USD Shorts Squeezed Despite Tectonic Shift in US Short Rates

USD strength faded as the US core inflation finally failed to rise for the first time in 16 months. Still, there has been a tectonic shift in rate expectations of late – a particularly important driver of USDJPY.

The US core inflation data came in slightly below expected for February, and the year on year comparison pulled back -0.1% to 2.2%, the first drop in year-on-year comparisons since October of 2010. This is more than a bit ironic as US consumers are paying record prices for petrol at the pump for this time of the year – yet other data, including another strong rise in the weekly Bloomberg Consumer Comfort index yesterday, seems to be showing us that the psychological effect on confidence from high petrol prices is so far limited (the blow to confidence will crop up eventually if prices continue to rise, but probably not until prices get closer to 5 dollars a gallon since this is the third time in less than five years that prices have spiked to the four-dollar area.).

The slightly lower than expected inflation data saw the USD punished through tactical support areas as it failed to bolster the case for the Fed moving from neutral to a more hawkish stance. Still, as we look at below, there is a tectonic shift on the attitude toward Fed policy that has the market second guessing the Fed’s stated policy trajectory, as 2013 US rate expectations are on the move.

USD/JPY and Fed expectations
A couple of days ago, we looked at the seasonality in USDJPY, which for the fourth year in a row is rising as the end of the Japanese financial year approaches at the end of March. There may be a spurious correlation, however, in this “end-of-Japanese-financial-year” seasonality idea, as the moves in the US yield curve had me looking at what US rates were doing at the short end of the curve over that time frame. Indeed, as US short rates were coincidentally rising in every instance as well into early April since 2009. So, while there certainly could be a couple of figures of USDJPY volatility related to a change in hedging activity at the end of the Japanese financial year, the more important indicator for USDJPY will be US rate expectations and whether they continue higher. (That and risk appetite – which will likely be two sides of the same coin.)
Looking ahead
The move in the USD today is making it uncomfortable for the USD bulls, as the AUDUSD found support ahead of the 200-day moving average and has screamed off recent lows, EURUSD failed to take out 1.3000 and GBPUSD has zoomed back from a false break of the recent range lows. The ranges are still intact, but the greenback is in technical limbo as we look for whether next week brings a bolder statement of the USD’s intentions, one way or another.

Key point du jour: The USD would have an easier time maintaining its rally legs in an environment of risk-off and a Fed policy shift away from QE – as the US curve shift will have a hard time out-gunning other countries’ rate expectation shifts (ex-Japan, that is). Take a case like Canada – the two year swap there has risen almost 40 basis points this year, while the US 2-year swap has shifted a mere 12-14 bps. If we were going into a neutral to more hawkish policy stance and had risk off at the same time, the story would likely be a different one.

GBPUSD might be an interesting one next week as the pair fiddles back closer to the 200-day moving average and the CPI is up on Tuesday and the BoE minutes on Wednesday. The market is also beginning to take a guess that BoE rates could be on the move in 2013 as well.