President Powell could have been very balanced or even hawkish. But he effectively chose to endorse the market's discount for a future rate cut phase. He had a strong reaction. Risk assets rose, the dollar fell, and so did front-end yields. However, watch the longer-term yields - deep thinkers in the bond market are not completely convinced that all cuts are good.
Disruptions on the horizon
President Powell in Jackson Hole:
"Inflation risks tend to be on the upside, and employment risks tend to be on the downside - a difficult situation. He noted that when our targets are in such tension, our framework calls for balancing both sides of our dual mandate. Our policy rate is now closer to neutral by 100 basis points than it was a year ago, and the stability of the unemployment rate and other labor market measures allows us to proceed cautiously while considering changes to our policy stance. However, with policy in restrictive territory, the baseline outlook and changes in the balance of risks may justify a shift in our policy stance."
This was more pessimistic than we expected in the interest rate strategy. He did not object to the rate cut at all. It is clear that he is keeping his options open, but the main move was to reduce the inflation risks arising from tariffs, largely due to a weak labor market. The market's reaction to the phrase "changing risks may warrant a policy adjustment" mostly reflected increasing market fears that Powell was explicitly hawkish in his speech. Front-end yields are lower in yield (below 3.7%), likely structurally. The 10-year Treasury yield is also (near 4.25%). The probability of a rate cut in September has returned to 90%, after being below 70% before his speech.
There is a clear incentive for the yield curve to decline from this. The front end is now aligned with President Powell, and yields there are expected to remain low. The market anticipates a final move towards a 3% effective federal funds rate, so the two-year yield at 3.7% is still about 70 basis points higher than this future minimum. However, the long end does not favor this. The 30-year bond yield has returned to where it was at 3.9%. This likely reflects doubts that the Federal Reserve may risk inflation here.
The renewed threat this morning from President Trump to dismiss Federal Reserve Governor Lisa Cook (for alleged bank document forgery) is another element to consider, as Trump continues his quest to turn the Federal Reserve into a hawkish entity. The front end will not care about this, as it is dependent on where the interest rate on money is heading. But the back end is deeper thinking and can worry about the effects of second and third rounds, especially concerning the medium-term risks that inflation may face.
The net effect here is a steeper curve, formed from both ends as the potential speculation in the future.
The dollar takes a hit and more is coming in the future
Once foreign exchange traders saw the key signal of "policy adjustment", the dollar fell sharply - dropping by nearly 1% against some major currencies. This discourse supports the conclusions reached after the July jobs report that the Federal Reserve might move in September after all. This discourse comes at a time when the market has largely ruled out any expectations of additional easing from the European Central Bank. And as the market seriously considers another rate hike from the Bank of Japan in October.
The decline in short-term U.S. interest rates also fuels the narrative that foreign investors may increase their foreign currency hedging ratios on their holdings of U.S. assets. We have targets at 1.17 and 145 for EUR/USD and USD/JPY at the end of this quarter. If we are right about a series of rate cuts from the Federal Reserve by the end of the year, EUR/USD and USD/JPY may trade at 1.20 and 140 respectively.
High-yielding currencies in emerging markets, already favored by global investors, are expected to continue performing well. Within the G10, we also believe that activity currencies should outperform. Typically, an upward slope in the U.S. yield curve is good for commodity currencies. We think AUD/USD could play a small role here. With stocks seemingly performing well on the Fed's interest rate cuts without a recession, high experimental-value Scandinavian currencies that are undervalued should also perform well.
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