USD: Time to Re-focus on Fed Pricing?

US Treasury bonds experienced continued downward pressure on the preceding day, owing to a troublesome amalgamation of factors including robust US activity indicators, an upsurge in supply, and the repercussions of Fitch's credit rating downgrade. This convergence of circumstances seems quite extraordinary, resulting in a bearish stance, and it is reasonable to raise concerns about the sustainability of this market downturn. It's doubtful that the dollar's potential for further strengthening can be attributed to these specific conditions.

The intricate details of the ISM service figures from the previous day might have been somewhat overlooked amidst the turbulence in the bond market. While the main survey's decline was only slightly more pronounced than anticipated (52.7), it remains in expansionary territory. However, the employment component exhibited a notable deceleration, dropping from 53.1 to 50.7. Furthermore, the ISM manufacturing employment gauge has reached its lowest point in a span of three years. 

The downgrade of the US sovereign credit rating and the escalation in long-term US yields have lent support to the dollar, particularly in contrast to higher-beta currencies. As mentioned earlier, this effect appears largely driven by transitory factors, and the dollar's immediate and medium-term prospects primarily hinge on the unchanged expectations of the Federal Reserve despite the recent bond market upheaval. Market projections imply minimal likelihood of further rate hikes (8 basis points) and anticipate the initial rate cut to occur in May 2024.

This positioning within the market allows for meaningful room for revaluation in either direction (such as pricing in a rate hike before the year's end or advancing the timing of the first rate cut). Interestingly, the heightened volatility in longer-term yields may lead to significant movement along that portion of the yield curve following the data release, thus influencing the foreign exchange market today. However, once the fiscal and bond supply factors abate, concrete economic data will be the guiding force beyond the immediate future.

I am closely monitoring the behaviour of two currencies that have become more affordable in this period of risk aversion: the New Zealand Dollar (NZD) and the Canadian Dollar (CAD). The former appears to have almost incorporated all the negative aspects, having already absorbed the dovish shift by the Reserve Bank of New Zealand (RBNZ), lacklustre domestic data, and concerns regarding China's economic growth. Should sentiment stabilize and interest in carry trades return, it could provide some relief for the high-yielding NZD. It is not unreasonable to speculate that the RBNZ may need to reconsider tightening policies based on an eventual resurgence in inflation later in the year.

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