Video: Positioning for USD weakness (7:13)
The greenback has fallen 10% from its 2022 peak. What's next? Listen in to CIO FX Strategist Teck Leng Tan.

Thought of the day

US equities, bond yields, and the dollar all declined Wednesday, after a Fed mention of staff projections for a “mild recession” pulled market attention away from the relatively benign March CPI release. Risk-off sentiment continued through to Asia on Thursday, with pressure on China's tech sector also weighing on sentiment.

US headline CPI rose 5% y/y in March, which was the smallest increase since May 2021 and down from 6% in February. However, core CPI increased by 5.6% y/y in March, up from 5.5% previously. Shelter has been one of the biggest inflation drivers in recent months, even though data on new leases shows that rent increases have sharply slowed. In March, rent for primary residences slowed to 0.5% m/m, down from 0.8% in February. Given the lags in the data, it's likely that rents will continue to slow over the course of 2023, in our view.

The softer data supports the perception that after raising rates by a total of 475 basis points in a little over a year, the Federal Reserve is nearing the end of its tightening cycle. But we still see reasons to remain cautious about the outlook for the US economy and corporate earnings.

Inflation is cooling but remains sticky and well above target. In our view, the March data will not be enough for the Fed to declare victory over inflation, and we look for another rate hike at the next FOMC meeting on 3 May. If the data continues to show the labor market and inflation cooling off, this could be the last hike of the cycle. But even if the Fed opts to pause after the May meeting, with US inflation still running well above its 2% target, we think the central bank is likely to want to see the hikes delivered thus far bringing inflation down closer to that target before it can consider any rate cuts (i.e., a pivot).

The FOMC minutesreflect the negative economic impact of banking uncertainty. The minutes from the March meeting show that the FOMC anticipated that credit tightening would have a negative impact on economic activity and inflation, especially considering that the rate hikes the Fed had previously implemented were already weighing on business investment. They also saw an impact on consumer sentiment, which could lead to restraints on spending.

The US economy is already slowing, and credit conditions are tightening. US recession risks are rising, as evidenced by the latest March ISM manufacturing PMI falling to 46.3, its lowest level since May 2020 and the fifth consecutive month in contraction territory. The US labor market is also starting to cool, with March nonfarm payrolls and February JOLTS data showing slower wage growth and lower job openings. According to the Dallas Fed Banking Conditions Survey conducted 21–27 March, commercial and industrial loans, real estate lending, and loan volumes have fallen while credit standards have continued to tighten. Historically, tighter credit conditions have been correlated with weaker corporate earnings.

So, with the US economy cooling and a Fed pivot not imminent, we believe the environment for equities will remain challenging in the coming months. We are least preferred on global equities, including the US, where we expect earnings to contract 4.5% this year. We prefer bonds to equities, and we like high grade (government), investment grade, and sustainable bonds relative to high yield bonds. Apart from the potential tailwinds from an eventual Fed pivot, we think that high-quality bonds can offer defensive traits to a portfolio in the event of a sharper economic downturn.