It has been a tougher week for equities and bonds, particularly in the US, as economic data once again weakens the narrative around interest rate cuts being just around the corner
The US employment and inflation numbers for March were both stronger than expected, pointing to a resilient labour market and the disinflation process stalling above the Federal Reserve’s 2% target.
We’ll start with the data and then consider the market reaction and what comes next. The US labour market showed continued strength in March with Non-Farm Payrolls increasing by 303,000, well ahead of the 214,000 expected. The numbers for January and February were also revised upwards and the unemployment rate fell to 3.8%. The report added to the narrative that there was no urgency for the Fed to cut rates, with the probability for a June rate cut falling from 74% to 54%. The inflation data published on Wednesday saw markets push back expectations for the first rate cut to September, as inflation surprised to the upside for the third month in a row. US headline and core CPI were both up 0.4% month on month in March, against expectations of an increase of 0.3%. The year-on-year figures were 3.5% at the headline level and 3.8% for core inflation (which excludes energy and food prices). The shorter-term data, when annualised highlighted that the disinflationary trend seen through 2023 has now ended, with three month core CPI running at an annualised pace of 4.5% and six month core CPI at 3.9%.
We have seen prior to this week’s US CPI data two consecutive months where inflation was higher than expected. Federal Reserve Chair Jay Powell said earlier this month that “it is too soon to say whether the recent readings represent more than just a bump.” However, another CPI print above expectations this week brings into question the trajectory of inflation and the potential for interest rate cuts given the resilience of the economy and the persistence of inflation, which appears to have settled at a level outside of the Fed’s comfort zone. We have already seen a huge shift in rate expectations since the start of the year and the data this week has further shifted expectations lower – after the inflation numbers, markets are now pricing just a 21% probability that the Federal Reserve cutting rates in June, with July now at only 50% having been fully priced. The first 25 basis point cut is now not expected until September, with only one further cut to come. This means the market is now predicting fewer cuts than the Federal Reserve predicted when they last met.
The consequence of repricing of rate expectations for financial markets has been further pain for bonds, with yields on US Treasuries moving sharply higher across the yield curve and equities struggling, particularly further down the cap scale. The momentum in US equity markets that has been very strong since last October has clearly slowed, but has not yet gone fully into reverse. While the inflation and jobs data are a negative for those hoping for early rate cuts, they are a reminder that the US economy is still in robust health and there is no need for the Fed to cut rates to try and avoid an economic slowdown. The rally in US equities had taken markets into ‘overbought’ territory so a pause, or even a correction, would not be a huge surprise. However, we are still yet to see a US equity market drawdown of more than 2.5% this year, and much bigger corrections are ‘normal’ feature of markets. Both equity and bond markets are set to be very sensitive to inflation and employment data, likewise the words of Federal Reserve members will continue to shift the risk appetite for some time to come.
The European Central Bank does not appear to be facing such sticky inflation issues as the Fed, and indicated at their meeting yesterday that if their forecasts remain on track, they will be looking to cut interest rates in the near future. Eurozone CPI is now 2.4% and the ECB held rates at 4% for the fifth consecutive meeting. The key sentence from the statement said, “If our updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission were to further increase our confidence that inflation is converging to our target in a sustained manner, it would be appropriate to reduce the current level of monetary policy restriction.” ECB President Christine Lagarde said the bank would remain data dependent and this statement is “not pre-committing to a particular rate path” bit noted “a few governing council members were already sufficiently confident” on inflation “but in June, we know that we will get a lot more data and a lot more information”. Market pricing continues to point to three rate cuts this year, in June, September and December.
For the moment, it looks like the ECB will be cutting well before the Federal Reserve but if we see a resumption in the downtrend in US inflation, we could yet see expectations shift again. Central banks continue to emphasise their data dependence, and for now, the evidence suggests the first rate cuts are more likely this side of the Atlantic given the respective inflation and growth trajectories.
Have a good weekend,
Regards,
Anthony.
