Will the Santa rally arrive this year?

After Friday’s sharp selloff in risky assets when another 1.2% was knocked off the S&P 500 and the Nasdaq lost nearly 1%, many are questioning if the seasonal Santa rally will return this year. While the Santa rally is defined as rising stock markets in the last 5 trading sessions in December and the start of January, there is still time, however, it is cutting it fine. After a slew of more hawkish than expected central bankers and some disappointing economic data, particularly retail sales in the US and the UK, it is getting harder to see where the driver of this Santa rally could come from.

Central bankers switch on Grinch-mode

While the Santa rally phenomenon is something that traders like to cling onto at this time of year, when hearts and minds are usually away from trading screens, so a formula to follow to trade the markets is a nice to have, it was always going to be a long shot for 2022, which has been a tough trading year for investors. Anyone who thought December would pass by in a whirl of tinsel and glitter were sorely disappointed, especially by the particularly hawkish comments from the ECB. Although Christine Lagarde et al trimmed their rate increases to 50 basis points at last week’s meeting, down from 75 basis points and in line with the Federal Reserve, the use of words like “substantial rise in the inflation outlook”, “we judge that interest rates will have to rise significantly” higher to bring inflation under control, and announcing that its asset purchase programme will end from March 2023, the ECB was like the Grinch that stole Christmas.

The ECB double whammy: rate rises and QT

The reaction after the ECB meeting was swift, Germany’s yield curve inverted, and the 2-10 year yield curve closed -25 basis points on Friday, which indicates a recession is likely. EUR/USD initially jumped past $1.07, however, it gave back some gains on Friday and closed the week 0.4% lower, as the dollar caught a bid. Most worryingly, heavily indebted Italy saw their 10-year borrowing costs rise by 40 basis points in the aftermath of the ECB meeting. This is most likely a reaction to the news that the ECB remains firm in its commitment to sell off its huge portfolio of assets from its APP. Not only are the ECB tightening monetary policy, but soon they will be embarking on quantitative tightening, and although this will happen at a “measured and predictable” pace, the ECB is clear: the Euro system will not reinvest all the principal payments from maturing securities, as part of its “normalisation of its monetary policy holdings”. However, this is a scary time for countries like Italy, who have relied on the ECB to be the main purchaser of their debt in recent years. To put this into some context, for the last 7 years, the ECB has bought the entire government bond issuance of the Eurozone. However, things will be changing, and from March, the private investors will need to step back in and absorb government bonds once the ECB bows out.

The ECB talks tough  

Added to this, the ECB means business when it comes to inflation, Lagarde told the market explicitly that they will continue to hike rates at 50 basis point increments until inflation is under control. Lagarde also tried a ‘Fed’ move and is trying to push up what the market expects for the ECB’s terminal rate, to the 4% mark. Rate expectations for the ECB are nowhere near that, for example German 2-year yields are only just above 2.4%. Thus, there is a mismatch between what the market thinks central banks will do and what central banks are saying that they will do. The impact of this mismatch on markets will likely cause some volatile trading at the start of 2023, and whether the market or central banks are correct will be the key driver of risky assets as we start a new year.

Testing the Fed’s resolve

It is worth noting, that the Fed is not indicating that it will cut rates quickly next year, yet the market is predicting that the Fed will reach its terminal rate by May/ June 2023, and then cut interest rates by nearly 70 basis points from July 23- January 24. Is the market arrogant to test the Fed’s resolve, or have traders heard it all before from the Fed and so don’t trust their resolve? Anyone remember the phrase “inflation will be transitory”?  Thus, the market is choosing to treat the expected recession with more respect than the view of central bankers who were behind the curve when inflation was rising sharply and now seem to be blind to the blatant recession risks building in the West. 2023 will be an interesting year.

Looking at the last trading week before Christmas, and the chance of a Santa rally would be boosted by a few things: 1, less hawkish comments from central bankers and 2, a Christmas ceasefire for Ukraine.