The euro and earnings
There have been several moving pieces to the narrative in financial markets this week, including hawkish central bank policy, some disappointment that China’s monetary policy shift has not been more aggressive in the face of its zero covid policy and some mixed takes in the US Q1 earnings season. Stock markets were pulled lower on the back of the hawkish central bank speakers during the IMF and World Bank Spring conference in Washington, and some of their comments set the bond market on fire. As we have mentioned, the financial markets are currently driven by economic fundamentals so central bank decisions are the key drivers across asset classes right now.
75bps touted as a possibility for the Fed
Members of the Fed, the ECB and the BOE were out in force this week and some of their comments were shocking. Looking at the Fed first, Jerome Powell, chair of the Federal Reserve, said that the Fed would move “a little more quickly” to tighten rates and fight inflation. It appears that the Fed wants to front-load rates, however, the market was shocked by comments from the notoriously hawkish James Bullard, who said that the Fed could tighten rates by 50bp or even by 75bp at the next FOMC meeting in May. This dragged US stocks lower, the S&P 500 fell nearly 1.5% while the Nasdaq Composite was down more than 2%. It is worth noting that high quality tech names like Apple fell by a smaller amount as these mega-cap blue-chip stocks can withstand higher interest rates than some of their peers. The US bond market was set on fire by the mixture of Powell and Bullard’s comments. The rates market is now pricing in a near-certain chance that the Fed will hike rates by 50 basis points in May. The US yield curve flattened once again and is now a mere 22 basis points, after 2-year Treasury yields jumped to 2.7%, their highest level since 2018.
Bond markets to test enthusiasm for risk assets
It is hard to find any dove on the FOMC right now, and that is driving conviction that the Fed is truly committed to combatting inflation at any cost. What is interesting is that while the knee jerk reaction was to sell stocks on the back of hawkish comments from the Federal Reserve, hedge funds are now net buyers of US equities, suggesting that the mood music may have changed for equities, and positivity could come back into play even though bond yields are surging. But the next phase in the stock market rally may not be comfortable. The bond markets are pushing risky assets and the economy on a journey of discovery, what is the highest equilibrium yield that they can take before there is a recession or economic slowdown and a sharp market sell off?
ECB changes its tune
The ECB was also out in force at the IMF conference, and they also delivered a shocker of a message to a market that was unprepared for their level of hawkishness. The ECB Vice President stole the limelight from Christine Lagarde when he said that the first rate rise could come as soon as July, after the ECB stops its bond purchases. He also said that rates could move above zero before the end of the year, which indicates that potentially the ECB could hike rates three times in Q3 and Q4. Considering that not so long ago, Christine Lagarde said that it was unlikely that rates would rise above zero this year, this is a huge change and one that could have big consequences for European asset prices. However, while the ECB has elevated inflation concerns above growth fears and the risks associated with the ongoing war in Ukraine, German producer prices rose by an annual 30% last month, which surely can’t be tolerated by any central bank? The result of the shift in communications from the ECB was a sharp rise in bond yields, and German yields. The German 2-year yield rose by 16 basis points at one point on Thursday, to 0.19%, its highest level since 2014.
The impact on financial markets from this hawkish tilt in the world’s two largest central banks, is worth noting. While the focus is on bond markets this week, it will have a knock-on effect on the FX market. Already this week we have seen the euro index outperform the dollar index. While FX markets have been relatively quiet and low on volatility, we think that there could be a potential for the euro to move higher on the back of a more hawkish ECB and buyers could come in on the dip around $1.08, although this may not be until next week.
Earnings: Drama for Netflix
Elsewhere, earnings season is in full swing. From the drama in Netflix’s Q1 results to the stability shown in Tesla’s, the earnings season has something for everyone. Two things strike us: 1, Netflix’ Q1 earnings cast doubt on the prospects of the steaming sector and a portion of the US tech space. Secondly, the drama-free results from Tesla suggest that maybe Elon Musk is the CEO of the future and Twitter’s share price could do better with Elon at the helm?
Pricing power is the stock market winner for Q2
Overall Q1 earnings season in the US has seen results beat expectations. 81% of S&P 500 companies who have reported results have beaten expectations so far. The key themes that are emerging from last quarter’s earnings season is the re-opening trade, which is boosting sales, inflationary and interest rate concerns. Looking forward, the key measure to gauge is companies plans for price increases. In this high inflation environment, the key question will be which companies can easily pass on their cost increases to the consumer as these companies will be the ones that could outperform as prices continue to rise in Q2. Look at American Airlines, who reported their results on Thursday and said that they have never seen such strong demand for flights. This is a company with pricing power, and if there are no more lockdowns, then AA is expected to return to profitability in. Q2, leaving the pandemic as a distant bad dream behind them.