Week Ahead: A central bank fest could make or break market sentiment

This is the last big data week before the Christmas holidays, and the line-up is sure to have something for everyone, as well as drive market sentiment through to year end. We will hear the latest major central bank decisions, US CPI, UK jobs data, the Q4 Japanese Tankan survey and global preliminary PMI reports for December. The week kicks off with a plethora of Treasury auctions in the US, in the UK there is a major split in the ruling Tory party over migration policy, and there is an EU leaders’ summit at the end of the week. As we move into this pivotal week, the yen is at a 3-month high, the oil price is at a 5-month low after American crude oil production reached a record high of 13.2mn barrels per day, and stock markets in the US and Europe had a positive week.

Will the Fed stick to their dovish mantra?

All eyes will be on the Fed meeting on Wednesday. The Fed will deliver their interest rate decision at 1900 GMT, they will also deliver their economic projections and their future interest rate projections for 1,2 and 3-year periods. The Fed chairman Jerome Powell will then deliver his press conference at 1930 GMT. The market is expecting no change in rates at this meeting, there is a 97% chance that rates will remain steady at 5.25-5.5%. However, the Fed’s interest rate projections, along with the press conference from Chairman Powell is what the market is really waiting for. Expectations had been building that the Fed could cut interest rates as soon as Q1, with the CME Fedwatch tool projecting a 43% chance that rates could fall to 5-5.25% at the March meeting next year. This had been higher in recent weeks, however, there was an adjustment of interest rate expectations on the back of the better-than-expected NFP report for November. NFPs rose by 199k last month, 180k had been expected. The unemployment rate also edged down to 3.7% from 3.9%. There was notable job creation in the healthcare sector and in government, the end of the auto workers strike also boosted employment in the manufacturing sector, although the retail sector shed workers last month. Employment in other areas of the service sector, including leisure and hospitality also trended higher, and this sector alone has added an average of 51k jobs per month in the past year. Average wage growth was 0.4% higher on the month, and the YoY rate for average wage growth was 4% for November. Thus, the labour market remains strong, and it will be interesting to see if the Fed tones down their recent dovish messages on the back of the latest labour market report.

Where stocks could go next

As always, what the Fed says will have major implications for global financial markets. Ahead of the FOMC meeting this week, the 10-year US Treasury yield has fallen by 40 basis points in a month to 4.23% and is at its lowest level since September. October’s volatility in the US bond market now looks like a distant memory. As bond yields have fallen, US stocks have rallied. The S&P 500 is up by 5% in the past month, and more than 19% YTD. The Nasdaq is up by 5.4% this month and more than 36% YTD. This has been another stellar year for US stock markets and compares with a mere 1.38% gain for the UK’s FTSE 100. It is adding to the view that you should bet against the US stock market with care. However, there is always the risk that the Fed could knock this rally off course by suggesting that interest rates will not be cut by as much as the market expects. Currently there is a 28.8% chance that US rates could fall to 4-4.25%, or by 125 basis points by December 2024. The market could be over their skis when it comes to expectations of what the Fed does next. If the Fed does signal that they won’t cut as far as the market expects next year, then we could see some unwinding of the recent market exuberance including declining stock prices into next year and a stronger dollar.

Why the Fed can’t ignore the trend on inflation

Overall, we think that the Fed will sound a mildly dovish note, while confirming that they remain wary about the threat of inflation. However, with clear signs that the trend for inflation is lower, and with the price of Brent crude trading around $75 per barrel, its longest weekly losing streak since 2018, there are few signs of inflation pressures building as we move into 2024. US inflation for November is expected to remain stable for last month. Tuesday’s release of headline CPI is expected to show price growth at 3.1% on an annualised basis, with core price growth at 4% YoY. It is also worth noting that China also recorded price deflation in November, with prices falling 0.5% MoM. This was the sharpest decline in 3 years, producer prices have also been in negative territory all year. Thus, with China no longer exporting inflation, there are few reliable signs that inflation pressures are building in the global economy, which could give the Fed more justification to hint at future interest rate cuts at this week’s meeting.

The ECB and the future of the Dax

The ECB and BOE meetings on Thursday will be worth watching. The ECB is expected to cut rates by 70 bps in the first 6 months of next year, which is more than other major central bank. The BOE is also expected to cut by a more modest 26 bps by June next year. If there is any official push back on this then the recent rally, especially in European stocks, could be under pressure. It is worth noting that the Dax reached a record high last week and rose by more than 2.5% last week. It is outpacing gains for US stocks, even as German economic data nosedives. We believe a large part of this surge in German stocks is based on expectations that the ECB will cut rates quickly and sharply next year, if the ECB pushes back on this next week, then we could see some of the recent Dax strength unwind.  

FX focus: why further yen strength could be on the cards

The FX market will also be in focus, after the dollar index reversed recent losses last week and managed to record a 0.4% gain on the back of the stronger NFP report. A less dovish Fed could also help reverse the downtrend in the dollar. However, if the Fed sticks to its recent dovish message, then we expect the USD to continue to trend lower. USD/JPY bucked the stronger USD trend at the end of last week, as expectations rose that the Bank of Japan would raise interest rates. Last week, the BOJ governor told the Japanese parliament that monetary policy will becoming more challenging in the coming weeks, which has raised speculation that the BOJ could raise interest rates when they meet the week after next. Right now, the market is very sensitive to relative interest rates, and any sign that the central banks will change direction on monetary policy. While the western world moves towards lower interest rates, Japan is looking to unwind decades of negative interest rate policy, which is impacting the yen. USD/JPY fell by nearly 1.5% last week, and the Nikkei also bucked the trend for stock markets and fell by 2.55%. Thus, more “hawkish” commentary from the BOJ could trigger more downside for the Nikkei 225 index. The question for investors as we lead up to the Tankan and then the BOJ meeting on the 19th of December, is will more hawkish commentary from the BOJ trigger a deeper downturn for Japanese stocks, one of the key themes for investors in 2023?