A key week for economic data

After the weaker than expected US Non-Farm Payroll report on Thursday, stocks gave back some recent gains and the dollar dropped across the board, with USD/JPY dropping more than 1.3% at the end of last week. As we are about to start a new week, the market is at a crossroads trying to digest the mixed economic signals coming from the US. For example, jobs growth slowed, but wages are still rising and Citi’s US Economic Surprise Index is also at its highest level in 2 years. This does not look like the environment where the Federal Reserve should be looking to pause interest rate hikes, however, the market will look to the US CPI data released this Wednesday that may determine where stocks, bonds and the dollar go next.

The global rise in bond yields is a good thing…

Sometimes in financial markets there is an asset class that seems to be leading the way for overall price action and they provide the guiding light or general direction for where prices go next. The bond market has been one such asset class this year, and we think that it could provide the lead yet again this week. Last week’s move in bond yields was worth watching closely, firstly, 5-year yields rose approx. 20 basis points in the US, Canada, Australia, the UK, and the Eurozone, secondly, this move was global. When this happens, it is worth watching and could be providing us with an important signal. So, what does the shift higher in 5-year yields mean? Shorter term yields of 2-years and below, tend to give us a good signal of where monetary policy will go in the short term, whereas longer term yields of 5-10 years tend to act as a proxy for economic growth. Thus, the fact that 5-year yields are rising around the world is a sign that the market believes a soft economic landing is possible, and growth could be maintained and even boosted in the medium term. The uplift in US long term yields, the 10-year yield also rose by more than 20 basis points last week, has been more pronounced than the movement in 2-year yields, the US 2-year Treasury yield rose by a mere 2 basis points last week. This means that the US yield curve, which is used to predict recessions, has steepened somewhat in recent days. An inverted yield curve is a sign of recession, and the US yield curve has been extremely inverted for the past 12 months. Thus, the slight steepening in the yield curve is worth watching. In layman’s terms, it means that a slowdown in growth now could lead to stronger growth in the future, which is no bad thing.

Disinflation theme could be given another boost this week

However, what the US yield curve does next could depend on the US inflation report that is scheduled for release this Wednesday. Analysts polled by Dow jones are looking for another sharp decline in headline inflation for June, which is expected to show a 3.1% YoY rate, down from a 4% YoY rate in May. The market is also looking for a decline in the core rate of inflation from 5.3% to 5%. Thus, the disinflation theme is expected to continue in June, especially in super-core elements of the price index, which excludes energy, housing, and food costs. If analysts are correct, and price growth did moderate last month, then it could give another boost to the narrative that the Federal Reserve is close to completing its tightening cycle. The market is pricing in a more than 90% chance of a 25bp rate hike from the Federal Reserve later this month, and the market expects this to be the peak for the US hiking cycle.

Why stocks may struggle

The market reaction to a weaker than expected inflation report is harder to gauge. The market has been driven by bullish sentiment for most of 2023, even if US stocks fell last week. The S&P 500 is still higher by more than 14% so far this year. It may be harder for a weaker inflation report to spur further stock market gains since so much good news is already priced in. Added to this, there are small signs that cracks may be appearing in the economic data at the same time as US interest rates are at their peak. The market is not expecting rates to fall until Q2 2024. Thus, a weak economy, combined with a high Fed Funds rate and stretched valuations, particularly for some technology stocks is not necessarily positive for risky assets, which tend to thrive when rates are low. Thus, until the Fed is ready to signal that its fight against inflation is over, which we doubt will happen in the coming months, it could be hard for stocks to extend recent gains. This week is also the start of Q2 earnings season, which is worth watching closely. We will provide a more detailed update on this in a later report.

Worrying times for the Bank of England

In contrast to the strong performance from the US stock markets this year, the UK index is lagging its global peers, and the FTSE 100 is down 2.61% year to date, and it dropped sharply last week, and was down more than 2.8%. There is also some key economic data to watch in the UK next week, the first is labour market data due on Tuesday, and the second is the 10-year bond auction that is scheduled for Wednesday. You may remember that UK wage growth for the three months to April grew by a whopping 7.2%, which set off a chain of events that included surging bond yields and falling UK stocks, as the market priced in more aggressive tightening from the Bank of England. The market now expects the BOE to hike rates to 6.5%, and this has been reflected in surging bond yields and mortgage rates. Thus, whether wage growth continues to grow at the same rate for the three months to May, is worth watching closely. The signs aren’t looking good for a reduction in wage pressure and there is unlikely to be much respite after a BOE survey showed that businesses are expected to continue to keep rising their prices in response to rising wages, and businesses expect output inflation to be 5.3% in the next year. This is lower than the current rate of headline inflation, but it is still above the BOE’s 2% target rate. The outcome of the labour market data may impact the UK Treasury’s 10-year bond auction that is scheduled for Wednesday. Watch demand for UK debt and the price that the UK government needs to pay for borrowing, as the government’s borrowing costs have also soared. Our debt to GDP ratio has recently risen above 100%, so rising debt costs and a low bid-to-cover ratio could be a negative development that could heap further pressure on UK bond yields. GBP/USD has risen by more than 2.2% since the last inflation and wage data report, but can it continue to thrive if we get more strong wage data that threatens the UK’s economic outlook? That might be a step too far for the pound in the coming month.