Strength of Germany CPI shocks the market. European rates higher; EUR higher; US on holiday, but futures point to 5bps lift in 10-year rate

The US Memorial Day holiday has been a moderating factor in market movements. However, the positive inflation surprises keep on coming and the latest update from Germany was a complete shocker, driving global rates and EUR higher as the market eyes up the ECB meeting next week. The surprise hasn’t got in the way of risk sentiment improving, with US equity market futures showing modest gains and the NZD edging higher.

Another month, another inflation shocker. Germany’s CPI surged by 1.1% in May, a massive 0.6 percentage points stronger than expected, taking the annual increase to 8.7%, a fresh multi-decade high. The data puts the heat on the ECB to quickly move away from its ridiculous negative policy rate settings at its meeting next week. Remarkably, the ECB is still buying bonds every week in a bid to keep interest rates suppressed and has previously guided that QE will end soon.  A strong consensus on the Governing Council has been building for rate hikes in July and September, so the key question is whether the ECB moves in 25bps or 50bps increments, and President Lagarde has been pushing against being too aggressive.

Overnight, German Finance Minister Lindner called the fight against inflation his top priority and he reiterated government plans to restore constitutional limits on net borrowing from next year, suggesting that the 2023 finance plan will be “fundamentally different” to recent budgets.

European rates surged higher as the state-by-state German inflation data were released, seeing Germany’s 2-year rate up 11bps on the day to 0.43% and the 10-year rate up 9bps to 1.05%. Other European rates show similar increases. The US bond market is closed for the public holiday, but Treasury futures point to about a 5bps lift in yield for the 10-year rate.

US Fed Governor Waller showed his hawkish credentials, saying he supported more 50bps hikes “for several meetings” and not taking these off the table until “I see inflation coming down closer to our 2% target”. He supported a policy rate above neutral by the end of this year, and he said his plan for hikes was roughly in line with market pricing, which sees the Fed Funds rate at about 2.75% in December.

Despite the shocking German inflation data, underlying the market has been a continuation of more positive risk sentiment. Some argue that this is simply a dead cat bounce in risk assets after recently becoming oversold. Fundamentally, one might point to a better vibe on China’s COVID situation as a reason to buy risk assets again, although the zero-COVID strategy would mean a reversion to lockdowns on any new outbreak. This must surely remain a high risk, given the inability of any country to stamp out Omicron.

China reported the lowest number of new COVID19 cases in three months, supporting the easing of restrictions in Shanghai and Beijing, although schools and universities will remain closed and dining-in will remain banned in restaurants.

The backdrop of higher interest rates hasn’t perturbed buyers of the equity market dip, with the Euro Stoxx 600 index closing 0.6% higher and S&P futures up 0.5%.

Oil prices are up over 2% to a 2-month high, as traders eye increased demand from China, while the EU continues to work on a plan to ban imports of Russian crude. A sourced Bloomberg report says that EU leaders intend to reach a political agreement today on an embargo on Russian oil. Some temporary exceptions will be granted to several member states that will take more time to resolve. Brent crude is trading just under USD122 per barrel.

The USD was already under downward pressure during the NZ trading session, reflecting a continuation of the risk-on backdrop from last week, but the strong German CPI data helped fuel further gains in the euro, sending the USD lower. EUR is up 0.5% from last week’s close to 1.0785, while the risk-on backdrop with higher global rates has seen JPY the weakest performer, with USD/JPY up 0.3% to 127.55.

The NZD has pushed up to about 0.6560, up 0.4% from Friday’s close, but not much progress from yesterday’s NZ close. The AUD has done marginally better, returning to 0.72 and seeing NZD/AUD push down to 0.9110.

Yesterday, the post RBNZ MPS updates by senior staff continued, with RBNZ Chief Economist signalling “there’s probably some more 50 points coming over the next little while”, in reference to rate hikes, consistent with the market viewing 50bps hikes being more likely than baby 25bps hikes over the next few meetings. He indicated some confidence in guiding the NZ economy to a soft landing, but that looks optimistic in light of the aggressive tightening in policy underway with more to come, and some indicators such as consumer confidence and the negative 2s10s yield curve already consistent with recessionary economic conditions.

The swaps market continued to see the fallout from the more hawkish RBNZ update last week, with rates up 6-7bps across the curve, the move aided by global forces. The OIS market shows high conviction in 50bps increases at the July and August meetings, these being almost fully priced, while the market is more attune towards 25bps hikes as we get closer to the end of the year. NZGBs performed well yesterday, significantly outperforming swaps, with rates only up 1-2bps across the curve, ahead of month-end.

The economic calendar is full in the day ahead. In terms of the key releases, the ANZ business outlook survey will provide an update on how the economy is tracking, with activity indicators likely to remain on the soft side, and with confidence remaining depressed. The consensus sees an uplift in China PMIs from the deeply depressed lockdown-affected levels in April, but still consistent with very weak growth momentum. Euro area CPI data are expected to show annual inflation for the headline and core to stretch up to fresh multi-decade highs and surely there is now upside risk following Germany’s figures. US consumer confidence is expected to weaken further in May.