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Markets and macro insights with Bernard Swords, Chief Investment Officer
Last week equity markets continued to push higher while bond markets corrected modestly. Why was this?
- The US inflation reports, which I discuss in detail below, sapped the momentum out of the US bond market, pushing 10-year yields up by around 15bps and dragging euro area yields with them.
- This may be harsh on the euro area as it will not necessarily have the same inflation path as the US, but investors are erring on the side of caution. Inflation news has been slightly negative over the last couple of months, so it is not surprising to see some nervousness in fixed income markets.
- There is, however, alignment between bonds and equities in the corporate debt market. It outperformed the sovereign market as spreads tightened with a reasonable growth background reducing the risk of defaults.
- The positive equity market reaction to these developments comes from two sources. The main one is that growth remains respectable. Although the US retail sales report was tepid, it still indicates an economic growth rate not far below trend and that is good for earnings.
- The second source of strength is that interest rates are coming down – and that’s because inflation is coming down and not because the central bank has to support a faltering economy. Indeed, some tepid growth statistics would not go amiss as that would maintain the case for cutting interest rates.
- As with the bond market, where equity markets are aligned is in sectoral performance. The interest rate-sensitive sectors Property and Utilities were down last week. Outside of that, all sectors were up with no clear thematic leader.
The US inflation reports were much anticipated – what were the key takeaways from a central bank point of view?
- Both Consumer Prices Index (CPI) and Producer Price Index (PPI) were a little bit stronger than expected – and there were some encouraging developments in the Consumer Price release.
- Firstly, core CPI did decline on a year-on-year basis to 3.8%, the lowest level in three years. Secondly, all of the extra inflation came from used car prices and even in recent years that has not proven to be persistent. Lastly, there was a considerable slowdown in core services ex-rent inflation. In January, these moved up 0.9% month-on-month, and in February that dropped to 0.5%.
- Meanwhile, the PPI was a little bit higher than expected, but the core rate held steady at 2.0% year-on-year. It is well below the CPI rate of change, so there is little cost-push inflation coming from this source.
- While the core rates of inflation were a little higher than forecast, core CPI is declining and that is the important thing.
- Interest rate expectations have already been adjusted upwards – that is, fewer interest rate cuts at a slower pace are now expected, so markets had moved to price in stickier inflation in the short term.
The week ahead: what to watch out for
Inflation will be important again this week. The CPI report will be released in the euro area. It disappointed at the last reading, can we get a better figure this time? Outside of that, data is sparse, with consumer confidence in the euro area due to be released: is there any life coming back here?
It is a week for central banks. The main one will be the Federal Reserve with its interest rate setting committee (the FOMC) meeting where the ‘dot plot’ will be updated. The Bank of England and the Bank of Japan are also having their policy setting meetings. No changes to interest rates are expected from the UK but the Bank of Japan has just announced the end to highly accommodative policy. It has raised interest rates into positive territory, halted purchases of equities and scrapped bond yield control. It will continue to purchase Japanese government bonds.
