- Pace of future central bank rate hikes expected to slow in the US and Europe, supporting risk assets
- UK and New Zealand central banks buck the dovish trend
- Survey data points to slower growth; OECD reduces growth forecasts with UK and Germany expected to contract
- Next week: Last US labour market print ahead of December Fed meeting as well as European inflation update
Pace of future central bank rate hikes expected to slow in the US and Europe, supporting risk assets
The minutes from the November Federal Reserve meeting revealed that most rate-setters now favour a reduction in the pace of rate hikes from here, although they also expect peak rates to be higher than currently forecast. This trend was echoed in Europe by the ECB’s chief economist Philip Lane, who stated that the “platform for considering a very large hike, such as 75bp, is no longer there” and that while more tightening can be expected, it would likely be in smaller increments. Indeed, a recent Reuters poll indicated that the consensus view among economists is that the next interest hike by the European Central Bank (ECB) will be 50bp. The preceding two hikes implemented by the ECB have been 75bp each, for a total of 200bp since the central bank started raising rates in July.
This more dovish rhetoric boosted risk markets, with equity markets rising towards a three-month high. Global bond markets were also well supported, with yields generally falling over the week, especially for medium and longer-dated debt. With shorter-dated bonds underperforming, the US yield curve continued to invert, with the yield difference inversion between 2-year and 10-year debt increasing by 10bp to -78bp, a level last seen in the early 1980s. Market participants typically see an inverted yield curve as an indicator of an upcoming recession.
UK and New Zealand central banks buck the dovish trend
The dovish “trend” amongst central banks was not evident in the UK or New Zealand, with the Deputy Governor of the Bank of England noting that the fiscal tightening in the recent Autumn statement was not likely to be felt until 2025, beyond the Bank’s three-year forecast horizon. Catherine Mann, one of the more hawkish members of the MPC, further warned of the risks of letting medium-term inflation expectations getting out of control.
The Reserve Bank of New Zealand also bucked the dovish trend and increased its official cash rate by 75bp to 4.25%, the largest hike in its history. It marked a ninth consecutive increase in interest rates and took the official cash rate to its highest level for nearly 14 years. With annual inflation close to a 32-year high, the central bank warned that interest rates would need to head higher.
Survey data points to slower growth; OECD reduces growth forecasts with UK and Germany expected to contract
Turning to the data front, US data largely pointed to a slowing economy, notably the manufacturing purchasing managers’ index for October which came in at 47.6, below the key (and consensus estimate) level of 50 for the first time since mid-2020. The labour market also began to show signs of deterioration, with initial jobless claims rising to a three-month high. A slower growth outlook was reflected in the OECD’s latest global economic outlook; it sees global growth falling from 3.1% in 2022 to 2.2% in 2023. The UK is forecast to fare the worst among G7 nations, with GDP expected to contract by 0.4% next year, followed by Germany with a 0.3% contraction given its high dependency upon Russian gas.
China is also at risk from slower growth, as restrictions have been increased against a backdrop of rising COVID cases. This now represents the third-largest outbreak of new cases in China since the start of the pandemic and has dampened expectations of any imminent move away from a zero-COVID strategy. The PBOC moved to inject more liquidity (RMB500bn) into the financial system and cut the reserve requirement ratio by 25bp to support growth.
Next week: Last US labour market print ahead of December Fed meeting as well as European inflation update
The US non-farm payroll numbers next Friday will likely take centre stage as investors assess the likely pace of central bank hikes into 2023. This is the last US jobs report before the next Federal Reserve meeting on 14 December. Other data points include the release of the US PCE inflation for October and the ISM manufacturing survey. From Europe, we will receive an update on inflation, with November CPI releases for Germany, Italy and France, among others. In the UK, we will get an update on the impact of rising interest rates with both consumer credit and mortgage approval data being released. A number of central bank officials will also be speaking from all the major central banks.
- US PPI points to slowdown in inflationary pressures, yielding mixed messages from Fed speakers
- UK inflation climbs to 11.1% and Chancellor Jeremy Hunt announces the Autumn Budget
- Equity markets traded softer as the week progressed, although they appear to be finishing strongly
- Overall positioning remains defensive, however small changes look to take advantage of attractively priced markets
- Next week: Fed and ECB meeting minutes, flash PMIs and a number of sentiment indicators
US PPI points to slowdown in inflationary pressures, yielding mixed messages from Fed speakers
Following last week’s better-than-expected consumer inflation data for October, the pace of US producer price inflation (PPI) also slowed, rising by 8% year-on-year and by 0.2% over the month – in each case, this was less than markets anticipated. The figure supported the growing view that inflation has potentially peaked in the US and that the Fed may soften its hawkish tone going forward. Fed Vice Chair Lael Brainard suggested as much in a Bloomberg interview during the week, stating: “it will probably be appropriate soon to move to a slower pace of increases”, and that she favoured a 50bp rather than 75bp hike at the next policy meeting. However, more hawkish soundings emanated from other Fed officials, some of whom suggested that the tightening cycle could last longer than currently expected by the market. While the US 10-year Treasury yield was largely unchanged at around 3.8%, the two-year bond yield rose, leading to a further widening in the two-year/10-year bond yield spread.
UK inflation climbs to 11.1% and Chancellor Jeremy Hunt announces the Autumn Budget
UK annual consumer inflation rose to 11.1% in October, a significant jump from September’s 10.1% and ahead of market forecasts. It was the highest rate of inflation for exactly 41 years. Energy costs rose substantially (gas prices increased by nearly 130%), while food prices increased by 16.5% year-on-year, the largest increase for 45 years. Some cheer was provided by the fact that core inflation (excluding energy and food costs) was unchanged in the month at 6.5%. Pressure will undoubtedly intensify upon the Bank of England to tighten monetary policy further, and perhaps faster. However, UK bond yields fell initially, with the 10-year gilt yield trading below 3.2%, a two-month low, before recovering to end approximately flat on the week.
There was little surprise in the measures contained in the budget, totalling approximately £55bn. These featured tax rises (mainly through the freezing or lowering of thresholds at which income and capital gains tax is payable) and reduced public spending as UK Chancellor Jeremy Hunt concentrated on trying to reduce the country’s budget deficit and reassuring markets that the UK is determined to bring its finances under control. The chancellor also announced that the energy cap for typical household bill would rise from £2500 to £3000 next April. The market reaction was largely negative, with equities, bonds and sterling weakening as investors worried about the impact of the fiscal tightening on the economy. The Office of Budget Responsibility forecast the economy would slip by 2% over the next year or so.
Equity markets traded softer as the week progressed, although they appear to be finishing strongly
The impetus from last Friday’s better-than-expected US inflation figure initially carried over into the first few trading days of this week. Combined with the release of the favourable PPI data, sentiment appeared to improve and equity markets continued to rally. However, equities faded towards the end of the week as worries about Russia’s intense bombardment of Ukraine, and especially the missile that strayed into Polish territory, unsettled investors. Weaker earnings results and outlook statements coming out of the US retail sector and certain technology companies added to the unease. In addition, the unexpectedly strong US retail sales figure for October partly undermined the narrative of a more dovish Federal Reserve. That said, markets are trading more positively into Friday afternoon. Commodity prices edged downwards in aggregate, with Brent Crude falling mildly as investors focused more on the troubled global economic outlook rather than the benefits of potentially falling inflation.
Overall positioning remains defensive, however small changes look to take advantage of attractively priced markets
Our regime-based framework reminds us that typical conditions for a more substantial rally in government bond yields are still a way off, but having been running very low levels of duration, we began to edge up our government bond holdings towards the end of the last month and added additional exposure this week. We also added a small amount to our credit exposure (both investment grade and high yield), with both markets offering attractive levels of yield. Our equity weight remains well below average, and within the equity market complex, we prefer more value driven-markets. The cheaper valuations on offer should act as a cushion if the macroeconomic environment deteriorates further. We added to our broad equity exposures early in the week. A combination of stubbornly high inflation and the increasing prospect of slower growth reminds us that it is an environment of increased opportunities in alternative investments, and as such we continue to look for trades in that space that we expect to help our strategy.
Next week: Fed and ECB meeting minutes, flash PMIs and a number of sentiment indicators
Central banks will take centre stage for markets next week as the Federal Open Market Committee meeting minutes are released on Wednesday, and the European Central Bank account of its October meeting follows on Thursday. Both of these could provide insight into the likely terminal rate expected by both banks. Aside from that, several flash PMIs will be released, helping markets to gauge how the growth backdrop is evolving through a period of tighter monetary policy and persistent inflation. There is also an array of sentiment indicators due out of Europe, including consumer and manufacturing confidence, and the IFO survey for Germany.
- US inflation surprises to the downside, causing a repricing of central bank policy and a rally in equities
- UK growth contracts in the third quarter, with further monetary and fiscal tightening on the horizon
- Next week: US and China consumer data and management commentary; inflation and labour market data from the UK
US inflation surprises to the downside causing a repricing of central bank policy and a rally in equities
In our recently released multi-asset monthly, we wrote it seemed likely that peak inflation in the US was close, and indeed the CPI print on Thursday did all it could to confirm that. Monthly headline CPI came in at 0.4% (vs 0.6% expected), meaning a year-on-year number of 7.7% (vs 7.9% expected). As a result, the market hopes of a less hawkish monetary policy intensified leading to a rally across all major asset classes. The S&P 500 added 5.54% in a single day of trading, and two-year US treasuries moved just shy of 0.25% lower.
Using history as a guide, the path of inflation is unlikely to be a smooth deceleration back towards target. From the market's perspective, this path is critical, amongst other things, because a peak in inflation is one of the factors that has tended to mark the stock market bottoms in cyclically inspired bear markets. That, however, is not always enough. Expectations on policy and growth are also key. In terms of policy, peak inflation on its own seems unlikely to be the trigger for monetary policy to pivot to an easier stance because present levels of inflation are simply way too high. Moreover, the transmission mechanisms by which price rises become embedded are numerous, complex, and slow-moving. Central banks will want to see evidence that inflation is clearly heading back towards target. As markets are currently priced, there is an expectation of a 0.5% hike in December in the US, moving away from the 0.75% hikes we have seen in the previous four Federal Reserve meetings. As it stands, the peak rate may be reached in March of next year, somewhere between 4.75% and 5%.
UK growth contracts in the third quarter with further monetary and fiscal tightening on the horizon
In the UK, GDP fell 0.2% quarter on quarter in Q3, a better result than markets had expected. It was the first drop in six quarters, dating back to the first quarter of 2021. While consumer spending and private business investment fell 0.5%, exports rose by 8%, partly encouraged by a weaker pound. The Bank of England had recently predicted that GDP would dip by 0.75% in the second half of 2022 and remain negative through 2023. In a speech during the week, Bank of England Chief Economist Huw Pill suggested that, despite recent interest rate hikes, more rises are required to prevent inflation from becoming entrenched in the system. Expectations of peak rates in the UK, anticipated in 2023, have settled at around 4.5-4.75% – below the recent extreme of over 6% following Liz Truss’s infamous mini-budget. Pill also highlighted the current tightness in the labour market, partly spurred by large numbers of people retiring from the workforce, as a critical factor in pushing inflation higher, with the situation unlikely to change for the better for the foreseeable future. He also warned the government on planned tax hikes, saying this could “slow down spending in the economy more than we expect”. With a £50-£60bn hole in the UK’s finances, UK Chancellor Jeremy Hunt is expected to announce plans for steep public spending cuts and sizeable tax (and stealth tax) rises in his Autumn Statement next week.
Next week: US and China consumer data and management commentary; inflation and labour market data from the UK
Next week attention will turn to the US consumer for a sense of whether there is a decline in the strength recently observed. Retail sales for October are published on Wednesday, and the market expects a small bounce after a flat reading in September. There are earnings reports from both Walmart and Home Depot, along with guidance from management teams which should help markets gauge broader sentiment. Elsewhere, China's industrial production and retail sales data comes alongside earnings from major tech firms such as Tencent and Alibaba. In the UK, inflation and employment data is out, whilst the market will hear the government’s autumn statement.
- US Federal Reserve raises rates; rhetoric suggests pace will slow but terminal rate will be higher
- Bank of England hikes rates by record amount but is still dovish; Bank of Japan remains committed to easy policy
- Next week: US mid-term elections, US inflation, UK growth and the latter stages of earnings season
US Federal Reserve raises rates; rhetoric suggests pace will slow but terminal rate will be higher
The Fed increased the Fed Funds rate by 75bp, taking the upper bound of the Fed Funds Rate to 4.0%, the highest level since 2008. This marked the sixth successive rate hike and the fourth consecutive increase of 75bp. While the move had largely been expected by the market, much of the attention was focused on the accompanying statement from Fed Chairman Jerome Powell, who raised the possibility that the pace of interest rate hikes could ease as the Fed analyses the cumulative, but lagged, impact of higher rates on the economy. But he also warned that interest rates would likely need to rise further and added that the terminal rate (or peak) in policy rates might be at a higher level than currently priced in by markets. Lastly, Powell confirmed that it was riskier to under-tighten rather than over-tighten policy.
Bond yields rose and equities fell after investors digested Powell’s message. Short rates moved by more than rates at longer maturities, leading to a further inversion of the US yield curve. The spread between two-year and 10-year yields expanded to -55bp, the widest seen this cycle and in many decades. This spread is seen by many as a key indicator for an upcoming recession.
The US Federal Reserve faces higher levels of core inflation and an economy that is clearly running too hot if the labour market is any guide. This week saw several data points that supported a tight labour market; an increase in the number of job-openings (1.9 job openings per unemployed worker) in September as well as a ‘quits rate’ remaining at 2.7% for a third time running (voluntarily leaving your job is highly correlated with wage growth). The widely watched non-farm payrolls were also above expectations (+261,000 vs +193,000 expected) as well as an upward revision in the prior data point. Average hourly earnings also came in above expectations (+0.4% vs +0.3%). All these data points reduce the probability of the Federal Reserve slowing the pace of hikes at their December meeting.
Bank of England hikes rates by record amount but is still dovish; Bank of Japan remains committed to easy policy
As expected, the Bank of England (BoE) raised rates by 75bp, the largest hike since 1989, bringing base rates to 3.0%, their highest level since 2008. BoE Governor Andrew Bailey warned that the UK economy was potentially facing its worst slump in a century, with a recession likely to last well into 2024. However, he also stated that because of this, rates “will have to go up by less than currently priced in financial markets” and seemed very keen to talk down fixed-rate mortgages (given their impact upon UK disposable income). The BoE also began to sell off the government bond holdings accumulated during the many years of quantitative easing. It successfully sold £750m of bonds at auction during the week and has a target of reducing its balance sheet by £80bn through bond sales over the next year. It is the first major central bank to reduce its bond holdings through the open market and adds pressure to UK government bond yields when investor sentiment turns negative.
The other central bank to maintain a dovish tone was the Bank of Japan (BoJ). In a speech early in the week, BoJ Governor Kuroda stated that it was imperative that the central bank maintain loose monetary policy, given the sluggish nature of the economy. This stance has seen bond yields remain very low by international standards, and the yen weaken substantially against the US dollar, falling to 32-year lows. Kuroda did keep the door slightly ajar for a potential change in policy; he suggested that raising its yield targets and allowing bond yields to increase might become an option if inflation continues to rise, provided it is accompanied by wage growth.
Next week: US mid-term elections, US inflation, UK growth and the latter stages of the earnings season
The main focus next week will be in the US, on both the economic and political fronts. The US mid-term elections are on 8 November with the Democrats' narrow majorities in both the House of Representatives and the Senate at stake. The viability of President Biden’s agenda could be shifted if the Republicans take control of both, which is a more than likely outcome according to leading pollsters. COP27 will also kick off this week, with headlines more likely to come in the latter stages (ends on 27 November). The US October CPI print will also be released and will provide the next signpost for the market’s view on a potential pivot by the FOMC, despite the Fed’s recent hawkishness. The University of Michigan’s consumer sentiment survey will also provide an insight into the demand side of the economy. Elsewhere there will be trade data from Europe, China and Japan, as well as industrial production data from Germany and Italy. The UK will also provide its monthly and quarterly GDP estimates. We head towards the latter stages of the latest corporate earnings season, with over 420 of the S&P 500 already reported. Notable results to come include Disney, Berkshire Hathaway and Occidental as well as AstraZeneca, Softbank and Adidas.