More macro pain for financial markets

As we move into March, the main theme for markets is that good news is actually bad news, especially when it comes to the economy. In the US, there was some good news for workers: initial jobless claims fell once more last week, despite the ongoing headlines of layoffs across different industries. The labour market in the US keeps defying expectations of a slowdown, which poses a headache for the Federal Reserve, who are set to raise interest rates by 25 basis points later this month, although there is a 30% chance that the FOMC reverts to 50 basis point rate hikes at this month’s meeting. Thus, the positive economic surprises coming from the US economy, could set the stage for financial market volatility later this month, as markets would be rocked If the Fed does hike rates by 50 bps on the 22nd.

Eurozone inflation, unsurprisingly, beats expectations

There was more good news for workers in the US on Thursday, unit labour costs for Q4 2022 printed at +3.2%, which is the seventh consecutive rise for quarterly labour costs. Across the Atlantic, the inflation picture is looking similar. According to the ECB’s latest model to measure wage growth, which uses wages linked to job postings, the number of industries posting wage growth of more than 3% is growing, which is fuelling inflation, especially core prices which are looking sticky. The latest Eurozone inflation data for February exceeded expectations and rose by 8.5% on an annual basis last month, this is down slightly from January when prices rose by 8.6%. While headline inflation slowed, core prices continued to rise. Core price growth surged in February, rising to 5.6% YoY, well above the 5.3% expected, and a record high for the currency bloc. This data heaps pressure on the ECB to continue to hike interest rates at 50 basis point intervals. The market now expects Eurozone interest rates to continue to rise through to February 2024, and the terminal rate is currently 3.88%. 100 basis points of hikes are now priced in over the next 12 months, and no cuts are currently priced, as the market bets that the ECB will work hard to bring down inflation.

Why Eurozone peripheral bond spreads remain stable

An interesting reaction to higher Eurozone inflation and rising expectations of significantly higher interest rates in the Eurozone, is that peripheral sovereign bond spreads with Germany have not jumped and concerns about a sovereign debt crisis remain low. There are two reasons for this, in our view. 1, yields are rising across the Eurozone, including Germany, thus spreads are not widening, and 2, the brighter economic outlook for the Eurozone and reduced expectations for a recession is helping to keep peripheral debt markets stable.  However, the fact that the sovereign bond market does not look like it is in crisis gives the ECB room to continue to hike interest rates by large increments. If the ECB keeps doing this, or if they signal that interest rates could rise above 4%, then this could spook bond markets and cause peripheral bond spreads to blow out. Thus, as we move through Q1, we continue to keep a close eye on Italian bond yields.

ECB vs. Fed: who hikes more in 2023?  

The repricing of interest expectations is ongoing in the US and the UK. The market now expects the US terminal rate at 5.4% in August, with only 25 bps of rate cuts priced in by the end of January 2024. In the UK, rates are expected to peak at 4.77% by year end, and then fall slowly in Q1 2024. Andrew Bailey, BOE Governor, was talking on Wednesday, and he was neutral about the prospects for rate hikes. He said that it would all depend on wage data, which is exactly what will determine rate hikes in the Eurozone and the US.  The question now is, will the ECB get to 4% before the Fed gets to 6%? If yes, then we really are in a new paradigm for financial markets.

When will markets recover?

The market reaction to the stronger Eurozone inflation data and better US initial jobless claims data is further declines for stock markets globally. The 10-year US Treasury yield is firmly above 4%, after flirting with this level in recent days, this is the highest level since November. This has led to more US yield curve steepening, as the bond market anticipates US rate cuts in the future. The path of least resistance for stocks remains lower, and we don’t think the narrative will shift by the end of this week. Tesla is a notable underperformer on Thursday, after its investor day failed to excite investors, largely because there has been no progress on affordable models. Added to this, the market is still trying to digest analyst expectations for further margin compression later this year. The dollar is rising in line with long term bond yields, while European stocks are also lower on the back of the higher inflation print. What stocks do next could hinge on two factors: 1, if the US yield curve continues to steepen, and move away from recession territory, and 2, if analysts are too pessimistic for the first half of this year, with earnings and margins expected to decline. We will watch these factors to determine if/ when markets will recover.