The world's getting hotter, but at least inflation is starting to get cooler

There’s enthusiasm in the air this week, and it’s nothing to do with summer ice creams.

A more benign US CPI print buoyed markets during the past week, renewing hopes that the monetary tightening cycle would soon start to turn. A decline in core price growth from 5.3% to 4.8% will certainly be welcomed by the Fed, yet it is worth noting that that this month’s +0.2% increase follows in the wake of six consecutive months of monthly gains at a +0.4% rate.

In this context, inflation remains too high, and data is unlikely to dissuade the FOMC from hiking rates later this month, noting last week’s labour market report showed little sign of slowing in the economy. However, from a psychological point of view, we have witnessed on several occasions in 2023 how market participants have been enthusiastic to add duration on any good news.

Consequently, the notion that inflation appears to be trending back towards target has been a catalyst for increased optimism. With investors inferring that price pressures are dropping more quickly than the pace of economic activity, this has also driven hopes that a softish landing for the economy remains in prospect. This has supported equity markets and credit spreads alike. However, amidst the enthusiasm, we think that it remains appropriate to question the extent to which these moves will prove sustainable.

Looking at the US Treasury curve, we would note that it continues to trade in a directional fashion. That is to say that in a rallying market, we would expect the curve to bull steepen with any rally led by the front end, whereas flattening should yields rise. Thus, when assessing the scope for US yields to decline, it is interesting to examine the valuation of the two-year point on the curve.

In this context, if this is decomposed using rate forwards, then it can be seen that at a prevailing yield on two-year notes of around 4.65%, this embeds a forward valuation of 4.05% on a 1 year, 1 year-forward basis. In other words, with cash rates in the near term expected to peak around 5.5%, so markets have fully discounted substantial monetary easing through 2024, with cash rates expected to fall below 4% by the end of next year.

The pricing of these forward rates has been substantially below Fed projections on a persistent basis over the past months, demonstrating the underlying bullish bias embedded in rate markets. From that point of view, we think that a sustained rally in Treasuries requires confidence that rates will undershoot even further and for the time being, it is hard to feel too confident in making this call.

In our own assessment, we have thought that inflation will cool to around 3% this year, but it is likely to be resistant to a return to the Fed’s 2% target, unless there is a material weakening in the US labour market and a downturn in US consumption.

However, with economic activity remaining upbeat and the labour market historically tight, we see no reason why the Fed will be in a hurry to ease policy, especially with buoyant equity and credit markets and a softer dollar all serving to ease financial conditions. Ultimately, we still look for the lagged impact of past monetary tightening to catch up with the economy in the quarters ahead.

As a result, this leads us to conclude that forward pricing in US rates is not materially divergent from fair value. From that point of view, we think that US rates are in more of a tactical range trading environment, as has been the case since the beginning of 2023.

From a rates perspective, the market we have found more interesting of late has been the UK. Here we are more confident in projecting a slowing in the economy over the coming months, as shorter lags in monetary policy mean that past rate hikes are now starting to bite, with a growing number of mortgage borrowers feeling the pain, as past low fixed term rates reset to much higher levels.

In addition, the BoE under Bailey continues to deliver a more dovish message than other central banks we meet, appearing to acknowledge the limits of what monetary policy can achieve, based on the assertion that much of the current inflation has been the product of a supply side shock.

There also seems to be increased understanding that inflicting all pain for fighting inflation on a small number of households who are mortgage borrowers is suboptimal and that a more equitable outcome would see fiscal policy working in tandem with monetary policy, in order to limit the rate overshoot.

This point appears to be understood by Sunak and Hunt, even if it is not grasped by much of the UK Conservative Party. Herein a risk remains that the Tories will push the self-destruct button yet again and look to change Premier, as they stare at electoral annihilation later next year.

Yet aside from this, we have thought that the peak in UK rates would be lower than markets have recently discounted, and we have seen value at the front end of the UK curve, based on a view that base rates end 2023 at 5.75%, well below the 6.25% currently priced.

European markets have been quieter in the past week, taking their lead from US moves. Meanwhile, a weaker dollar has seen the euro climb above USD1.10, with the exchange rate now sitting back at the average for the past five years. A firmer euro should help moderate inflation, though we would question how much further this trend should run.

So far this year the EU economy has underperformed the US, with the past two quarters recording a technical recession in the Eurozone, with consecutive -0.1% quarter-on-quarter prints. We think that the next few quarters should be more upbeat, helped by lower energy prices and the feed-through from previously announced fiscal stimulus plans.

However, we retain a fairly downbeat outlook on Chinese prospects notwithstanding latest easing measures and this will continue to subdue EU export demand. From that point of view, the euro appears to lack much of an impetus from favourable rate differentials, growth differentials or a cheap valuation, which would push it towards USD1.20.

In Japan, higher wage data in June saw Japanese bond yields lift from their lows. BoJ Governor Ueda has previously cited disappointing wage growth as a reason to delay policy normalisation. Consequently, better news on wages has helped lift speculation that an adjustment to the policy of YCC could be forthcoming at the July policy meeting.

This thinking was also fed by comments from Deputy Governor Uchida, who appeared to admit that super accommodative monetary policy has been a factor, causing the yen to weaken to undervalued levels. In the wake of this, the rate versus the USD has fallen from a high of 145 to levels below 139. The policy meeting on July 28th will see an update to quarterly inflation forecasts, and we have been inclined to think that an upward revision to 2023 and 2024 inflation forecasts is likely and that this will give a pretext to a policy shift.

In this sense, policy changes around quarterly meetings are more likely than the interim meetings which occur in between. Hence we had thought a policy change could occur in April, shortly after Ueda commenced his tenure. However, speaking with the BoJ it became clear at that time that they were still anxious with respect to the fallout of SVB in the US and what this could mean in terms of recession risk.

Now those fears appear to have been quelled and in the intervening period, so the rate differential between Japan and overseas markets has continued to grow. On this basis, we think there is justification to look for a BoJ policy shift this month and may look for trends toward higher yields and a firmer yen to persist in the run up to the meeting in two weeks’ time.

Elsewhere, it was interesting to see Turkey positioning itself closer to NATO allies, by permitting Ukrainian commanders of the Azov battalions to return to Ukraine, announcing a plan to escort grain shipments in the Black Sea and also helping to supply Ukraine with drones for military use. These steps have angered Russia and it seems that Turkey has decided to pick a side, perhaps concluding that Russia’s position is likely to continue to weaken further.

Since the election, Erdogan has also been happier to sanction a return towards more mainstream policies and this has helped the credit to perform, though we see the lira continuing to weaken further as it is allowed to move towards a fair market valuation, in the absence of intervention. Russian assets aren’t trading due to sanctions, but recent weeks have seen the rouble under some pressure, breaching 100 versus the euro.

Ratification of Sweden’s NATO membership in the past week continues to demonstrate how Putin’s war has achieved the exact opposite of what the Kremlin may have hoped. As for Ukraine itself, it should be no surprise that it is not admitted to the Alliance in the middle of a conflict. However, support appears unwavering and we continue to expect that on a forward-looking view, Ukraine may achieve membership of both the EU and NATO on a 5-7 year timeframe.

Looking ahead

It seems that the focus for markets will now start to turn away from the data and back towards central banks. With central bank meetings two weeks away, so policy officials have a last chance to share their views over the next few days, before self-imposed blackout periods commence.

Yet before we get to those central bank meetings, next week also sees UK and Japan inflation data, which will be a particular focus for us, given respective long and short positions in the two markets.

Looking at market volatility indicators, the VIX at 13.5 continues to trade close to its post-pandemic lows. However, there appears plenty to debate and decide pertaining to the macro backdrop at the moment and no shortage of uncertainty as to where markets will sit six months from now.

What seems less open to debate is that 2023 looks set to be the hottest year in the history of the planet, on record. Keeping cool, calm and collected may be the theme we all need to reflect on over these summer months this year.