Double bogey

Saudi continues to double down on an ambitious agenda.

US yields have continued to push higher during the past week, in the wake of last Friday’s strong labour market report. Although the unemployment rate ticked up to 3.7%, the headline figure of 339,000 new jobs in May highlights ongoing strength in labour demand.

In light of this, markets are now discounting an 80% probability of one further hike at either the June or July Federal Open Market Committee (FOMC) meeting. It seems that next week’s consumer prices index (CPI) report will be decisive in determining the Federal Reserve’s (Fed) favoured course of action.

However, we continue to hear policymakers emphasising concern that inflation remains materially too high and with economists projecting core inflation to remain above 5% in May, we think that a 25 basis points (bps) hike, taking effective Fed Funds to 5.35% appears the most likely outcome next week.

Should the FOMC decide to stand pat, then we would tend to think this creates a higher bar, relatively speaking, for future rate hikes. In this way, we think that it would be slightly unconventional for the Fed to skip a meeting in June and resume tightening in July. This may mean that the risks of a hike next week are somewhat under-priced, whereas July may be over-priced.

That said, it was interesting to observe the decision from the Bank of Canada (BoC) to hike rates to 4.75% this week, in the wake of recent disappointing inflation numbers. The BoC has been on hold since the end of January and this serves as a reminder that even once markets may conclude that central bank rates have peaked, it may be premature to quickly discount rate cuts to follow thereafter.

Another factor generating an amount of discussion has been how US debt issuance is set to accelerate, now that the debt ceiling has cleared. Much of this additional supply will be in Treasury Bills, yet this will nonetheless act as a net drain on liquidity.

In essence, the Fed’s quantitative tightening has been on hold for the past few months and as this kicks back in, so there is a possibility that a return to supply could both act to push yields somewhat higher and also skew economic activity somewhat lower. Yet, quantifying these effects is not a precise science.

However, we are more actively pondering whether a further upward move in 10-year Treasury yields may represent a buying opportunity, now that we are on a path towards weaker growth and moderating inflation.

In Europe, the European Central Bank (ECB) is also widely expected to hike rates by 25bps to 3.5% next week. However, revisions to Q1 GDP data mean that the eurozone economy has recorded two consecutive quarters of -0.1% growth, inferring that we have entered a recession.

Data in Q2 has also been soft, though we think that it would be incorrect to be too pessimistic about the European economic outlook. Labour demand remains robust, with unemployment at its lowest since the formation of the Monetary Union in 2000.

Although there are pockets of weakness in the regional economy, there are also stronger spots as well and we see fiscal policy continuing to be growth supportive during 2023. This said, it appears that the ECB may be lowering its economic assessment, and so we think we are now close to the top of the rate cycle in the EU.

Next week also sees the Bank of Japan (BoJ) policy meeting. Q1 GDP in Japan expanded at an annualised rate of 2.7%, with core inflation sitting well above target at 3.4%. Expectations for a policy shift in June remain relatively muted, on the narrative that the BoJ remains content to continue to run an ultra-accommodative monetary policy, for fear of moving prematurely.

However, with CPI likely to jump further in June on the back of electricity price hikes, we think that Ueda could do himself a favour by adjusting policy next week, before market speculation of an adjustment starts to put the BoJ under greater pressure.

In April, the BoJ was more concerned about a spill-over from the US regional banking crisis, but with the Fed subsequently continuing to tighten policy, Japan risks being increasingly exposed to the growing rate differential versus overseas markets, if it continues to retain a dovish stance for too long.

Elsewhere, soft economic data has led to speculation of further stimulus measures in China. We think that some additional easing is likely, but any measures announced may remain relatively limited in scope. In a sense, prior policies which have served solely to stimulate short-term demand and growth in asset prices seem to have been eschewed.

Instead, we see Beijing continue to focus on structural reform of the economy, with a long-term strategy to gain ground in the ‘commanding heights’ of the economy, in the decades to come. The longer-term benefits of such policies remain uncertain, though in the short term, it is likely the case that, as with all structural reform, this will infer a relative drag on near-term growth.

Consequently, we retain a relatively downbeat assessment of the Chinese economy and the renminbi. Meanwhile, a creeping de-globalisation is likely to remain a structural headwind for Chinese activity, as companies in North America and Europe slowly draw back from the country.

In emerging markets, Turkey was once again the centre of attention over the past week. Following the appointment of Simsek as Finance Minister, it is widely speculated that Hafize Erkan will take the reins from Kavcioglu at the central bank. This appears to herald a return to a more orthodox policy stance now that Erdogan’s re-election has been completed.

Over the past two weeks, the Turkish lira has been allowed to devalue by 20%, with long-dated bond yields jumping, in anticipation that the new central bank governor will hike rates to address inflation and allow the lira to adjust to a free market valuation.

Meanwhile, these steps seem to be reducing the risk of a Turkish debt default and consequently, Turkish credit default swap (CDS) spreads have dropped as much as 200bps to 500bps.

Elsewhere, South African assets continued to recover from the Russian Arms scandal, which broke a couple of weeks ago. We doubt we will see sanctions on South Africa, given the US’s desire not to cede geopolitical opportunity to China

Looking ahead

Next week looks set to be a relatively significant one with US CPI, the Fed, ECB and BoJ all ahead of us. Each of these events has the capacity to drive volatility, with the path of policy more uncertain around the turning point in the cycle.

Away from financial markets, it was also interesting to see the news that PGA Golf will be merging with the Saudi-backed rival LIV Golf, in news which came as quite a surprise – most especially to some of the PGA players who had shown solidarity with the Tour by turning down bigger money offers. This has led to a narrative that Saudi Arabia is buying golf, but then looking at football, we also see eye-watering sums being invested by the Kingdom too.

Under Mohammed bin Salman, it appears that Saudi continues to double down on an ambitious agenda. Of wider significance perhaps, it will be interesting to see how this can have ramifications extending to geopolitics and financial markets. Perhaps for now, the perception is that cash remains king.

In the UK, the Bank of England (BoE) will only be meeting in the week after next. Here we continue to hold the view that the BoE will not want to be more hawkish than their peers, having been one of the more dovish central banks throughout this cycle.

From this point of view, we are sceptical that the BoE will deliver more than the 100bps of hikes priced through the end of 2023, with the economic clouds continuing to darken. As Noel Gallagher prosaically commented this week, Brexit has much to answer for. The former Oasis frontman is none too happy about it, and in a sense, we find it hard to disagree too much. That said, it is always easy to look back in anger….