Investor sentiment remains fragile amidst the fallout from the war in Ukraine and the prospect of major central bank tightening this year. US equities fell further on Friday while the US 10-year rate hovered around the 2% mark. The USD was broadly stronger, with USD/JPY hitting a five-year high and the NZD slipping back towards 0.68. The US 10-year breakeven inflation rate surged to a record high, just below 3%. Besides ongoing developments in the Russia-Ukraine war, the focus this week is the FOMC meeting at which the Fed is expected to kick off its tightening cycle with a 25bps rate hike.
Markets remain extremely volatile and jumpy. Friday night saw S&P500 futures jump by as much as 1.8% after Russian President Putin said talks with Ukraine had seen “certain positive shifts”. But the positive sentiment didn’t last long, with Ukraine’s foreign minister countering that there had been “zero progress” in talks. Equity markets and the EUR subsequently reversed course, with the S&P500 falling back into negative territory and closing 1.3% lower. It was the fourth weekly loss in the last five weeks for the S&P500, leaving it down 12% year-to-date. European markets weren’t open as US equities fell sharply into the close, so the EuroStoxx 600 index managed a gain of 1%.
Over the weekend, there have been mixed messages around the potential for a ceasefire. After a joint call between Macron, Scholz and Putin, French officials said Russia had no intention of ending the war. More encouragingly, the FT reported that there have been “some tentative signs of movement” on both the Russian and Ukrainian sides. Russia’s lead negotiator told state media “my personal expectation is that this progress could, in the coming days, turn into a unified position of both delegations, and in documents ready for signing.”
Besides the war in Ukraine, investors are wary that central bank tightening this year will hinder economic growth at a time when surging energy prices are already cutting into disposable incomes. The FOMC meeting takes place on Thursday morning amidst a near universal consensus that the Fed will kick off its tightening cycle with a 25bps rate hike. With a 25bps rate hike seen as a done deal, investors are most interested in how many rate hikes the new ‘dot plot’ indicates. In December, the median FOMC member projected four hikes this year although most Fed officials have turned substantially more hawkish since then. The market is pricing just less than seven 25bps hikes over the remaining seven meetings this year. Powell is also likely to be pressed around the circumstances under which the Fed would consider a 50bps rate increase at future meetings.
On Friday, the US 2-year rate increased 5bps, to 1.75%, its highest level since 2019, while the 10-year rate continued to hover around 2%. The FT reported that quarterly rebalancing could lead fund managers to sell as much as US$230b in bonds to reallocate into equities later this month, to maintain portfolio weightings, according to analysis by JP Morgan.
US 10-year ‘breakeven inflation’, a market-based measure of inflation expectations, is nearing 3% for the first time on record. The 10-year breakeven jumped 9bps on Friday, closing the week at 2.97%. The elevated level of inflation expectations mainly reflects expectations that inflation will be extremely high over the next year or two. But longer-term measures are also drifting higher, with the 5-year/5-year forward inflation swap closing at 2.72%, its highest level since mid-2014. Central banks tend to watch the 5-year/5-year measure closely, as a guide to whether longer-term inflation expectations remain consistent with their inflation targets. On the week, the 10-year US real yield was broadly unchanged, at around -1%, while the 10-year nominal rate increased by 26bps.
In economic data, the University of Michigan consumer confidence index fell to a fresh 11-year low of 59.7, undershooting market expectations. As in NZ, US consumer confidence is under pressure from rising petrol prices and rising inflation (which are eroding real incomes) as well as faltering stock market returns. Economists still think that consumer spending is likely to hold up, despite the depressed level of confidence, due to the large stock of household savings built up during the pandemic.
The USD experienced broad-based strength on Friday, appreciating against all the G10 currencies except the CAD. The BBDXY USD index rallied 0.5% to near its highs for the year. Of note, USD/JPY hit a five-year high, rising 1% to 117.30. The USD/JPY move partly reflects broader USD strength, although the weakness in the JPY has been magnified by the rising interest rate differential with the US, with the BoJ still supressing Japanese yields through its Yield Curve Control policy. Japan is also a large net importer of oil, so the recent surge in oil prices will dent the growth outlook for the country.
Illustrating that this has not been a classic ‘risk off’ episode, the JPY and the Swiss franc were the two worst performing currencies last week, down 2.2% and 1.9% respectively. Likewise, US Treasuries typically rally when equity markets come under pressure but that hasn’t been the case this time, with markets wary of the inflationary impulse from higher energy prices and with the Fed expected to plough ahead with its tightening cycle this week.
The CAD was the star performer in currency markets on Friday, appreciating 0.3%, after a super strong Canadian labour market report. Employment growth was almost three times expectations while the unemployment rate fell a whole 1%, to 5.5%, near its pre-Covid lows. Bank of Canada tightening expectations were ratcheted higher after the report, with the market moving to price a 65% chance of a 50bps rate increase at the next meeting in April and the 2-year bond rate surging 11bps.
The NZD and AUD were lower on Friday amidst a broadly stronger USD. The NZD was down 0.6% and the AUD 0.9%, with the NZD ending the week just above 0.68. The NZD/JPY cross traded above 80 for the first time in almost four months on Friday, before closing the week just below that level.
After their recent sharp run-up, commodity prices were generally lower last week. Brent crude oil rallied 3% on Friday but was still 5.6% lower last week. Oil prices were supported on Friday by news that talks between major countries and Iran over a nuclear deal had been “paused”, dealing a blow to those hoping that the removal of Iranian sanctions would increase supply to the market.
NZ rates continue to trend higher on the back of global forces and building expectations of aggressive RBNZ tightening. The 2-year swap rate briefly touched 3%, before settling 2bps higher on the day, at 2.98%, while the 10-year swap rate jumped 5bps to a new cycle high of 3.22%. There is around 85bps priced into the next two RBNZ meetings, with the market now seeing a better than even chance of 50bps OCR increases at both meetings. While not our central call, there is clearly a risk is that RBNZ feels the need to validate market pricing of a 50bps move to avoid a pullback in wholesale rates which could then filter through to mortgage rates and other real economy lending rates.
Besides the FOMC meeting, the Bank of England also meets this week, with markets pricing another 25bps hike, which would take the cash rate to 0.75%. Australia sees the release of its monthly employment report, with our NAB colleagues tipping the unemployment rate to fall to a post-GFC low of 4%. The super-tight labour market in Australia is one reason to be cautious about expecting a large rush of net migration to New Zealand even as border restrictions are eased. NZ GDP is the highlight domestically. We are in-line with consensus in looking for a 3.2% rebound in growth in Q4, although the data is very dated now and unlikely to move the needle for the market.
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