Markets in turmoil; US equities down 3%; USTs up about 20bps across the curve. As inflation fears increase and market prices in much more aggressive tightening. UK has recession on its doorstep and possible trade war with EU

Markets are in turmoil with few safe hiding places, with a plunge in global equities, surging global rates, wider credit spreads, and mostly weaker commodity markets. The safe-haven JPY and USD currencies have significantly outperformed. The NZD and AUD show the largest falls, down to 0.6260 and 0.6930 respectively.

Last week’s more hawkish policy update from the ECB and US CPI shocker continue to reverberate across markets. The set-up to start the new week was bad after the S&P500 closed down 2.9% on Friday, at its low for the session.  After mulling over the weekend, investors have been stampeding further out of risk assets and what were once considered safer assets – namely bonds – as they consider the super-strong inflationary backdrop and central banks’ determination to get on top of it.

With the narrative of “inflation has peaked” being extinguished in the US, the market has moved to price in a more front-loaded and aggressive Fed tightening.  Over 260bps of hikes are now priced for the Fed over the remaining five meetings this year meaning that, at a minimum, the Fed moves in 50bps increments with the chance of a super-sized 75bps hike thrown in – an extra 60bps priced into the curve in the space of a week.

Looking at the next three meetings, through June, July and September, a 75bps hike at one of them is now fully priced – about a one in three chance that the 75bps hike takes place later this week or, more likely, the Fed guides the supersized hike for the July or September meeting. The assumed peak in the Fed Funds rate is now close to 4% for mid-2023.

This re-pricing of Fed expectations has fed through into the Treasuries market but it has been a parallel shift between 2-10 years, both up about 20bps to 3.27% and 3.36% respectively, a sign that extra risk premia have been built into the long end of the curve, given the uncertainty about how successful higher short rates will be in combatting inflation.

The higher rates backdrop and fears that this will drive an economic recession have led to further chunky falls in equity markets, with the S&P500 currently down close to 3%, up from its intraday low in the morning session where it was down as much as 3.8%. A close around here would see the index down 21% from its closing high in early January.

Germany’s 10-year rate rose 12bps to 1.63%, with larger gains in peripheral markets, with Spain, Portugal and Italy 10-year rates up in the order of 21-26bps.  Greece is up “only” 12bps, after its much larger move on Friday. As well as the risk-off dynamic, the market continues to price in fragmentation risks as the ECB moves away from QE.  The Euro Stoxx 600 index closed down 2.4%.

The UK has been the strongest bond market, with the 10-year rate up only 8bps to 2.53%, as recession fears in the country are more advanced than others. UK GDP unexpectedly fell for the second month in a row, down 0.3% in April following the 0.1% contraction in March and the flat reading in February. On this trend, the economy might become the first major developed country to enter recession.  All major sectors including services, production and construction contracted in April, suggesting broadly based weakness across the economy. Surging inflation, trade frictions in a Brexit world and a lack of labour supply have all been contributing factors. The data comes ahead of the BoE’s policy meeting Thursday night, where the Bank is expected to raise the policy rate by only 25bps, because of the threat of recession.

The UK also faces a possible trade war with the EU, after PM Johnson introduced a bill that unilaterally rips up the Brexit deal with the EU covering trade with Northern Ireland. The Northern Ireland protocol bill aims to remove most checks on trade in goods from Great Britain to NI at Irish Sea ports, and end the oversight role of the European Court of Justice as well as EU control over state aid and value added tax in the region. The EU has threatened legal action over the move.

In currency markets, the safe-haven JPY and USD have been the strongest. The DXY index is up 0.8% to 105, after earlier printing a fresh high of 105.1, surpassing the mid-May peak. During the Asian trading session, USD/JPY rose as high as 135.19, a 24-year high. Governor Kuroda finally admitted to Parliament that the recent abrupt slide in the yen was bad for the economy but yet he continues to run the line that monetary easing needed to continue. Safe-haven flows have seen USD/JPY back down to 134 and even down through that level overnight. An eventual capitulation of the BoJ’s yield curve control policy seems likely at some stage which could unleash a much stronger yen, but perhaps not as early as later this week when the BoJ next meets.

The NZD has fallen about a cent since Friday’s close, to 0.6260.  We have been bearish on the NZD, noting that the currency typically performs poorly when there are concerns about the global growth backdrop. The currency remains above its May low of 0.6217 but in our forecast revision in early May we factored in a fresh low in Q3 that could see the currency take a peek below 0.60. Since then, the surging global rate backdrop has increased the chance of global recession, which ultimately reinforces the bearish NZD outlook.

The AUD has gone sub-0.70 again, currently 0.6930, falling a similar amount to the NZD and leaving NZD/AUD trading flat around 0.9030. GBP has underperformed EUR, given the weak economic data and looming threat of a trade war with the EU, with GBP down to 1.2150.  EUR sits at 1.0430.

The domestic rates market faced the full force of the higher global rates seen Friday night. NZGB and swap rates were up 12-14bps in parallel fashion across both curves. The Australian holiday didn’t help liquidity conditions.  The 10-year NZGB rate closed with a 4-handle, at 4.06%, something not seen since 2014. Other rates also closed at fresh multi-year highs and expect further upside pressure today. At some stage investors will see some great value here, but not yet.

In the day ahead, REINZ housing market data are expected to portray ongoing weakness in NZ’s housing market, with weak sales and falling prices. Tonight, UK labour market data should continue to highlight how tight the market is. Only second-tier US data are released tonight, but with the consensus looking optimistic in thinking that small business confidence barely fell in May, while PPI inflation data will likely remain strong.