Home Market news Articles US sends mixed messages as economy attempts to cool

US sends mixed messages as economy attempts to cool

By the OFX team | 8 February 2023 | 5 minute read

In announcing a 0.25% rate hike on February 1, the US Federal Reserve gave investors real hope that the goldilocks scenario of an economic soft landing was just right.

Markets rallied instantly on the perception that aggressive rate hikes were coming to an end. The dollar index (a measure of US dollar strength against a basket of currencies) dropped significantly as Powell was speaking, hitting an 8-month low. Decreasing or moderating interest rates, or a declining gap in interest rates between countries will result in the currency of the country moderating rates depreciating as investors chase higher returns.

“We can now say… for the first time that the disinflationary process has started” – Jerome Powell, US Federal Reserve President

Stockmarkets took off too as a “risk on” sentiment took hold, with investors concluding that with rates likely to moderate, some of the economic conditions beneficial to company profits would also improve.

“The thing of interest to investors and the market in general was the acknowledgement in Jerome Powell’s speech that disinflation is here,” says Hugo Horton from the Treasury team at OFX. “Inflation is still high but it is increasing at a lower rate which is good to see. Ultimately, (that message) has paved the way for lowish hikes (in the future)”.

The Fed’s pronouncement looked to reinforce the steady downward progression the US dollar has had against major currencies since late last year when the last of the series of outsized rate hikes of 0.75% was enacted.

But the party didn’t last for long. Just a few days later on February 3, the goldilocks scenario that looked just right on February 1, all of sudden looked a little too hot, with a jobs report showing new jobs were being created far faster than anticipated. Employers added over 500 thousand jobs in January, nearly double the amount of jobs added in December, pushing the US unemployment rate to its lowest level since 1969.

At a time when observers were hoping that the rate rises were starting to defeat inflationary pressures, it was something of a wake up call that completing a soft landing (something that has only been achieved a few times in 50 years) may not be so easy.

Goldman Sachs’ Chief Operating Officer, Gary Cohn, took the jobs market as the most important factor the Fed was focused on during Powell’s press conference.

Markets change their short term view

After the exuberant response to the Fed’s rate decision, the hangover from the jobs report has eroded confidence. US markets have fallen back from their gains and the dollar index has turned around to be 1.7% higher against major currencies since the jobs report came out.

Goldman Sachs’ Chief Operating Officer, Gary Cohn, took the jobs market as the most important factor the Fed was focused on during Powell’s press conference.2

Bond markets have also changed their view following the jobs report.

Prior to the report, bond investors had been pricing another 0.25% rate hike in March, with a peak interest rate under 5%. Now they are factoring hikes in May and possibly June, to take rates to 5.12% by mid-year.3

It’s the interest rate differential, and the economic conditions surrounding it that will be the ones to watch going forward. On February 2. The Bank of England raised rates by 0.5% to 4% – its highest level in 14 years – and the European Central Bank raised rates by 0.5% to 2.5% – its highest level since 2008. In the case of the UK, OFX’s Horton says a recession is likely in the first quarter of 2023 but it may be “shallower and shorter” than previously expected. This will likely keep downward pressure on the pound.

For the Eurozone, inflationary pressure has eased as an unseasonably mild winter has kept energy prices down but the ECB still said they will hike rates another 0.5% in March with inflation still high at 8.5%. While the euro did get something of a boost against the US dollar on that news, it quickly fell back again on those US job numbers.

Longer term, goldilocks hope remains

Ultimately, the key factor in whether the US dollar will continue its slide against other currencies will come down to whether the jobs numbers will outweigh other economic data that suggests the US is slowing.

The jobs report showed that despite red-hot demand, wage growth continued to moderate. At 4.4% it is still higher than the Fed’s inflation target but wages aren’t growing as rapidly as they were in December. The fact that wages appear to be moderating at the same time as inflation cooling is a positive sign.4 The closer the US is to the end of its rate hikes, the greater the likelihood its currency will depreciate. “The Fed was first to hike aggressively and that helped boost the dollar initially. Now it is looking to hike at a slower rate, whereas others are still hiking at an aggressive rate,” says Horton. “That’s where the interest rate differential comes into play. Once the US hits a terminal rate, and others keep hiking, that will mean that currency will likely appreciate against the dollar.”

The closer the US is to the end of its rate hikes, the greater the likelihood its currency will depreciate.

What to watch

Something worth keeping an eye on, according to Horton are the re-emergence of “risk on” sentiment and the re-opening of China.

If the US does manage to execute a soft landing then that will give investors confidence to invest and as the global economy fires up, companies will look to buy more goods from manufacturing nations. That would boost the prospects for so-called commodity currencies like the Australian, Canadian and New Zealand dollars as they are heavily oriented to commodity exports.

China’s reopening will also benefit, as pent up demand at manufacturing plants like steel mills will drive energy and materials usage.

The “risk on” sentiment is definitely there. That paired with China’s reopening and the need for commodities is going to pave the way for both the Aussie and Kiwi dollars to increase further than sterling and euro against the US dollar.”

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