Head of FX Strategy
Summary: US CPI release was broadly in-line with expectations although the core came in hotter-than expected MoM, bringing a 25bps rate hike from the Fed back on the table for next week if further market disorders are avoided. However, growth concerns have risen with banks likely to tighten lending standards which could have a larger and quicker impact on the real economy compared to a rate hike. Near-term volatility could persist but heightening margin pressures especially in smaller enterprises could mean further flight to quality.
US CPI continued to be hot, coming in bang in-line with expectations except for the core MoM print. Headline CPI rose 0.4% MoM in February but core (ex food and energy) was up 0.5% from 0.4% in January. The annual rate of headline inflation slowed to 6.0% from 6.4% while the core inflation moderated to 5.5% YoY from 5.6% previously.
The disinflation narrative in goods inflation got only a modest support, with core goods prices remaining flat vs. +0.1% MoM previously. Services inflation continued to be sticky with core services measure accelerating by 0.6% MoM vs. 0.5% earlier, and shelter costs rising another 0.8% MoM. Powell's preferred "Supercore" metric (which excludes shelter and rent) rose to 0.5% from 0.36%, the highest since September.
As inflation continues to prove harder to turn lower, it may be too soon for the Fed to take the foot off the pedal despite the brewing financial risks and concerns of a growth slowdown. Markets have now put 25bps rate hike back on the table at over 80% probability after dipping below 50% earlier this week. However, that will remain contingent on no further market disorders in the run upto the March 22 announcement.
There is no doubt that the risks of a financial crisis have further complicated the monetary policy response function in the US. But looking at the response of the authorities to the financial risks, there is reason to believe that they have maintained the room to continue their fight against inflation. A pause or a cut at the March meeting, despite market remaining orderly from here, would spell panic for investors who would sense this as the Fed potentially still being cautious of systemic risks. Inflation print isn’t spelling relief yet, and the Fed will need to maintain its inflation-fighting credibility.
It will therefore be important for the Fed to decouple monetary policy from financial risks, while standing ready to respond to any market disorders to avoid creating further panic. The Bank of England, in a similar move in September, had to respond to market disorders by adding short-term liquidity but the monetary policy stayed focus on the price pressures and we have seen 175bps of rate hikes since then.
The credit market remains key to monitor to asses any further stress in the system. Our Head of Equity Strategy, Peter Garnry, has noted the key indicators to watch in this piece. The FRA/OIS spread, or the spread between the U.S 3-month forward rate agreement and the 3-month overnight index swap rate, is a key funding stress indicator. The measure expanded to its widest since March 2020, although has cooled somewhat now. But there are still a lot of uncertainties ahead and this indicator remains key to monitor. If it rises again or remains elevated, it would suggest that the system remains fragile and vulnerable to further shocks.
The mass credit rating downgrades in the US banking sector yesterday are a further cause of concern. Moody’s has cut the outlook for the US banking system to negative from stable and placed six US lenders on review for downgrade. The S&P also placed First Republic on Negative Creditwatch.
The other key indicator to track will be the financial conditions in the US, which have tightened the most for this cycle mostly due to the widening in credit spreads. This can be significantly more impactful for growth outlook or the outlook for the equity markets rather than a large interest rate hike which takes time to trickle down to the economy.
Even if the Fed stays focused on inflation in the near-term, the longer-run path is now quite uncertain. Growth concerns have risen with banks likely to tighten lending standards which could have a larger and quicker impact on the real economy compared to a rate hike. But with inflation still remaining uncomfortably high, and potentially boosted further by China reopening and the Fed’s added liquidity measures, this means we might be now heading towards Stagflation.
Another key thing to consider is that corporate margins could squeeze further, and the impact may be invariably larger for the smaller enterprises (best represented by RUSSELL 2000) as bank failures dent sentiment. The NFIB survey released yesterday also indicated that inflation remains the biggest problem for small enterprises in February in the US.
So in a way, rising risks of growth slowdown could bring yields lower, but the risk premium is likely to rise. Near-term yields could remain highly volatile as growth, inflation and market risk dynamics are interpreted. But flight to quality will likely prevail as we are getting into a tougher economic environment.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
