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Expectations about the magnitude of interest rate hikes at major central banks may have peaked, which could mean financial and currency markets have seen a significant turn.
More importantly, it has led some analysts to suggest that the “peak of the dollar” may be near.
A look at money market prices suggests that the peak of expectations for the number and total amount of hikes by the Federal Reserve, European Central Bank and Bank of England may have been reached last week.
Reuters data shows a continued retracement of investor expectations for the extent of central bank tightening ahead.
The Federal Reserve’s maximum Fed Funds rate is now estimated at 3.4%, down from 4.1% before the Federal Reserve’s policy last week.
This shift was aided by surprisingly weak US PMI data on Thursday, which led to lower US bond yields, a weaker dollar and higher stock markets.
The European Central Bank’s peak rate is now seen at 1.8%, down from the peak of 2.6% seen last Tuesday, also helped by disappointing Eurozone PMIs released on Thursday.
The Bank of England is expected to push its bank rate to a peak of 3.0% from 3.6% last Monday.
The fall in the yield paid on government bonds reflects this change in anticipation.
French and German 10-year bond yields fell 20 basis points in the wake of disappointing PMI data on Thursday, while those in the UK fell a more subdued 12 basis points as UK PMIs defied expectations coming out stronger than expected.
This provides a compelling explanation for the rise in the pound-euro exchange rate in the wake of the PMIs.
Above: German (top) and French (bottom) ten-year bond yields.
“While it is not yet set in stone that a recession is inevitable, all the pessimism has clouded the expectations of aggressive tightening that market participants had priced in for major central banks. ‘raise their bets on rising rates to lower their forecasts of terminal rates,’ says Raffi Boyadjian, chief investment analyst at XM.com.
The dollar has been the main beneficiary of rising rate expectations, as it is the Fed that is leading the charge higher as it grapples with soaring US inflation.
But raising interest rates only lowers inflation because it slows economic growth.
And it was growing fears of slowing growth, which could lead to a recession, which in turn dampened investor expectations.
So the bet is that the Federal Reserve will make further aggressive hikes in the near term, then end its cycle before cutting again.
“A look at the US OIS band suggests it is now pricing in a shallower Fed tightening cycle with the first “rate cut” almost priced in for H223,” says Valentin Marinov, head of G10 FX strategy at Credit Agricole .
Above: UK ten-year bond yields (top) and US ten-year bond yields (bottom).
Because the other major central banks cannot afford to be left behind by the Fed, they will follow a similar path.
Until rate hike expectations turn higher again, the dollar may struggle to create upward traction, allowing stocks like the pound and euro to rally.
“The USD has generally struggled to extend recent gains,” Marinov says. “Part of that is because US rates and US yields haven’t hit new highs either.”
“It almost seems like the markets have concluded that the Fed has finally reached its peak of hawkishness. If this is confirmed in the coming weeks, it will support our belief that a lot of the Fed-related positives are in the overbought price and overvalued USD,” he adds.