No clear catalyst for the improvement in risk sentiment but markets' recession concerns appear to be easing a little. USD broadly weaker amid stabilisation in Fed rate expectations

Risk assets ended last week on the strong note (S&P500 +2.5%) as global recession concerns appeared to diminish.  This helped drive a strong rally in the NZD and other commodity currencies, the NZD closing above 0.65 for the first time since early May.  Global rates were flat-to-lower on Friday while NZ short-term rates pushed higher again, with the market continuing to digest the RBNZ’s hawkish messaging from last week’s MPS.

Last week saw a big turnaround in risk appetite.  The S&P500 recorded its first weekly increase in eight weeks, Friday’s 2.5% rally bringing its weekly gain to 6.6%.  The NASDAQ was 3.3% higher on Friday while the EuroStoxx 600 index added 1.4%.

While there was no clear catalyst for the rally in equities on Friday, the message coming out of the Fed minutes earlier in the week, which hinted at a possible pause in the tightening cycle later this year, probably contributed to the recovery in risk appetite last week.  Likewise, some better earnings results from US retailers, contrasting with the shocking results from Walmart and Target the week prior, may have eased some concerns about the state of the US consumer. And Shanghai continues to gradually loosen restrictions, even as isolated Covid cases are being detected in the community every few days.

That said, the rally in equities might be just as much a recovery from oversold levels amidst extreme levels of pessimism, likely aided by short covering.  For the Fed, it needs to generate a sufficient tightening of financial conditions to slow the economy and bring inflation into line.  The recovery in equities is undoing some of the recent tightening in financial conditions and, ironically, might mean the Fed needs to be more aggressive in the future.  Much depends on the path of inflation.  If inflation does moderate later this year, then it will more clearly open the door to a pause in the tightening cycle, but if inflation doesn’t slow sufficiently, the Fed will have no choice but to continue raising rates aggressively.

As for the US consumer, US personal spending data revealed an upbeat picture, with real consumption increasing 0.7% in April as households started to run down their huge stock of savings accumulated through the pandemic.  Even though the US household savings rate was just 4.4% in April, its lowest level since 2008, households are still sitting on an estimated US$2.2tn of excess savings.  This is a key reason many economists think US consumer spending should be relatively resilient despite falling real incomes and low levels of consumer confidence.

Like equity markets, commodities were generally higher last week, Brent crude oil gaining 6% and hitting a 2-month high, just below $120 per barrel, ahead of the start of the US summer driving season.  EU leaders are meeting over the next two days, hoping to convince Hungary to sign up to a plan to phase out Russian oil exports.  Meanwhile, copper, often seen as a barometer of the global economy, was up a more modest 0.5% on the week, but is still almost 6% off its recent lows.  At face value, the market’s concerns about global recession risk have eased a little.

Despite the rebound in equities and commodities there was no such recovery in global rates last week.  The US 10-year yield was flat on Friday and 4bps lower on the week, ending just below 2.75%.  The German 10-year rate was barely higher last week despite a barrage of hawkish talk from ECB officials, with rate hikes in July and September now seen as a done deal and markets starting to toy with the idea one of those hikes could be a 50bps move.

The USD was broadly weaker for the second week in a row as Fed rate expectations stabilised and risk aversion started to abate.  The BBDXY index was down 1.2% on the week, adding to the previous week’s 1.4% fall, and is at its lowest level in a month.  Unwinds of consensus USD long positions have likely played a part in the recent correction lower.

Against a backdrop of improving risk appetite and stronger commodity prices, the NZD rallied strongly on Friday, closing above the 0.65 mark for the first time in almost four weeks.  The NZD was more than 2% higher on the week, only outdone by the oil-sensitive NOK (+2.9%), and with the AUD (1.7%) not far behind.  The hawkish RBNZ MPS was an added tailwind for the NZD last week.

Domestic short-term rates remain under upward pressure as the market continues to digest the hawkish messaging from the RBNZ MPS.  While the Fed minutes might have tentatively suggested a possibility of a pause in the US tightening cycle when the cash rate is closer to neutral, the RBNZ is seemingly set on continuing to aggressively lift the OCR above neutral, with its projections indicating a good chance of 50bps hikes at each of the two upcoming meetings.  The 2-year swap rate was another 3bps higher on Friday, at 3.8%, bringing its move on the week to a sizeable +28bps.  Market participants appear to have been wrongfooted by the RBNZ and position unwinds have exacerbated the upward pressure on shorter-term rates.  The market prices a peak in the OCR just above 4% in 2023 with rate cuts expected the following year.

In a reminder of the major downside risks to the domestic growth outlook, the ANZ consumer confidence index fell back to 82.3 in May, levels that would historically be associated with recessionary conditions.   The plunge in consumer confidence earlier this year due to Omicron was understandable. But the lack of any recovery since then is consistent with the cost-of-living crisis and significant tightening in monetary policy playing key roles.  We see a significant risk of a NZ recession next year.It should be a relatively quiet session ahead with the US cash market closed for Memorial Day.   German annual CPI is expected to reach a new post-reunification high (8.1% on an EU harmonized basis) while Fed Governor Waller is speaking on the economic outlook.

Later this week sees the key nonfarm payrolls release, where markets are looking for a 325k increase in jobs and a 0.1% fall in the unemployment rate to 3.5%,which would match its pre-Covid lows.  The Chinese PMIs are expected to rebound in May, albeit to sub-50 levels, reflecting the continued Covid restrictions affecting significant parts of the country.  Tomorrow’s ANZ business survey is the highlight domestically this week.