Financial markets have begun 2023 with a spring in their step. US inflation data has been interpreted positively. Bond yields have fallen and stocks have rallied. The focus is shifting from inflation to economic growth, with hopes of a softer landing than previously expected. In our view, however, the vanquishing of inflationary pressures in the US economy will not be as straightforward as many in the markets now anticipate.
BoJ confounds markets
At its meeting on 18 January, the Bank of Japan (BoJ) resisted market pressure and left its yield curve control measures unchanged, weakening the yen and pushing Japanese stock valuations higher as it maintained a core pillar of its ultra-loose monetary policy.
There has been considerable pressure on the BoJ to end Japan’s two-decade experiment in massive monetary easing. This week, governor Kuroda insisted yield controls were sustainable. The decision follows weeks of turmoil in the Japanese government bond market during which yields have surged.
The BoJ has deployed the equivalent of about 6% of Japan’s gross domestic product over the past month on buying bonds to try to hold yields within its target range. This week’s decision not to change either its policy or forward guidance is likely to prolong this struggle with the market.
In December, the BoJ unexpectedly decided to allow a higher target yield ceiling on 10-year government debt — permitting yields to fluctuate by 0.5% above or below its target of zero. This raised the prospect of a historic pivot by the last of the G3 central banks still adhering to an ultra-loose monetary regime. Scrapping the cap on yields would in effect push up interest rates, at least for longer-term government debt. Instead, the BoJ made no further changes to its yield curve control (YCC) policy, sticking to the range set in December.
Governor Kuroda, who will step down in April after a record 10 years at the helm of the BoJ, said last month that changes to the YCC limits were meant to improve bond market functioning and were not an ‘exit strategy’. Since the policy meeting on 20 December, 10-year government bond yields have continued to rise, to above 0.5%. This has prompted markets to pressure the central bank to abandon the yield target altogether.
In the wake of the latest BoJ’s meeting, our multi-asset investment team has initiated an overweight position in the Japanese yen versus the euro. They see the euro/Japanese yen exchange rate near the top of its trading range of recent years with the yen also attractively valued on a longer-term basis. The euro, in contrast, appears to be priced for an unrealistically positive scenario this year (e.g. economic strength and a problem-free resolution of the energy crisis).
US Treasury borrowing limit in sight
US Treasury Secretary Janet Yellen warned Congress last week that she expected the debt ceiling to be hit on 19 January. The Treasury can resort to so-called extraordinary measures to fund itself and avoid a technical default at least until early June. This gives policymakers in the House of Representatives time to negotiate an agreement to raise the ceiling.
However, the political gamesmanship witnessed in the recent House leadership election suggests there is little appetite for compromise. Once the extraordinary measures take effect, the Treasury will continue to make room to issue T-bills and boost its Treasury General Account balance as the ‘X-date’ approaches, cheapening T-bills further and potentially tightening short-end spreads.
US inflation falls again
US inflation fell in December to its lowest in more than a year, in a further sign that the peak in price pressures is in the past. The rate of increase in the headline consumer price index (CPI), published on 12 January, declined for a sixth consecutive month, leaving the annual increase at 6.5%.
While still near a multi-decade high, this was its lowest since October 2021 and represents a significant fall from the 9.1% reached in June 2022. Compared with the previous month, prices dropped by 0.1%. The core measure, excluding volatile food and energy prices and regarded as a more reliable indicator of inflation’s trajectory, rose by 0.3% from the previous month, translating into a 5.7% annual pace.
We expect the core measure to fall more slowly than the market anticipates due to the continued strength of the US labour market translating into pressure for higher wages.
Although the headline and core CPI data was in line with expectations, markets have turned away from the nuances of the data to focus more on the overall broad disinflation taking place in consumer prices.
On account of the fall in headline inflation, the market is pricing less than 50bp of US rate rises between now and the Federal Reserve’s March policy meeting, implying a potential pause in the tightening cycle in March. With a likely further downshift to 25bp rate rises before pausing, market participants appear to be looking through the end of monetary tightening and focusing on the depth of a potential recession.
Our macroeconomic research team still expects the Fed to raise rates by a further 75bp in 2023 (50bp in February and 25bp in March).
Our view is that core inflation will be slower to fall than currently priced by markets. For this reason, we expect the Fed to raise and then hold policy rates at above 5% throughout 2023 rather than lower them, as priced by markets, later this year.
Weaker US economic data
Despite the more upbeat interpretation by the market of the outlook for inflation, US economic survey data have continued to look weak. This week, the Philly Fed survey will follow the Empire State survey in providing a first look at business conditions in the manufacturing sector at the start of the year. The Empire State Manufacturing survey signalled a contraction, with a reading of -32.9.
In foreign exchange markets, the US dollar touched a seven-month low on 18 January, continuing the reversal of the rising trend that dominated much of 2022. The dollar’s fall is one of the steepest since the global financial crisis. This week’s drop came as US retail sales figures showed a 1.1% year-on-year drop in December — a bigger-than-expected fall.
Moreover, industrial production data may add to weak factory signals. Industrial output is expected to have dropped for a third straight month in December, adding to signs of deterioration including disappointing data from the Institute of Supply Managers (ISM) and a slide in manufacturing hours worked in the recent jobs report.
On the sunny side of the street
Markets, however, have continued to trade in risk-on mode. Sentiment has improved amid short-covering in stock markets, with futures net positioning falling to below half of peak short levels. Part of the rally was driven by a repricing of central bank hawkishness as investors were reassured by the latest US CPI report. As a result, bond yields have trended lower and duration-sensitive sectors have outperformed.
Moreover, European equities have outshone their US counterparts as investors anticipate that softer energy prices and a reopening of China will blunt the global economic slowdown expected for this year.
The minutes of December’s ECB policy meeting will be in focus this week. The tone of the meeting was hawkish despite policymakers agreeing to a downshift in the tightening cycle to 50bp, so we would expect the minutes to reflect this. The language introduced at the time (“interest rates will still have to rise significantly at a steady pace”) suggested more rate rises to come.
Our macroeconomic research team is maintaining its forecast for a 3.50% terminal rate. The market is pricing a terminal rate of 3.3% (which is down by 15bp since the start of the year). One key aspect of the minutes that markets will be monitoring is the degree of adherence or otherwise by the ECB to this hawkish language, and any nuances in the discussion, including how contingent on inflation it is.