Dollar is king as the FTSE 100 dominance set to continue

Risk appetite is higher at the end of the week after a mixed few days where central bank hawkishness has once again taking the shine off risk assets. In contrast, central bank hawkishness, most notably from the Federal Reserve, has had a huge impact on the US dollar, the dollar index is surging at the end of the week and is within touching distance of 100.00, the highest level since May 2020 and USDJPY is once again back above the 124.00. The 10-year Treasury yield is higher by nearly 4 basis points early on Friday and caps off a bad week for Treasuries, 10 -year Treasury yields are up by nearly 30 basis points since Monday. In fact, this is causing the US yield curve to steepen, so is there less of a recession risk in the current environment? 

US yields drive asset prices, but not recession risk  

The 10-year – 2-year US yield curve is still getting a lot of attention in the press. Earlier this week we were talking about a yield curve inversion, at the time of writing the yield curve has steepened and is currently  +19 basis points. This means that right now, longer dated yields are higher than shorter dated yields. We do not think that this means that the US economy’s recession risk has retreated in just a few days, instead it means that the market potentially thinks that the Federal Reserve will have to raise rates for a longer time period. Interestingly, the yield curve steepened at the same time as the 10-year breakeven inflation rate, which is used as a gauge of long-term inflation expectations, rose close to 3% earlier this week. This is problematic for the Fed, since long term inflation expectations are psychologically important, and are seen as a key driver of current inflation changes. A long-term rate at around 3% would be well above the Fed’s 2% inflation target and it would mean that the Fed would need to tighten rates for a longer period than currently anticipated. It would also mean that the Federal Reserve neutral rate would need to be significantly higher than the 2.5-2.8% currently expected. 

The prospect of losing the anchor on long term inflation expectations may have driven the raft of hawkish Fed speak this week and the content of the minutes from the Fed’s March meeting, where the Fed stated that they could start shrinking the balance sheet at a pace of $95bn per month. If this is the Fed’s strategy, then it seems to be working, as the 10-year breakeven inflation rate has retreated back to 2.82% at the time of writing. 

The strong dollar and what it means for markets 

Apart from highlighting how the yield curve is not a reliable recession indicator (if rates have to move higher for a longer period of time then the prospect of an actual recession is even greater), this is one explanation for why the dollar is strong. When/ if the dollar index breaches the psychologically important 100.00 level and stays there, then there are a few things worth watching out for. Firstly, the Bank of japan could choose to intervene to strengthen a very weak yen. Since Japan is a key energy importer, it is the world’s largest importer of LNG, the authorities in Japan have a vested interested in strengthening the currency to keep the price of imports lower. Thus, intervention risk is growing as USD/JPY approaches the 125 level. Also remember that the market could test the BOJ’s resolve in the coming hours and days to see if its previous threats to intervene have bite. If they do not intervene then we could see more upward pressure on USD/JPY in the coming days. Added to this, back in the 1987 stock market crash, it was currencies that triggered the wave of volatility that eventually caused equities to tank. While this time it could all be different, the prospect of the dollar index at 100 is worth watching closely. 

French elections weigh on the euro 

Bond yields around the world are rising in unison, for example, German 10 -year yields are now at 0.66%, their highest level since 2018, likewise, UK 10-year Gilt yields are higher by 16 basis points this week even though some Bank of England speakers have erred on the dovish side including Sir John Cunliffe. This is what happens when global bond yields are rising in unison and we could see significant further rises for European and UK bond yields. The increase in German bond yields has not boosted the euro, which is close to the $1.0850 low from March. That was the lowest level since May 2020, and if that level is breached then we could see back to the low at $1.07 from the height of the coronavirus pandemic. The euro is impacted by election jitters in France. The first round of voting for the next French President takes place on Sunday, with the second round of votes later in April. The markets have been shaky this week after polls found that Marine Le Pen, the far-right, traditionally anti euro candidate, was gaining votes and narrowing the lead with incumbent President Macron. It’s obvious that a good showing for Le Pen would weigh on French assets, and the euro in particular. In the past, Le Pen has never done well in second round votes, thus a good showing on Sunday does not mean that Macron will be out the door of the Elysée Palace, but it is likely to push EUR/USD back towards that $1.07 low from 2020. 

Brent crude oil props up the FTSE 100 

Elsewhere, the Brent crude oil price is back above $100 and is currently trading at $101.65 per barrel. We  continue to think that the oil price remains at risk from further upside, even though it gave back considerable gains in the last two weeks, falling from above $120 per barrel on 24th March.  A high oil price is helping to boost the FTSE 100, which is outpacing its US blue chip counterparts,  as you can see in the chart below. In the current environment, the UK index is doing well due to the large number of energy and mining companies. For example, Shell and BP are both up more than 2% on Friday as the market looks towards bumper Q1 earnings that will be released in the coming weeks, and news that new exploration will take place in the North Sea. Banks are also rising alongside interest rates. However, the weakest performers in the FTSE 100 at the end of the week, include Sainsburys and Ocado, after the former announced a wage rise for employees, and investors fret about costs and wage price inflation for grocery companies that have a high proportion of lower salary workers, which is where wage packets are increasing at a fast rate. This should come as no shock to the market, after all it was institutional investors who pressured Sainsburys a week ago to boost wage packets to help staff with the cost-of-living crisis the UK currently faces. 

Chart 1: 

To conclude…

Overall, it’s been another wild ride for the markets. Economic data is key and so will earnings season be for the future direction of stocks. Asset price movements have gone back to fundamentals (finally!) and the coming weeks are set to be a fascinating time for traders and analysts alike.