We’ve seen financial markets, particularly bonds, repricing this week for an environment of stickier inflation
The constant talk from central bankers, most notably in the US, that interest rates will likely have to stay “higher, for longer” is seemingly no longer falling on deaf ears. After the US jobs report showed the labour market to be exceptionally strong, this week we have seen renewed signs of the resilience of the US economy, with robust retail sales data for January published. While inflation in the US has eased somewhat, there remain concerns that inflation in services appears persistent even as inflation in the goods side of the economy rolls over.
US inflation data published this week showed CPI in January rising at 6.4% year-on-year, which was a 15-month low but higher than the expected 6.2%. Core CPI, which excludes food and energy, was up 5.6% on January 2022. Subsequent market moves have seen futures pricing for US interest rates shift higher and expectations for rate cuts later this year fade. The move higher in Fed Funds futures is bringing the market closer to what Fed members have been saying for some time: they are not done hiking rates yet, and they see little prospect of rate cuts until some point next year.
Lorie Logan from the Dallas Federal Reserve said this week “we must remain prepared to continue rate increases for a longer period than previously anticipated”, while Thomas Barkin of the Richmond Federal Reserve said that “if inflation persists at levels well above our target, maybe we’ll have to do more”. US futures are now pricing peak US rates at 5.25% in July, easing to 5.05% by year-end. Fed Board member Michelle Bowman reiterated that while “there are costs and risks to tightening monetary policy to lower inflation, I see the costs and risks of allowing inflation to persist as far greater”.
The US also reported very strong retail sales data for January, up 3% month-on-month. This suggests consumers are still in reasonable shape – no surprise given the strength of the labour market and the fact that accumulated savings from the pandemic period are not yet exhausted. With indicators suggesting first quarter growth in the US will be around 2.4% on an annualised basis, it would seem that both the US economy and, in turn corporate earnings, are holding up better than expected. The outperformance of US equities and recent strength of the US dollar, meanwhile, highlights a more positive market view of the current state of the economy – though of course we are yet to fully see the impact of 450 basis points of interest rate highs over the past year, with more to come.
In the UK we also saw inflation data reported, as well as employment data for December. UK CPI eased to a five-month low of 10.1% year-on-year in January from 10.5% in December. This was due to lower fuel prices and slowing price increases in hotels and restaurant prices. Core CPI, which excludes food and energy, slowed to 5.8% year-on-year from 6.3% in December. The Bank of England forecast earlier this month that inflation would fall “sharply” over the course of the year thanks to falling energy prices. Markets are pricing in another 25bps hike for the Bank when it meets in March; further hikes will become less likely if we see inflation continuing to ease, though with wage rises still high as a result of a tight labour market, the Bank, much like the Federal Reserve, will want to ensure inflation is truly tamed before cutting rates. UK unemployment held steady at 3.7%, as expected. December saw 843,000 working days lost to strikes. Average earnings climbed by 6.7%, still some way below inflation.
Elsewhere in the world we saw Japan avoid falling into recession after reporting Q4 GDP of 0.6% annualised. This was some way below expectations but an improvement on the 1% contraction in Q3.
Japan was also in the headlines following the announcement of the replacement for Bank of Japan governor Haruhiko Kuroda, who will step down in early April. The academic economist Kazuo Ueda has been appointed to the role, which came as something of a surprise with the consensus view being that deputy governor Masayoshi Amamiya would take the job, but it appears he turned it down. Ueda previously served on the BoJ board between 1998 and 2005, but his views on monetary policy are little known with only a few published articles, some of which lean hawkish, others more dovish. We will likely learn more during confirmation hearings in a couple of weeks. Ueda will face some immediate challenges: inflation is at 4% and interest rates still negative, while financial markets will likely test the BoJ’s Yield Curve Control target which was widened in December but still leaves Japanese Government Bond yields artificially low, and well below international peers. The sheer amount of money being spent keeping yields suppressed suggests this policy may well be loosened once the new governor takes charge.
