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Market participants are shifting focus towards downside risks to the economy. Since the start of the year, the focus has been largely on US inflation and the rapid catchup of Fed hike pricing. At this point, with short rates factoring a terminal of close to 3% for the Fed, it is difficult to argue that USD rates are clearly too low. Moreover, there has been increasing concerns on the US economy and these worries are starting to overshadow inflation worries. Last night’s weakness in new home sales (actual: 591k, consensus: 748k) marked the first clear sign that higher rates are restraining the US economy. This shift has been capping longer-term USD rates even as the Fed has not shifted on its hawkish rhetoric. We might well be past peak inflation / duration fear for the US. Current USD rates are probably a tad low and could grind higher when sentiment improves, and recession fears recede. However, we do think that the bulk of the adjustment higher may be done and a further grind higher may not be as damaging for sentiment. The upshot is we have turned more cautious on the US and are on the watch for downside risks. While we doubt that the Fed would be deterred from hiking in the coming two quarters, if data weakens materially in subsequent quarters, the runway for tightening may get shortened (resulting in a lower terminal rate than we currently expect).
There has also been a shift in focus from Fed tightening to other central banks tightening. Note that this has been the case even as the Fed was not the quickest amongst the G10, the RBNZ and the BOE were ahead of the Fed. Notably, attention is shifting to the ECB, which has hinted that an exit from negative rates may be on the cards as soon as 3Q, and the RBA, which just kick offed with a rate hike in early May. This might mean that the interest rates differential between the US and the laggards (in terms of policy normalization) will narrow going forward. Policy convergence in the DM space is accelerating with many central banks communicating / or embarking on tightening. Only the BOJ remains clearly dovish. Policy convergence towards tightening is also more apparent across EM / Asia where there is an increasing impetus to accelerate tightening. China remains the exception as it took more aggressive steps (cutting the 5Y LPR) to cushion the economy.
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