Opportunities In Local Currency Assets After The Sharp Dollar Move

The Fed meeting last week led to higher asset price volatility across asset classes. A handful of economic indicators suggests that the US economy may be on the verge of slowing down over the next quarters. If the US government does not approve the planned infrastructure package or increase welfare spending the Fed would likely soon revert to a dovish stance for a longer period. On the other hand, if the Biden Administration succeeds in keeping the economy running hot by passing the ambitious infrastructure investment programme and/or boosting welfare policies inflation could remain a problem. Either way, we believe the Dollar’s sharp move higher last week represents an opportunity for Emerging Markets (EM) local currency assets. Alongside progress on vaccinations across most EM countries, stronger GDP growth would allow EM local assets to outperform, even in an environment of higher nominal US interest rates. EM central bank policies have already turned more hawkish, which provides further carry support at a time when EM real interest rates are already higher than real rates in the US and other developed economies.

The Fed’s reaction function

The Fed’s reaction function as far as inflation is concerned has not changed, in our view. The Federal Open Market Committee (FOMC) deliberated about the possibility of reviewing its policy on bond purchases (‘talking about talking about tapering’), which suggests that tapering will likely be discussed in July or August, but the Fed may not necessarily announce a change in policy at those meetings. Hardly hawkish, in our view. The so-called dot-plot, which illustrates FOMC members’ rate hike expectations, posted a surprise as seven out of the sixteen members of the FOMC foresaw the need for a rate hike already in 2022 and most members now expect two hikes by 2023. Although this was not far from what the US Treasury market (UST) was already pricing in, the FOMC was not expected to signal rate increases so soon. In effect, the FOMC acknowledged that it was behind the curve in terms of its expectations about nominal GDP growth (both inflation and real GDP) and has now adjusted its position in recognition of the recent improvement in data. Still, in our view, the Fed is likely to remain focused on keeping real interest rates at extremely depressed levels for a long time by actively pursuing higher inflation. This should keep real rates very low and the Dollar (USD) on the back foot.1

Market reaction

The initial UST reaction following the FOMC was to push yields higher with 5-year and 10-year yields rising about 10bps to 0.90% and 1.59%, respectively, while the yield on the 30-year bond rose 5bps to 2.21%. Over the next two days, the curve bear flattened as 2-year yields kept on increasing to 0.25%, but the rest of the curve declined with 5-year, 10-year and 30-year bond yields closing the week at 0.87%, 1.44%, and 2.01%, respectively. The yield on the 10-year and 30-year bonds closed 1bp and 13bps lower than at the start of the week. Other markets also moved. Commodity prices declined 3.0% with lumber prices down 15.2%, copper prices 8.5% lower, soy beans down -7.5%, gold off by 6.0%, and iron ore prices 5.5% lower. Equities also sold off as the S&P 500 closed the week down 1.9%, while the S&P 500 materials and financials components were down more than 6.0%, and energy and industrials were down 5.2% and -3.8%, respectively.