Happy daze

Imagine a world where we could all live peacefully.

Global markets continued to be supported by hopes of moderating inflation pressure over the course of the past week. Softening producer price inputs suggest that inflation pressure can continue to ease in the coming months on both sides of the Atlantic.

At the same time, underlying consumer demand remains robust, with ‘nowcasts’ of US growth continuing to hover around 2.5%. In addition to relatively upbeat corporate earnings, this has fuelled optimism for a ‘soft landing’ in the coming months, in the absence of a more material economic downturn. Ultimately these hopes may well be disappointed, as we think that lags on past policy tightening will continue to bite through 2024.

Moreover, we are somewhat sceptical that inflation will return to central bank targets in the absence of a more material slowdown. This simply means that in the absence of weaker data, so rates can be expected to go higher for longer, and ultimately this is something which is likely to take its toll.

That said, in the near term, we don’t seem to have reached that inflexion point just yet and in the next few weeks it is not immediately obvious what will cause recent optimism to dissipate.

Next week the FOMC is widely expected to hike rates by 25bp, taking effective cash rates to 5.35%. We doubt that the Fed will change its language too much, with comments already noting that it would be premature to read too much into one better CPI print in June.

Consequently, the Fed is likely to signal further monetary tightening ahead, also noting how stronger credit markets, rising equities and a weaker dollar are all helping to ease US financial conditions. Yet with inflation set to trend lower, it seems unlikely that Chair Powell will be able to say anything to bring about a bigger re-pricing of rate expectations.

With US yields having declined about 30bp from their highs a couple of weeks ago, we are inclined to think that an extension of this rally will lead to an even larger disconnect between the Fed and market forward pricing into 2024.

In this context, we think that a rally in US 2s to 4.5% or US 10s below 3.6% could now offer an opportunity to implement a short rates position on a tactical basis, which marks a change from how we had recently been more positively disposed to yields at higher levels. 

In the Eurozone, comments from ECB’s Knot questioned whether a rates hike in September will be necessary, leading to a reduction in peak rate expectations. The ECB will surely raise its deposit rate to 3.75% next week, although rates also seem close to peaking in the region, as inflation data starts to improve.

An impetus from past fiscal spending packages on infrastructure can support economic output over the summer. However, we would observe that underlying consumption is not as strong as in the US. On this point, anecdotally speaking, it has been striking to observe the relatively conspicuous level of consumption by American tourists to Europe, whereas their continental counterparts remain much more restrained.

Across the Channel, UK policymakers were relieved to see a softer CPI report this week, mitigating fears that UK inflation was still running out of control, even as the backdrop improves elsewhere.

The 0.1% monthly gain pulled CPI below 8%, with core prices also lower at 6.9%.

UK inflation remains elevated versus other developed economies for reasons previously discussed, but with the BoE concerned by the lags in monetary policy and the potential to harm the UK housing market and broader economy, this data should alleviate any pressure to deliver a 50bp hike next week.

A 25bp increase in cash rates to 5.25% now appears probable and should a move towards more moderate price gains be confirmed, then we think that the BoE will surprise to the dovish side of expectations. Markets still discount UK cash rates close to 6% by year end and this appears too elevated in our opinion.

Next week also sees the BoJ announce its policy decision. Comments from Ueda again this week seem to have tried to play down speculation of a policy shift by markets in the run up to this meeting.

However, a growing number of other past and present BoJ officials have been voicing their thoughts that this month will see an adjustment to the inflation forecast, which should trigger an adjustment to YCC. We have thought that moves at quarterly meetings where the BoJ updates its forecasts are more likely than those in between.

In this context, if Ueda does surprise to the dovish side, then this could push back expectations for a normalisation until October. This would trigger renewed pressure on the yen and could mean that by the time an adjustment occurs, a more substantial and radical policy shift would be needed, perhaps with the BoJ also raising cash interest rates. We think that a more gradual approach is warranted and so continue to expect a lift in the YCC target band from 0.50% to 0.75% or 1.0% next week.

Emerging markets have continued to trade well in the past week, buoyed by the broader rally in risk sentiment. Growth data in China have continued to disappoint, triggering additional policy easing. However, we feel that domestic consumption will likely remain subdued, and we continue to be relatively downbeat on both near-term and medium-term Chinese economic prospects.

Elsewhere, improving inflation trends have been helping local rates to rally, along with sovereign credit. EM currencies have also rallied, helped by the context of a weaker USD. In FX more broadly, the pound moved weaker in the wake of reduced expectations for short-term UK interest rates, whereas the trend higher in the euro took a pause, consolidating after its recent strong run.

Credit markets have been supported by a constructive backdrop for risk assets. Receding recession fears have seen lower quality credit performing relatively well. Generally speaking, we feel that index level spreads are starting to look a bit rich.

However, in the absence of new news to drive spreads wider, it won’t be surprising to see credit continuing to trade relatively well for the time being. In equities, we have observed investors closing out bearish downside trades quite broadly, having lost patience that these will work.

Consequently, risk indicators have continued to move more explicitly into ‘greed’ territory. Historically speaking, we have sometimes seen markets turn lower, only after the last of the deeply entrenched bears is pushed to capitulate.

It is open to debate whether this will occur again, but for now price action seems to be of a market happy to climb a ‘wall of worry’, even if market breadth has been very narrow on the move to the upside.

Looking ahead

It will be a busy week with all four major DM central banks having their policy meetings. As articulated above, the ECB and Fed meetings appear the most predictable of these, with both the BoE and BoJ outcomes subject to a degree of uncertainty.

We see US and euro rates as more tactical trade opportunities, subject to the levels we are trading at within the range. Elsewhere, Japan and UK seem to offer a more compelling structural narrative. We continue to see plenty of macro volatility ahead of us, given elevated levels of uncertainty over future outcomes.

In this context, it is hard to remember the last time one would meet with an array of analysts ranging from those who might expect US rates to rise by 300bp in the next two years, to those who would discount a similar amount of rate cuts to occur.

Although in the UK it feels like southern Europe has stolen all of the sunshine and warm weather, generally speaking it still feels like a week when good news has prevailed over bad. Indeed, this week it was even pleasing to see rapprochement between the ever-genial US Treasury Secretary Yellen and Chinese Vice Premier He Lifeng.

Maybe there was something in the mushrooms, but it is refreshing to think for a moment of a world where we could also co-exist very peacefully and happily. Happy summer daze indeed….