What a difference a week makes: why the trading vibe changed

As we start a new week the market is still digesting a strong labour market report in the US and weak big tech earnings. US 10-year bond yields are up 8 basis points on Monday, the 2-year yield is up 9 basis points. The US yield curve has moved further into contraction territory, it is now a whopping -77 basis points, however, the US economy looks nowhere near a recession, especially after January’s Non-Farm Payrolls report came in at 517k, the unemployment rate remained unchanged at 3.4%. The swift shift in market sentiment is striking. Last week the market was in boom mode because of a less hawkish tone from the Federal Reserve, however, the question now is, how much does the US labour market data shift the dial for the Fed, and thus the market outlook?

Strong US data shocks market

This is the big question that we are facing as we start the week. Not only were job gains across the US broad based, but the US economy seems to be firing on all cylinders. The ISM service sector survey was also released on Friday, and it jumped from 49.2 in December to 55.2 in January. The new orders component stunned the market, coming in at 60.4, suggesting that there could be more strength in the future for the US service sector, which is an important bell weather because the US economy is 70% service based. The prices paid component, continued to trend lower, although by less than was expected and it remains at a high level. After two positive surprises for the US economy, Citi’s US economic surprise index has jumped back into positive territory, after a spate of worse than expected economic data points had left it in negative territory for most of this year.

Why revisions may have boosted the NFP report

As we have pointed out above, the question is how does this change things for the Fed? There has been one Fed member who has spoken to the media post the report, Mary Daly from the San Francisco Fed. She suggested that this data point alone doesn’t change things for the Fed, as they always knew that the trend for employment has been strong. However, the Fed still needs to remain vigilant when it comes to inflation. We agree that the labour market trend has been strong during 2022 and now into 2023, for example, the average monthly job creation in 2022 was 401k. Thus, the Fed knows that the labour market is strong, and their rate hikes so far have had no meaningful effect on job growth in the US. There are a couple of things to remember, the labour market is a lagging indicator, and it tends to take some time for rate hikes to filter through to job growth. Added to this, the BLS Establishment Survey Data, which measures payrolls, was revised in January due to annual benchmarking. The Household survey data, which measures the US unemployment rate, reflected updated population estimates. Thus, due to the distorting effect that these revisions may have had on the data, the Fed will be watching to see February and March payrolls before shifting their message, in our view.

Why the Fed won’t change course

It is worth clarifying that in our view, the Fed remains happy to slow the pace of rate hikes and is likely to pause after May’s expected rate hike to 5%-5.25%. After May, we think that the Fed’s decisions are much harder to predict, as a quick succession of rate cuts in the second half of the year, will only happen if inflation continues to fall and if the US economy shows signs of stumbling. Inflation is showing signs of abating, the average hourly wages data showed a slowdown in growth to 4.4% from 4.9% in December, however, the economy looks like it is firing on all cylinders. Aside from the revisions included in the January NFP report, which could mean that it is distorted, the massive job growth does not fit well with the decline in the pace of wage growth. Did workers take jobs that are plentiful at lower wages than other people who were employed in recent months? Thus, January’s labour market data may be painting too rosy a picture of the US labour market, although we will only know this later.

The Fed always has the last say

The Fed will release its latest “Dot Plot” and economic forecasts in March, this will also be an important piece of the jigsaw to see if the Fed is happy with a terminal rate around 5-5.25%. If, this is revised higher, then there could be carnage in finaical markets, particularly the bond market. Right now, the selloff in stocks and bonds and other risky assets looks like animal spirits in our view.

Earnings to watch out for

Looking ahead to the rest of this week, there are earnings from Disney and Uber, if the US economy is performing strongly, then that could impact these earnings reports. One would assume that Uber is still attracting customers, and Disney’s subscriber growth is positive, due to recent signs of US economic strength. If they deliver negative surprises, then it will add to the contradictory picture that is emerging within the US economy: an earnings recession without an economic recession, and a stock market rally to start the year. In any case, if the stock market rally does get back on track, then an earnings recovery in Q1 and beyond could be on the cards, as earnings tend to lag financial markets.

What to watch for this week

The key economic indicators that we will look at this week will be the UK GDP report on Friday. The market is expecting the UK to narrowly avoid a recession, with Q4 2022 growth expected to be 0%, while the annual pace of growth is expected to slow to 0.4%. While avoiding a recession is good news, there is not much to celebrate, with stagnation the name of the game when it comes to the UK economy for the foreseeable. Interestingly, UK asset prices seem to be less impacted by domestic concerns and more impacted by global risk appetite. The FTSE 100 jumped to a record high on Friday, although that has been short-lived. The pound is flat on Monday, and support is holding at the psychologically important $1.20 level. Overall, if the stock market sell off continues, and if the focus shifts back to a hawkish Fed, then this will boost the dollar, and weigh on GBP/USD. The Turkish lira is stable today, USD/TRY is down approx. 0.4%, even though a devastating earthquake has torn through Turkey and Syria. We believe that this is a sign of broad-based dollar weakness, rather than TRY strength, as the dollar falls across the G10 space, reversing some of Friday’s gains.

Why we remain optimistic on risk

Overall, our base case is for a recovery in risky assets this week, as sentiment remains biased to the upside. If we see a weaker dollar in the early part of the week, then it could be a precursor to a recovery in risk appetite, which could benefit stocks. However, for this theme to gain legs, we may need to see more Fed speakers shrug off the recent strong NFP and ISM reports.