AUD/USD, ASX 200: An inverse play on what happens with US 2-year bond yields

• ASX 200 and AUD/USD have rallied hard following the Fed’s dovish pivot
• Both charts are basically the inverse of the US 2-year Treasury note yield, underlining the importance Fed rate expectations may have on their future performance
• Given strength in the US economy, the potential for rate cut bets being pared appears an unappreciated risk

Australia’s ASX 200 and the AUD/USD remain driven by sentiment on the prospects for a soft landing for the global economy, reflecting their exposure to early stages of supply chains through Australia’s vast commodity wealth. And when it comes to what could determine whether we see a soft landing, much will come down to what the Federal Reserve does with interest rates given its proxy role as the world’s central bank.

ASX 200, AUD/USD surge following Fed’s unexpected early pivot

Both the ASX 200 and AUD/USD rallied hard in late 2023 as the Fed introduced financial conditions as a driver of monetary policy in mid-October, paving the way for the FOMC “pivot” towards signalling rate cuts in December. The pre-emptive dovish move – at odds with warnings issued by Fed Chair Jerome Powell previously about declaring victory over inflation too quickly – was perceived by markets as the Fed prioritising growth over inflation, resulting in cyclical assets ripping higher.

But now that’s priced. And there remains unease that progress in returning inflation back to the Fed’s target may stall, especially with the US economy continuing to grow above potential with tight labour market conditions helping to fuel wage pressures, providing the environment that could leave services inflation at uncomfortably high levels.

But economic models suggest US growth, inflation and wages remain strong

You only need to look at the GDPNow, Inflation Nowcast and Wage growth tracker from the Atlanta and Cleveland Fed to see why doubts remain as to whether the FOMC will cut rates as much as six times this year, as markets are currently priced.

The Atlanta Fed GDPNow suggests the US economy grew at a seasonally adjusted annual rate of more than 2% in Q4, adding to the momentum reported in the three months to September. That’s the kind of growth that would normally add to inflationary pressures.

Source: Atlanta Fed

And based on the Cleveland Fed Inflation Nowcast, core PCE inflation may increase 0.26% and 0.25% respectively in December and January, lower than those seen for much of 2022 and early 2023 but not compatible with the Fed returning inflation to 2% on an annual basis.

Source: Cleveland Fed

The Atlanta Fed wage growth tracker also shows the prior deceleration in wage pressures stalled in late 2023, suggesting average hourly earnings grew 5.2% from a year earlier with rates for job leavers and stayers either remaining steady or increasing from a month earlier. That, too, is incompatible with the Fed achieving its inflation mandate unless we see an unlikely surge in productivity growth to accompany it.

Source: Atlanta Fed

While these are models and not infallible, they conflict with markets who refuse to let go of the view that widespread and large-scale rate cuts are coming in the United States, providing fuel for the soft landing narrative. Much of the progress in reducing inflation has come from volatile goods prices. But if that trend was to reverse with services inflation remaining strong, it would make it incredibly difficult for the Fed to cut rates by as much as 150 basis points. Right now, rather than a hard landing, that comes across as the more realistic tail-risk.

Trapdoor risk for cyclical assets appears elevated

For cyclical assets that have run hard on the lower rates, stronger growth narrative, such as the ASX 200 and AUD/USD, a meaningful unwind of US rate cut bets could lead to an ugly and abrupt air pocket for these markets. When you look at both, they’re basically the inverse of the US two-year yield, underlining the importance of US rate cut expectations in helping to sustain or promote further gains.

The ASX 200 sits in a descending triangle on the 4-hourly chart, testing downtrend resistance ahead of the US inflation report for December later In the session, an event that carries the potential to deliver a meaningful shift in Fed rate expectations despite it not being its preferred inflation measure.

A break to the topside would being a retest of the December high above 7630 into play, and likely an attempt at record highs after that. On the downside, minor support is found around 7438, 7368 and 7320, the latter the intersection with uptrend support running from late October.

For the AUD/USD, the setup is not too dissimilar, trading in a descending triangle having pulled back from multi-month highs struck in late December. On the downside, the pair has attracted strong buying on probes below .6672 dating back to the middle of last month. Below, uptrend support running from late October kicks in around .6620 with minor support near .6610 just below.

-- Written by David Scutt

Follow David on Twitter @scutty