Below trend growth to continue
A hot US CPI report and signs of inflation expectations de-anchoring on Friday has seen yields surge, risk assets sell off, and recession talk rise.
A hot US CPI report and signs of inflation expectations de-anchoring on Friday has seen yields surge, risk assets sell off, and recession talk rise. Monday has been a rinse repeat of Friday’s price action, significant given the chance to mull over the trends on the weekend. Clearly the Fed will have to lift rates more aggressively and markets are pricing in a 30% chance of a 75bp rate hike on Wednesday, while 50-75bp hikes appear the norm with markets pricing in 287bp of hikes over the next five FOMC meetings, up from 209bp on Thursday. Yields have soared at the short end (US 2yr +55.2bps since Thursday to 3.36%) with curves flatting (US 10yr +31.9bpsbs since Thursday to 3.36%). The move in the 2yr is the worst two day stretch since the early 1980s, while being more than fully reflected in real yields with the 10yr TIP yield +41.6bps to 0.68.1% and the implied inflation breakeven actually falling -9.5bps to 2.68%.
Risk assets have plummeted with recession risk rising given the surge in yields and expectations of the Fed doing a Volcker. The S&P500 fell -2.9% on Friday and was down -3.9% overnight. Since its peak the S&P500 is down 21.8% to be now in official bear market territory. All eyes are on retail investors and whether they capitulate which could drive equities lower. One estimate of shares purchased by retail punters over recent years has retail investors sitting on larger losses of around 41%. It’s no only equities that are feeling the heat, crypto is as well with Bitcoin currently trading at $23,223, having fallen by 23.4% since Thursday. Former Treasury Secretary Summers on Sunday said a recession was likely in the US within the next two years, while a recent CFO survey by CNBC found all CFOs expecting a recession, while 68% expected one to occur during the first half of 2023. Morgan Stanley’s CEO just on the wires is tipping a 50% chance of a recession, up from his prior estimate of 30%.
As for the US CPI report on Friday, it was undeniably hot, squashing any notions of inflation having peaked and of a possible Fed pause this year. Headline inflation was a full three tenths higher than expected at 1.0% m/m against 0.7% expected, taking the annual rate to 8.6% y/y and its highest since 1981. The core measure was also one tenth more than expected at 0.6% m/m against 0.5% expected, with the annual rate at 6.0% y/y. Alternative core measures suggest the breadth of inflation pressures has actually picked up with the Cleveland Fed Trimmed Mean at 0.8% m/m, its highest in the history of the series which dates back to 1983. Ditto for the y/y version at 6.5% y/y. Fed officials in the lead up to the FOMC meeting on Wednesday said they would be looking at the monthly inflation prints to see whether the Fed moves back to 25bp hikes from September, after two 50bp moves in June and July. Clearly the foot will still have to be on the pedal.
More worryingly for the Fed (and your scribe and for markets) is inflation expectations also appear to be becoming de-anchored. The University of Michigan 5-10 year inflation expectations rose three tenths to 3.3% from 3.0%, its highest since June 2008 to be more than two standard deviations away from its post-1996 average of 2.8%. The message here is the Fed needs to go harder and quicker in order to re-anchor inflation expectations amid high inflation. From a growth point of the view consumer confidence plunged 14% in May to 50.2 (58.1 expected), its lowest level ever in the history of the monthly survey that dates back to 1978. US Retail Sales on Wednesday will be closely watched for signs of weakness, while freight data has been showing a slowdown since April, aligning with the bloated inventories narrative from retailers. A separate survey of inflation expectations by the New York Fed released on Monday had three inflation expectations steady at 3.9%, but the one year ones lifting three tenths to 6.6% from 3.3%.
Wednesday’s FOMC meeting will be closely watched for how the Fed will react to the inflation data and whether they still see a soft landing. Markets are pricing in a 30% chance of the Fed lifting rates by 75bps, while the Fed prior to the blackout was guiding a 50bp hike. If the Fed hikes by 75bps that will be a true Volcker moment and underscore front loading, a 50bp hike in contrast would cement the likelihood of 50bp hikes at every meeting for the rest of the year. Markets now price a peak Fed Funds rate of 4% by early next year. The Fed’s unemployment forecasts will also be closely watched with the Sahm rule noting that a recession occurs when the three-month moving average of the unemployment rate rises by at least 0.50 percentage points relative to its low in the prior 12 months.
It’s not only the Fed meeting this week, but also the BoE and BoJ. Nowhere is recession risk higher than in the UK with m onthly GDP for May at -0.3% m/m against +0.1% expected, following a 0.1% contraction in March and the flat reading in February. On this trend, the economy might become the first major developed country to actually enter recession. All major sectors including services, production and construction contracted in April, suggesting broadly based weakness across the economy. Surging inflation, trade frictions in a Brexit world and a lack of labour supply have all been contributing factors. The BoE meets on Thursday with the market split between a 25 or 50bp hike (33bps are priced), while economists favour a 25bp hike. The UK also faces a possible trade war with the EU, after PM Johnson introduced a bill that unilaterally rips up the Brexit deal with the EU covering trade with Northern Ireland. The EU has threatened legal action over the move.
The BoJ will also be watched closely given the 0.25% yield cap on the 10 year yield. The same inflationary winds are starting to be felt in Japan and it is unclear what the BoJ’s tolerance for inflation is and how long inflation has to be at target before the BoJ starts to remove its substantial policy accommodation. The USD/JPY has depreciated sharply over recent months, with USD/JPY testing above 135 in Asia yesterday, its highest since 1998. The sell-off in risk assets overnight though did boost the JPY with USD/JPY +0.1% over the past 24 hours to 134.49. Although not meeting this week, the ECB policy path is also being watched closely and has a more rocky road than the US, which is adding to EUR weakness. The surge in yields is seeing fragmentation risk rise with the Italian-German 10yr spread blowing out to 239.6bps, its highest since early 2020. During the European sovereign debt crisis the spread got as wide as 552bps, so some further widening could occur here.
In FX it has been all about USD strength. The USD DXY is up around 1.1% to 1.05, its highest since 2022. The significant sell-off in risk markets (namely equities) have weighed heavily on AUD (-1.9%), NZD (-1.5%) and GBP (-1.5%). Also weighing on GBP was the negative monthly GDP print as discussed above. Should global growth risks rise further, it is likely the AUD will come under further pressure with the correlation with S&P500 futures re-asserting itself over the past couple of days.
Finally, as for oil, it has been relatively flat with earlier losses unwound given the tight oil market. Libya’s oil production has almost fully halted as a political crisis leads to more shutdowns of ports and fields. The OPEC member’s daily output — which averaged 1.2 million barrels last year — is down by about 1.1 million barrels. Working the other way is that restrictions on Russia appear to be faltering a little in the face of the cost of energy. Bloomberg reports Russia leapfrogged Iraq to become Italy’s biggest supplier in April as the nation’s shipments surged to the highest for any month since October 2019. India has also moved from being an insignificant buyer of Russian crude to the second-biggest destination for shipments, behind only China.
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