminal rate, the market currently sees only one more rate hike. Assuming the ECB holds fire next month, the October meeting has 21bps of tightening priced, which is the peak level.

The data mattered this week, and the market shifted ECB expectations accordingly.

A Look at Key US and EZ Markets

We now turn to three specific markets we have written about extensively in recent months: 2-year US Treasuries, 2-year German bonds, and EUR/USD.

2-Year US Treasuries

So far this year, the US 2-year treasury yield has traded in a 3.55-5.12% range.

The top of this range has proven a tough level to crack, with a virtual triple top printing in 2023 – on 8 March (5.08% high), on 6 July (5.12% high) and three days ago (5.1% high).

This triple top in the 5.08-5.12% zone now forms an important level for investors, giving a resistance that can be leaned against. This can give longs more confidence going forward.

As we wrote back in March, less than one week before the 2-year UST yield topped out and fell sharply, short-end US yields near 5% will attract buyers, given the attractiveness of the outright yield level.

We liked fading those higher yields back then and continue to favour the exposure now.

Additionally, with market pricing suggesting that the Fed is near the end of its tightening cycle, the trade becomes even more attractive.

2-Year German Bonds

The YTD range for the 2-year German bond yield is 2.1-3.38%.

The top of the range printed on 9 March, with the peak since then being 3.35% on 6 July, marking a virtual double top.

Even though ECB pricing has tilted hawkishly in recent days, the 2-year German yield is still ~30bp below the YTD peak.

Our view is that the same dynamic at play with 2-year USTs above 5% is at play with the 2-year German yield above 3%. The outright yield level is proving attractive to investors and, as a result, the yield struggles to make much headway above 3%.

We liked fading these higher yields back in March and July and continue to favour the exposure now.

Moreover, as with the Fed, even with hawkish ECB expectations firming this week, market pricing says the central bank is also nearing the end of its tightening cycle. This also makes this trade even more compelling.

EUR/USD

EUR/USD has traded in a ~1.05/1.13 range so far this year. From mid-June until last Friday, the range was even tighter (~1.08/1.13). On that day, the pair traded as low as 1.0766, closing at 1.0796. That was the first sub 1.08 close since 13 June.

Since that trough 6 days ago, the pair has rebounded sharply, now trading back above 1.09, comfortably within the range that has held all but that one day for the past 11 weeks.

The rise off last week’s low has mostly been driven by weaker-than-expected US data, with US yields falling sharply. At the same time, German yields are little changed.

Since the close last Friday, the US 2-year yield has fallen 22b, while the corresponding German yield is 4bp higher. Interest rate differentials, therefore, have moved in favour of the euro over the US dollar.

My colleague Bilal Hafeez noted last week that (until then) rate differentials had not been driving EUR/USD. If they had, Bilal argues that the euro would be much weaker.

Instead, general risk sentiment/global factors were driving the dollar, which means that a risk-positive backdrop is supportive of EUR/USD, while a negative backdrop weighs on the pair.

This assertion is consistent with price action this week, where equities in the US and Eurozone have risen simultaneously with EUR/USD.

This week has also seen ECB pricing tack hawkishly while the market’s Fed tightening expectations have softened. Should these dynamics sustain, and risk sentiment remain buoyant, this will benefit EUR/USD materially.

As a result, we think last week’s low in EUR/USD should now be a formidable support and that the pair should trade back towards the top of its YTD range.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)