Tokyo Drift - not quite Fast and Furious

This week’s Federal Reserve meet passed without much comment, with Powell raising rates by 25bps as widely expected. US cash rates now sit around 5.35% and money markets are evenly split in terms of whether this week’s hike will be the last of the cycle, or whether there will be one further move to come in September or in Q4.

Inflation should continue to fall over the next several months, though with the economy continuing to perform relatively well, a tight labour market continues to point to the threat of renewed pressure on wages.

Meanwhile, US Financial Conditions indices are at their easiest point for the past 12 months, notwithstanding Fed action. Although we expect past rate hikes to impact economic activity over the coming 18 months due to the long lags on policy, should activity continue to hold up then we would not be surprised to see the Fed continuing to push rates higher.

Indeed, there is a school of thought reflecting on the strength of the US consumer who will argue that if the economy has not slowed with rates going from 0% to 5%, what is to stop rates going to 6% or 7%?

A more hawkish view on the Fed could be justified by the notion that the economy needs to cool appreciably, in order to push inflation from a 3-4% range, back closer to the Fed target at 2%. However, with policy rates already well into restrictive territory, it seems sensible to us to think that the FOMC is nearly done with rate hikes, if inflation and growth data do move lower as we would reasonably expect in the months ahead.

From that point of view, it may be easier to take issue with market pricing, should futures markets discount too many early rate cuts in the coming 12-month period. As it stands, June 2024 pricing has US cash rates at 4.8% (50bps below today’s level). Meanwhile, December 2024 rates sit close to 4.0%.

Although we think that it is correct to assume that once a FOMC easing cycle begins, rates can then decline relatively quickly, it strikes us that it will be difficult for the market to extrapolate much lower rates in the meantime, until such a time that the economic backdrop is substantially weaker than it is today.

From this point of view, we continue to think that it will prove difficult for yields to rally much, given the inverted shape of the yield curve. Consequently, should rates move lower, then we would be more inclined to short duration with 10-year Treasuries closer to 3.75% or US 2s towards 4.7%.

In the Eurozone, the ECB also hiked rates by 25bps this week, in line with market expectations. Christine Lagarde was more dovish than at previous press conferences, and it is now debatable whether the ECB will hike rates in September or beyond.

This being the case, it is now very conceivable that the ECB could go on hold prior to the Fed and by extension, one wonders whether that could mean that the ECB would be the first major central bank to embark on policy easing in 2024.

EU data has been materially weaker than has been seen across the Atlantic over recent weeks. To give context to this, a measure of economic data surprises stands at +68 in the US compared to -136 in the Eurozone. Euro area PMIs have continued to fall to new lows over the past month, whilst the latest ECB Senior Loan Officers Survey highlighted further credit tightening and weak demand for new bank loans. Southern Europe has been helped by a robust tourist season, though recent excessive temperatures have started to impact activity in the sector.

Manufacturing appears particularly weak, with the backdrop in China likely to remain soft, regardless of Beijing’s measures to stimulate demand. Consequently, Eurozone growth is reliant on fiscal initiatives, but sentiment in the region remains relatively downbeat.

We don’t have a strong view on Eurozone yields for the time being, though we would not be surprised to see yields in the region outperform Treasuries. In turn, a widening of growth and interest rate differentials could give renewed impetus to the US$ in the coming months. From this point of view, we are inclined to position short euro relative to the US$, as we are sceptical that weaker fundamentals will allow a rally beyond the high for the year witnessed earlier this month.

With government yields in the US and Eurozone little changed over the past week, credit spreads have continued to grind tighter, as equities march higher. Last week we flagged that capitulation from entrenched bears has seen investors putting capital to work and the lifting of downside hedges, in the absence of an obvious near-term catalyst to bring about a reversal in price action.

As we head into August, it seems that this narrative continues to be in the ascendancy, and it is tempting to think that the S&P will want to test the early 2022 high just below 4800. It is striking to think that 500bps of interest rate hikes and a doubling in the long-term rate, which can be used to discount future cashflows, has done very little to deter equity valuations in a lasting way. It is true that earnings momentum has been robust and with little sign of a material slowdown evident for the time being.

Yet ultimately it strikes us that either the economy will downshift leading to earnings disappointment, or else Fed rates may continue to push higher, also triggering a re-pricing in risk assets. But with the medium-term trajectory difficult to predict, it is easy to understand why investors focussing on upcoming events on a much shorter timeframe could conclude that it makes more sense to try to follow, rather than oppose, market momentum for the time being.

Meanwhile in Japan, the BoJ today delivered the tweak to its policy of Yield Curve Control (YCC), as we had been predicting. This saw JGB yields rise and the yen strengthening, with the BoJ also raising its inflation forecasts for the coming year.

With Tokyo CPI showing a renewed upside inflation surprise today, we are inclined to think that the BoJ will have cause to continue to raise its inflation expectations at future meetings, and it seems right to question whether this will see the policy of YCC scrapped altogether at the next quarterly meeting in October.

For now, the messaging is that 1.0% is the new ceiling for 10-year JGBs, but the BoJ is eager to avoid volatility and so is likely to smooth moves. Over the next few weeks, we would expect yields to climb up towards 0.75%, and so we continue to see merit in running a short JGB position. We also see this policy shift stabilising the yen. Over the medium term, we continue to look for a materially stronger yen, as it continues to strike us that the Japanese currency is extremely undervalued on a relative basis.

Looking ahead

After a week of central bank action, so the focus next week moves back to the data with US payrolls coming next Friday and CPI to follow in the week after. However, away from this, we are now into mid-summer markets, and this could make for relatively quiet trading conditions in the absence of a catalyst.

We would note that August can often be a more volatile month than many will realise. There is a sense that at this time of year when minds drift towards the beach, so relatively little should happen in financial markets. Yet the seasonal ebb in liquidity and absence of a number of senior risk takers does make markets more likely to over-shoot in our experience, where shocks occur.

Next week will also see a focus back on the UK with the Bank of England (BoE) meeting shortly ahead of us. Since the 50bps hike at the last meeting, there has been speculation that the BoE would follow this up with another outsized move in order to reassert control over inflation.

However, given last month’s downside miss on CPI we think that a less hawkish assessment is warranted. With food retailers now cutting prices and energy bills falling, we are confident that inflation should drop towards 5% in the next few months. Although this will leave inflation at levels which is still higher than desired, we think that the BoE needs to be careful not to over-tighten policy. This is the message that also seems to be coming from the UK Treasury.

Yet we do also think it would be helpful if the government understood that in order to help bring inflation down, then there won’t be room to ease fiscal policy, especially with a large fiscal deficit thanks to losses on BoE QE asset purchases. Consequently, we look for the BoE to hike by 25bps next week and UK rates to peak at 5.5%, a level well below what markets have recently discounted.

In politics, it has also been interesting to pick up on new trends where enthusiasm for far-right parties seems to be giving way to a new anti-woke agenda. Last weekend’s polls in Spain saw a drop in support for the right wing Vox party, which could signal a halt in the rise of parties across the continent at that political extreme. Yet in the Netherlands, it has been notable to witness a surge in support for the Agrarian Party, which seeks to roll back the green agenda.

Public resentment towards self-righteous acts of protest by campaigners from groups such as ‘Just Stop Oil’ has also been compounded by an aggressive rollout of policies designed to modify behaviour in all areas, ranging from how we live and how we travel, to what we are allowed to eat. In this context, it was interesting to witness a Conservative bi-election win in Uxbridge, on a revolt over Labour plans to extend the Ultra-Low emission zone into the suburbs.

Elsewhere in the UK, Nigel Farage must be feeling delighted at how bungling actions from Natwest have served to substantially boost his reputation. Indeed, any motivation by woke management to seek to protect their firm’s reputation by severing their association with a client such as Farage, have spectacularly backfired, with Natwest’s reputation now the one in the gutter. Maybe it is about time for some of the woke crowd to wake up and realise the opposite and unintended consequences of some of their actions, before it is too late….