Are central banks winning the fight against inflation?

This has been the most important question driving markets right now, and, for once, it looks like the outlook for inflation is finally starting to become clearer. There are clear signs that inflation and the labour market are cooling in the US, with both headline and core price growth falling last month, in fact, headline price growth fell below 5% on an annualised basis for the first time in nearly two years. Added to this, the BOE is predicting that inflation will fall sharply in the UK in the coming months and will fall below the 2% target rate within 2 years, while the ECB appears to be a lone wolf when it comes to central bank policy, with a plethora of ECB officials sticking to their hawkish mantra in recent days. As we move towards a peak in short term rates, the questions we need to ask will change. Firstly, is deflation the new threat to worry about, and 2, how high will the ECB raise rates?

Markets were mixed on Friday, with the S&P 500 and the Nasdaq closing lower on the week, possibly fuelled by a bout of profit taking, after the main US stock index rose 0.52% on the week. Investors are nervous, as there is still no breakthrough on the US debt ceiling, and the stakes appear to get higher each day as we near the June 1st deadline when officials expect the US to reach its $31.4 trn debt limit. Added to this, there are signs that the US consumer could be losing steam, after putting in a strong performance in Q1. University of Michigan consumer confidence fell sharply in May, from 63.5 to 57.7. The decline was driven by worries about the economy and concerns about the debt ceiling. The University of Michigan officials said that the decline did not suggest that a recession was imminent, however, Americans are starting to worry about a prolonged downturn. Thus, at this point of the economic cycle, a crisis in confidence about the economy could impact stocks down the line.

Elsewhere, the regional banking crisis in the US continues to linger, Pac West bank’s share price declined sharply on Thursday after it informed the market that it had seen a near 10% decline in its deposit base in a week. Deposit flight from regional banks remains a concern. Pac West has a large share of its loan book with commercial real estate developers, which is problematic in an environment of rising interest rates. However, as we move through Q2, we believe that the data is starting to show a softening in the US economy, which could give the Fed room to pause next month and beyond. We shall have to see if this is enough to stabilise the US banks, on Friday the KBW regional banking index fell a further 0.7% on Friday.

UK asset prices are still trying to find their feet after the BOE meeting on Thursday and the GDP report for Q1. The UK economy is now expected to avoid a recession, and inflation is expected to decline. The BOE expects the UK’s CPI rate to fall sharply in April, with an average of 8.2% in Q2, 7% in Q3 and 5.1% average rate in Q4. This is a large decline in price growth, and headline inflation is expected to fall below 2% in the medium term. BOE Governor Andrew Bailey mentioned that some of the stickiest elements of inflation are in the headline measure, not the core measure as you would expect. Food prices in the UK and Europe have been stubbornly high, especially compared to the US, which is likely to mean that rates in the US can be cut at a faster pace than elsewhere. However, back to the decline in the BOE’s inflation forecast, this has weighed on sterling. GBP/USD is bleeding lower and is below $1.25. Part of this decline is also dollar strength, as it gains haven status on the back of the US debt ceiling crisis. We expect this to continue, and GBP/USD is at risk of further losses in the short term. $1.2435 – the low from May 2nd, is key support, and if this level is broken it could be a game changer for the medium-term outlook for GBP.