Market continues to increase Fed rate hike expectations as inflation concerns mount. S&P500 flat overnight, commodity prices fall

There hasn’t been any major news or data to drive markets overnight.  Market movements have been reasonably limited, albeit with a slight risk-off tone.  The S&P500 is broadly flat, commodities are lower, while US bond yields are higher as the market brings forward Fed rate hike expectations.  The NZD made a fresh 4½-month high yesterday, just below 0.7220, but it has turned lower overnight amidst broader weakness in commodity currencies.

Probably the most notable development overnight has been the continued increase in Fed rate hike expectations, with US 3 and 5-year bond rates up 5-6bps to their highest levels since early 2020.  The market now fully prices two 25bps rate hikes by the Fed by the end of next year, with the first move expected by September.  The curve has flattened, with the 10-year rate up by a lesser 2bps, to 1.68%, as it edges closer to its year-to-date highs (1.77%).

Economic data was generally positive, but it wasn’t the catalyst for the repricing of Fed rate expectations.  US jobless claims fell to a new post-Covid low, symptomatic of an extremely tight labour market.  The Philly Fed business survey’s headline number dipped lower, but the details were strong, pointing to an increase in the nationwide ISM survey released early next month.

Inflation concerns continue to bubble away.  Intel’s CEO said he expected the shortage of semiconductors, which has hampered auto and electronics production, will continue into 2023.  Meanwhile, consumer products bellwether, Unilever, said it had increased the price of its products by an average of 4% during the third quarter, with its CEO saying that it expected inflation pressures to continue through the first half of next year.

Despite central bankers still claiming current inflation pressures are likely to be “transitory”, markets are starting to have their doubts.  The US 10-year breakeven inflation rate broke above 2.60% overnight, to its highest level since 2012, despite a 2% fall in oil prices. In a sign that the market thinks inflation may remain elevated even in the medium-to-long-term, the five-year five-year forward US inflation swap reached its highest level since 2014.

Equities are holding up relatively well considering the market continues to bring forward rate hikes among major central banks.  The S&P500 is flat overnight, holding just below its all-time high, while the NASDAQ is up 0.3%.  The Energy and Materials sectors have underperformed on the back of lower commodity prices (e.g. copper -3.5%) while defensive sectors, such as Utilities, have outperformed.

In the FX market, a reversal of recent trends sees the safe-haven JPY and Swiss franc top the currency leader board with commodity currencies bringing up the rear.  After its recent strong run higher, USD/JPY is down 0.4% overnight, falling back below the 114 mark.  The NZD traded up to a fresh 4½-month high during the Asian session yesterday, close to 0.7220, but it has turned around overnight and is back down at around 0.7140.  Against a backdrop of softer commodity prices, the NZD is the weakest of the G10 currencies over the past 24 hours, down 0.8%, followed closely by the AUD, which has fallen 0.7%.

In Covid news, Pfizer reported that a booster shot of its vaccine was found to be 95.6% effective in clinical trials.  Only 5 of the 5,000 people given the booster tested positive for Covid-19 compared to 109 in the placebo group.  In the UK, PM Johnson urged people to get a booster shot as he resisted calls to move to the so-called ‘Plan B’, which includes a mask mandate and work-from-home advice.  UK daily cases have been trending higher, now exceeding 50,000, although hospitalisation rates, while also moving higher, are well below their prior peaks.

In Australia, the RBA again passed up the opportunity to buy the April-2024 bond under its Yield Curve Control framework, leading to renewed questions among market participants around the RBA’s commitment to the policy.  The April 2024 yield closed the day at 0.17%, now some 7bps above the target level of 0.1%.  The Yield Curve Control framework is important because it is tied to the RBA’s forward guidance that it does not expect to raise the cash rate until 2024.  It’s fair to say the market already has major doubts about the RBA’s forward guidance, given it prices a 25bps rate hike around August next year.

Yesterday’s news that there were 102 new Covid-19 cases, the first time New Zealand has seen more than 100 cases on a single day, helped keep short-end NZ rates in check, with the 2-year swap rate just 1bp higher on the day, at 1.96%.  The implied probability of a 50bps OCR hike in November is now just less than 20%, having been as high as 50% in the immediate aftermath of the CPI release.

It was a different story further out the curve, with the 10-year swap rate up 4bps, on the back of global moves, and the 10-year bond yield 6bps higher on the day, as market absorbed $500m in bond supply at the weekly tender.  Both the 10-year swap rate and government bond yield are at almost three-year highs, at 2.60% and 2.50% respectively.  Liquidity remains very patchy, with volatility in the NZ market and offshore likely dampening offshore investor demand at present.

The recent sharp rise in wholesale rates has started to filter through to the mortgage market, with ANZ and Westpac lifting their fixed mortgage rates by between 20bps and 45bps.  Assuming the other major banks match the new rates, it would imply a 70-75bps increase in one-year and two-year fixed mortgage rates since the start of September, a meaningful tightening in financial conditions over a period when the OCR has only increased 25bps.

Aucklanders and those in the Waikato will be looking on enviously as Melbourne came out of lockdown overnight, with the state of Victoria having hit 70.5% full adult vaccination. Among the loosening of rules, hairdressers and hospitality businesses will reopen for the fully vaccinated.  The New Zealand government is widely expected to announce its long-awaited new traffic light framework for Covid-19 restrictions this morning, to replace the four-level alert system.  We will be looking for clear indications from government as to what will be required in order for the framework to be adopted. The detail contained within these guidelines will be important in helping us to form a view about the economic outlook ahead.

RBA Governor Lowe speaks on a panel this morning and there is a chance he uses the opportunity to push back against market pricing for a rate hike next year, although whether the market pays much attention is another matter.  Tonight sees the release of the preliminary European PMIs which are expected to slip a little further in October, albeit from relatively high levels.  Supply chain bottlenecks and surging energy prices are two key factors holding back activity at present.