US treasuries turnaround, Fed sees more work to do to contain inflation pressures as RBNZ moves into the spotlight

By Jason Wong*

US Treasuries showed a sharp turnaround Friday night, with yields closing lower after trading at fresh three-month highs. The US dollar (USD) tracked the turnaround and finished modestly weaker after heading higher through the Asian trading session. The NZ dollar (NZD) closed just under the 0.6250 mark after a test of the key 0.62 support level.

There was little news on Friday to guide markets but there was still some notable price action. Through Asian trading and the early European session, US Treasury yields extended their run higher, with fresh three-month highs for both the 2-year and 10-year rates, the latter peaking at 3.925%. From that point on, there was a sharp turnaround, with an 11 basis points fall in yield to close near the low for the session at 3.815%. There was no obvious explanation for the turnaround, with traders noting some short-covering flows ahead of the long US weekend, and the move coincided with a similar track for German bunds. Still, the 10-year rate was up for the fourth successive week (+8bps), reflecting the run of positive economic surprises and fears that inflation could remain stronger than longer following the uncomfortably high Consumer Price Index and Producer Price Index prints.

This was seen to add to the chance of more Fed tightening than previously thought. Goldman Sachs and Bank of America economists added another 25bps to their Fed Funds rate projections, both now picking three more 25bps hikes over the next three meetings through to June, for a peak target range of 5.25% to 5.5%. Market pricing for the peak Fed Funds rate closed the week at 5.19%, or 61bps higher than the current effective rate, meaning two full hikes and a near-even chance of a third additional hike.

Fed speakers continued to run the line that there was more work to do to contain inflation pressures. Richmond Fed President Barkin still favoured hiking in 25bps clips but didn’t get drawn into how high rates might need to go, saying “how many of those, I think we will have to see”. Fed Governor Bowman said “we’ll have to continue to raise the federal funds rate until we start to see a lot more progress” on reducing inflation and she would be looking for “a consistent decline in inflation” before favouring pausing rate increases.

The USD followed the move in Treasury yields, trading at a fresh six-week high before reversing course. Reflecting this profile, the NZD briefly traded just below 0.62 – a key support level – before rising through the US session and closing the week just under 0.6250, albeit down now for three weeks on the trot. Narrower NZ-US rate spreads was one factor for NZD weakness last week, as the market pared expected (Reserve Bank) RBNZ hikes (see below) at a time when it extended the path of Fed hikes.

The AUD (Australian dollar) fell towards 0.68 before closing the week around 0.6880. The NZD was flat to modestly weaker on the crosses. The only economic data released of note was a “surprise” lift in UK retail sales volumes in January, with the volume of core sales up 0.4% m/m. This continued the pattern seen elsewhere, of stronger January data after a weak end to last year – speaking to some widespread seasonal adjustment issues around the turn of the year featured across a number of countries.

The domestic rates market saw further re-pricing of monetary policy expectations that pushed short rates down, while longer term rates ticked higher, resulting in further curve steepening.

The devastation wrecked by extropical cyclone Gabrielle, as well as the weaker inflation expectations print earlier in the week, has the market convinced that the RBNZ won’t be delivering a 75bps hike this week, and the Bank is more likely to settle on a 50bps hike, with a small chance of either no change or a smaller 25bps hike, with Overnight Indexed Swap (OIS) pricing closing at 4.715%.

The 2-year swap rate ended the day down 6bps at 5.09% – down 16bps from the 5.25% peak earlier in the week, albeit down only 2bps from a week ago. The 10-year swap rate closed the day up 3bps at 4.49%.

Sunday, Finance Minister Grant Robertson put a figure on the expected cost of recovery at $13b of “around the ballpark that we’re looking at right now in terms of the cost”. That isn’t the government’s share, as insurance will cover some of that. NZ Government Bonds slightly underperformed swaps last week in a kneejerk reaction to the likely increased bond supply to cover the costs of the government’s share. But with tight supply conditions, rebuilding infrastructure will take many, many years so the fiscal cost would be spread over a long time.

The calendar for the day ahead is light and the US Presidents Day holiday will likely mean quiet trading conditions. In the week ahead the domestic focus turns to the RBNZ Monetary Policy Statement on Wednesday, where expectations are centred on a 50bps hike in the OCR to 4.75%, as noted above, and the projected rate track likely no higher than the 5.5% peak projected in November.

The same day, Australian wages data could be market moving if it surprises in either direction. Globally, the key releases include flash PMIs (Services Purchasing Managers' Index) for February and US spending and income data alongside the PCE deflators (Personal Consumption Expenditure Deflator) at the end of the week.

Check out our Economic Calendar here ».

*Jason Wong is Senior Markets Strategist at BNZ.