Left feeling a bit deflated

Looking ahead with central banks and major data releases behind us, there is no clear focus for market attention over the next couple of weeks.

US inflation data this week confirmed the downward trajectory of price gains and was broadly welcomed by financial markets. However, the inflation trend remains significantly above the Federal Reserve (Fed) target. Also, with the labour market remaining tight and the growth backdrop broadly looking robust, it strikes us that we remain far from where we should be thinking about lower interest rates, even if the hiking cycle now looks largely done.

With 10-year Treasury yields 140 basis points below cash rates, we see limited scope for yields to rally much unless and until growth slows materially and prospects for monetary easing move more clearly into sight. In that context, we don’t express a clear view of US rates for the time being, continuing to view the market on more of a tactical rather than a structural basis.

Similarly, risk assets have already discounted plenty of good news up to this point. A recession does not appear imminent and may be avoided altogether, even if policy tightening means there will inevitably be a period of sub-par economic growth.

Corporate earnings can continue to grow, and companies should be able to refinance borrowings, maintaining default rates at modest levels if this is seen to be the case. But much as a diminution of downside worries has supported equity markets and credit spreads in the past couple of months, it is less clear that there will be much to drive prices higher to new highs, with lower interest rates remaining a distant hope.

In Europe, updated ECB projections highlighted a moderation of inflation expectations against a relatively soft economic backdrop. This helped to benefit Bunds, as central bank shifts aimed at penalising sovereign cash holdings in Germany prompted a switch from cash into short-dated government bonds.

In part, this move is part of a wider attempt by policymakers to limit budgetary losses stemming from quantitative easing as rates rise. This follows on from steps to limit payments on minimum reserves at the ECB, as well as governments raising bank levies against an improved backdrop for profitability for the sector.

However, Europe remains a highly banked economy. With bank stock prices continuing to languish well below book value, our concern is that such measures will only add to a tightening of lending standards, which is already underway and thus serve to limit bank lending.

The somewhat bungled attempt at a tax on bank profits in Italy this week can be seen in this light. The surprise announcement saw Italian bank stocks fall as much as 8%, threatening a negative feedback loop from developing before the government was quickly forced to re-think and water down its plans. By contrast, it is not surprising to see an economy such as Canada, which has valued the health and success of its banks, continuing to outperform global peers, thanks to a more constructive and supportive policy framework.

In China, weak import and export data, as well as CPI and PPI figures, all served to confirm the downbeat economic backdrop. Meanwhile, the imminent default of Country Garden one of the real estate names, investors had thought would be one of the most likely survivors within the distressed sector, also added to negative sentiment. It appears that sequential easing measures aimed at improving the domestic economy may see an improved tone to incoming data in the next month or two.

Structurally speaking, we continue to retain relatively downbeat prospects for the Chinese economy. Chinese weakness could be a globally disinflationary factor. However, much of this deflation is domestic because it links back to the property market, echoing Japan in the 1990s. Additionally, as supply chains are re-routed in the wake of deglobalisation and medium-term geopolitical fears, disinflationary benefits are likely to be less apparent than would otherwise have been the case.

Nevertheless, elsewhere in emerging markets, we have seen a more disinflationary narrative from a number of countries recently. This has served as a catalyst for rate cuts in countries including Brazil and Chile, with other central banks expected to follow.

Many of these economies are now reaping the benefits of having tightened policy much earlier in the economic cycle than either the Fed or the ECB. This may favour local rate curves, though as the carry advantage versus US$ is eroded, this also represents a risk towards currency weakness.

This appears most pronounced in currencies, the largest beneficiaries of the FX carry trade, where currencies have strengthened materially over the past 18 months. We doubt that too many central banks will fight against a degree of FX weakness, though there will be a desire to limit volatility, especially if exchange rates re-price too quickly.

Elsewhere, Japan continues to be a focus. We think that if the yen approaches 145 versus US$, this will force a debate within the Bank of Japan (BoJ) around its communication policy. We expect Ueda to need to dial back on his uber-dovish tone.

Meanwhile, we look for domestic data on inflation to continue to surprise above expectations. This being the case, we would look for a reduction in the size of upcoming Rinban bond buying operations to allow JGB yields to move higher in the next several weeks.

Failure to do this will give speculators the green light to push the yen weaker. Moreover, it will be very difficult for the Ministry of Finance to be credible in any currency intervention if the BoJ is the principal actor responsible for driving yen weakness.

Looking ahead

With central banks and major data releases behind us, there is no clear focus for market attention over the next couple of weeks. At the end of the month, the Fed will hold its annual meetings in Jackson Hole.

Still, we are doubtful that any message will be much different from what was recently delivered at the ECB symposium at Sintra. It is possible that the occasion could be used to debate longer-term thoughts around natural interest rates, as well as topics such as the monetary transmission mechanism, and so we will await the announcement of the agenda and line-up of speakers with interest over the days ahead.

We don’t see much merit in chasing price action in the current market environment. Nor does it feel like we are being paid much to take too much risk. Consequently, we have been content to reduce risk and await more interesting entry points into trades, which we like, in the days and weeks ahead.

Recent market moves have whipsawed a few investors, leaving many nursing losses from active position-taking. Most recently, this has seen investors increasing exposure to stocks. It has been a great bull run for the S&P, with the index gaining nearly 30% from its October 2022 lows this year.

But as the last of the bears capitulate, it strikes us that the party may soon be over. As the USA Women’s football team will attest to, the landscape can shift quite rapidly. Similarly, a benign investment environment could give way to a moment of realisation when there is suddenly not so much left to laugh about…