It has been another difficult week in financial markets as investors continue to reassess the trajectory for interest rates, in the US in particular
Central banks have emphasised their ‘data dependence’ and, unfortunately for those betting on rate cuts, that data is not consistent with interest rate cuts in the near term. We have also seen risk appetite unsettled by a significant escalation in Middle East tensions after Iran’s drone and missile assault on Israel.
Geopolitics have dominated the headlines after Iran retaliated for the recent Israeli attack on an Iranian diplomatic compound in Syria with a missile and drone attack. This is the first time that we have seen an attack on Israel by Iran directly from Iranian soil. Iran said “the matter can be deemed concluded” but warned of a bigger response if Israel retaliated. Israel intercepted 99% of the 300+ missiles fired but Israeli war cabinet minister Benny Gantz said Israel would “exact a price” for the attack when the timing is right. Israel has not waited long to retaliate as we woke this morning to news of an attack on Iran from Israel. At the time of writing details are scarce but Iranian media is reporting ‘explosions’ in the central city of Isfahan, home to a large army base. Iran has scrambled air defences and says it has shot incoming targets. President Biden and other world leaders had called for no further escalation, and the US said it would not participate in any retaliatory strikes against Iran. The United Nations Security Council was warned of a full-scale conflict by Secretary General Antonio Guterres, who said it is time to “step back from the brink”. It is in neither Israel or Iran’s interests for these tensions to develop into a regional conflict but we may well see tit for tat responses continue following the response from Israel overnight – meaning the risks of escalation have now increased significantly. An all-out war between the two nations remains a relatively low probability outcome, but a very high risk one, with clear implications for the oil price, financial market risk appetite and wider geopolitical stability.
The hangover from last week’s CPI data in the US continues to weigh on markets, further reducing expectations for a pivot from the Fed to cutting rates in the near term. Commentary from the Federal Reserve dampened any hopes that the Fed saw the three consecutive upside surprises in CPI as a blip, with Chair Jay Powell hinting at a delay to rate cuts, saying “the recent data have clearly not given us a greater confidence and indicate that it is likely to take longer than expected to achieve that confidence” [in the path of inflation]. Powell added that “given the strength of the labour market and progress on inflation, it’s appropriate to allow restrictive policy further time to work”. Fed Vice Chair Philip Jefferson noted that “if incoming data suggest that inflation is more persistent than I currently expect it to be, it will be appropriate to hold in place the current restrictive stance of policy for longer. I am fully committed to getting inflation back to 2 percent.” Ultimately the Fed has to move with the data, and coming into 2024 with disinflationary momentum strong, the market was expecting around six rate cuts this year. At the end of last year, dovish commentary from the Fed supported this optimistic outcome, though the Fed themselves never went as far as predicting so many rate cuts. Right now, with inflation ‘sticky’ and the economy ticking along, markets are now pricing less than two cuts before year end. We’ve even seen some chatter about rate hikes, though this has a low probability for now. Strong US retail sales data this week further trimmed expectations of rate cuts – against a backdrop of a resilient economy, strong labour market and Core CPI now rising, is seems the Fed is comfortable being patient, even if financial markets are impatient for a rate cut.
The commentary from the Bank of England and European Central Bank continued to be relatively dovish compared to what we’re hearing from the US. Christine Lagarde, President of the European Central Bank said “if we don’t have a major shock in developments, we are heading towards a moment where we have to moderate the restrictive monetary policy that we have”. Her colleague, the head of the Bundesbank, Joachim Nagel, who is seen as generally hawkish, said an ECB “rate cut in June has become more likely” though “there are still some caveats”. At the Bank of England, Governor Andrew Bailey was sanguine on the inflation outlook even as CPI for March surprised to the upside (more on this later). Bailey saw “strong evidence” of price pressures easing in the UK and that the latest data showed the UK was “pretty much on track” with their forecasts. Markets appear a little more sceptical – in the past fortnight expectations for the first UK rate cut have shifted from June towards August or even into the autumn.
The economic news saw the UK update inflation and labour market data, with CPI for March at 3.2% year on year, slightly higher than the 3.1% expected but lower than the 3.4% in February. Core inflation was also slightly above expectations, at 4.2%, with services inflation at 6.0%. The employment data also showed wage growth remained robust, up 6.0% year on year, arguably still above the Bank of England’s comfort zone. The unemployment rate however did hint at some weakness, climbing from 3.9% in January to 4.2% in February. It’s worth noting the Office for National Statistics continues to question the reliability of their methodology in constructing the unemployment data – not helpful for the Bank of England right now. What cannot be questioned is payroll data from HMRC, and this showed a fall of 67,000 people on payrolls in March, weaker than expected. Further afield, China saw the monthly ‘data dump’, including growth figures for the first quarter of the year. The Chinese economy grew by 5.3% in Q1, ahead of the expected 4.8%, and slightly ahead of the governments 5% target for the year as a whole. The other data was less positive, with industrial production and retail sales for March behind expectations, while house prices continued their decline, down 2.7% year on year in March, an acceleration on February’s decline and suggesting that Chinese house prices are yet to find a bottom.
The International Monetary Fund (IMF) updated their global growth forecasts this week and edged up their expectations for the world economy, citing strength in the US economy. They continued to express caution on the outlook amid persistent inflation and geopolitical risks. The IMF expect the world economy to grow by 3.2% this year, up from 3.1% made in their January forecast, but warned that short term growth was being held back by the withdrawal of fiscal support and high borrowing costs. They said the medium-term economic outlook remains weak, thanks to low productivity and global trade tensions. The country forecasts saw growth for the US upgraded to 2.7% from 2.1% while the UK and eurozone were trimmed by a tenth of a percent to 0.5% and 0.8% respectively. China was unchanged at 4.6%. Chief Economist Pierre Oliver Gourinchas said that bringing inflation back to target should remain a priority, and noted concern that “progress toward inflation targets has somewhat stalled since the beginning of the year”. Gourinchas described the US economy as “overheated” requiring a “cautious and gradual approach to easing” by the Federal Reserve. Gourinchas also raised concerns over the rebuilding of fiscal buffers, saying it is “best not to wait until markets dictate their conditions”. The US was singled out, with the IMF describing the economic performance as “impressive” but coming from budget policy that is “out of line with long term fiscal sustainability”. Don’t they know Joe Biden has an election to win??
Have a good weekend,
Regards,
Anthony.
