Last week saw mixed performances from global stock and bond markets as investors continued to digest the large amount of news of the previous week. The penny may finally be dropping: that hope for an immaculate soft landing for the U.S economy is just that -hope.
There appears a growing appreciation that, in response to stubborn core inflation arising from tight labour markets, the Fed may well mean what it says when it warns of a ‘bumpy’ road ahead.
We await tomorrow’s U.S. inflation data with bated breath – watch out, in particular, for the direction of month-on-month core inflation. December’s number was 0.3%, up from 0.2% the previous month. The Fed wants to see a clear downward trend develop. As do we.
Investors should remain diversified!
Mixed news on stock markets
The S&P500 suffered its first weekly fall in over two months. The NASDAQ also fell. Reuters reported that U.S. stocks have seen 12 consecutive monthly outflows as investors switch into fixed-income and overseas stock markets.
Yields rose on interest rate-sensitive two-year Treasury bonds, the inverted spread over ten-year yields is almost the largest since 1981. Many economists see this as an indicator of a coming recession.
European stocks performed better, with the STOXX 50 eurozone index up, helped by a fall in German inflation. The FTSE 100 reached a new high, supported by the large weighting in the index of materials, energy, financials, insurance, and pharma multinationals.
Last week we learnt that the new governor of the Bank of Japan is expected to be Kazuo Ueda. He is considered a ‘dove’, who has warned against an early exit from the yield curve control program (YCC). Nonetheless, the Nikkei 225 fell slightly over the week.
The Fed is a little clearer
Driving the market’s reassessment of the terminal rate for Fed funds was the consideration of the previous week’s rate hikes from central banks and January’s astonishingly strong U.S. payroll data that suggested core CPI inflation may prove hard to subdue.
Last Tuesday, Fed Chair Powell spoke at the Economic Club of Washington. He clarified his rather garbled messaging of the previous week, warning that ‘the disinflation process still has a long way to go’, and that the road to the 2% CPI target is ‘probably going to be bumpy’. He said that the Fed might have to raise rates more than the market expected with the labour market still so strong.
The market is now expecting two more 25bp rate hikes, rather than just one, peaking in the summer at 5.2%. Just one rate cut is now expected at the year end, rather than the two that were priced 10 days ago.
How to unwind QT?
Meanwhile, quantitative tightening (QT) goes on in the background. The Fed is allowing around $95 billion of U.S. government debt and mortgage-backed securities to roll off its balance sheet each month. A suitable policy at the moment when the Fed is fighting inflation.
But it could become a policy problem later this year for the Fed, if economic conditions do warrant rate interest cuts and cheaper money. There will be enormous temptations and political pressure to once again use QE to stimulate economic activity. If it is used as a normal policy tool, brought in to stimulate demand at each downturn in an economic cycle, the prospect of the Fed ever shrinking its balance sheet is negligible.
It risks remaining, along with other central banks, a very large holder of bonds and a hugely distorting influence on market prices for financial assets.
The coming U.K. recession
Fourth quarter U.K. GDP was flat relative to the same period a year before, but the economy shrank by 0.5% in December. This was worse than had been expected. The BoE now expect the economy to contract throughout 2023 and in the first quarter of 2024. It is not expected to return to its pre-Covid level until 2026 on account of high inflation, high-interest rates, and a decline in fiscal support for the economy.
Sterling is likely to come under pressure against the dollar, since the Fed is now perceived to be more ready to raise interest rates to combat inflation than the Bank of England. (Perhaps this is what U.K. policy officials hope will happen?)
BP delivers, Credit Suisse and Wells Fargo less so
High energy prices continued to deliver strong results for energy companies, such as BP, but also appear to slow the oil major’s commitment to investment green energy. Although we have seen wider net interest margins support banks everywhere, last week continued to see some spectacular own-goals from the sector: Credit Suisse and Wells Fargo both revealed appalling numbers as they struggle to shake off the consequences of past moral failings.
It is reassuring that Wall Street appears to be taking Powell’s warning of a ‘bumpy’ road ahead seriously. Mini-bull markets over the past year have exacerbated the inflation problem for the Fed, as they loosed financial conditions for firms and households.
An end to these will bring about a faster end to core inflation and allow the Fed to start easing interest rates. A proper bull market can then start as a fresh economic cycle kicks in.
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