Risk appetite continues to improve amid signs of less pessimism in global economy. Fed officials continue to beat the drum that the job on inflation is not done yet. Big move higher in NZ rates as the market awaits this week's RBNZ MPS

Market sentiment continues to improve, with investors considering the possibility that falling inflationary pressures could provide a pathway to a soft landing for the global economy.  Equities were up strongly again, the S&P500 up 1.7% on Friday and more than 3% on the week, while the NZD and AUD outperformed on more positive risk appetite.  Friday saw the US 10-year rate reverse some of its big move higher the previous night, although it was still up on the week.  NZ rates were much higher on Friday – 10-12bps across the swap curve – as the market awaits the RBNZ MPS this week.

There wasn’t much fresh news to drive markets on Friday, but the positive vibes since the US CPI release continue to linger.  The downside surprise to CPI, in conjunction with the recent falls in oil prices, apparent improvements in supply chain bottlenecks (the New York Fed’s Supply Chain Pressure Index is at its lowest level since January 2021), and signs of reduced pricing pressures from US business surveys, appears to be forming into a narrative that the US has passed peak inflation.  A meaningful moderation in inflation is expected to give the Fed a little more flexibility around how much it needs to tighten, creating some emerging optimism that the fabled ‘soft landing’ for the economy is still in play (i.e. a recession is still avoidable).

Certainly, risk asset markets continue to trade positively, with equity indices recording strong gains again on Friday.  The S&P500 was up 1.7% on Friday, bringing its gains on the week to over 3%, while the NASDAQ was up over 2% on the session.  The S&P500 is now almost 18% off its mid-June lows, close to joining the NASDAQ in ‘bull market’ territory.  The rally in equities has accompanied falls in volatility, with the VIX index closing the week just below 20 and at its lowest level since early April.

The recent rally in risk assets also needs to be seen in the context of what were extreme levels of pessimism a few months ago and, according to a Bank of America survey, investors’ lowest allocation equities since the GFC.  Thin liquidity conditions in the Northern Hemisphere summer holiday period have also probably exacerbated the moves.  Sceptics still think the recent rebound is merely a bear market rally which will eventually give way as the Fed keeps tightening and the global economy ultimately heads for recession.

Certainly, Fed officials continue to reiterate the job is not yet done on inflation.  Richmond Fed President Barkin told CNBC that the Fed is “going to just have to continue to move rates into restrictive territory” until it sees “a period of sustained inflation under control”, adding the experience from the 1970s was the Fed shouldn’t cut rates until inflation has convincingly returned to target.  The market continues to price a peak in the Fed funds rate around 3.65% but it has been gradually pushing out the expected timing of rate cuts, now seen in the second half (rather than the first half) of next year.

In economic data on Friday, the University of Michigan survey showed a rebound in consumer confidence, albeit from what were rock bottom levels, no doubt supported by the recent decline in gas prices at the pump.  The survey’s 5-10 year inflation expectations rebounded to 3%, slightly higher than expectations but well within the range of outcomes over the past 12 months.  The upside surprise to both confidence and inflation expectations alongside Barkin’s hawkish comments helped US short-term rates rebound modestly on Friday, with the US 2-year rate increasing 2bps, to 3.24%.

It was a different story at the longer end of the US curve, with the US 10-year rate falling 6bps, to 2.83%, reversing around half the previous day’s big move higher.  The US 2y10y yield curve fell back to -42bps, still sounding an ominous warning signal to the optimists about the risk of a recession next year.  Rates were slightly higher in Europe on Friday, the German 10-year rate increasing 2bps, to 0.99%, its highest close in three weeks.

In currencies, the USD was slightly stronger on Friday, the BBDXY index gaining 0.2% and the EUR slipping back below the 1.03 mark.  On the week, the broader theme was one of USD weakness, with the downside surprise to US CPI catalysing a broad-based improvement in risk appetite.    The NZD and AUD were the standout performers last week amidst a backdrop of less gloom about the global economy and higher risk appetite, gaining 3.5% and 3% respectively.  The NZD closed the week at its highest level in over two months, just above 0.6450.

Even weaker Chinese credit data on Friday wasn’t enough to detract from the positive mood.  Total social financing and new loans were both much weaker than expected in July, likely reflecting some payback from very strong lending the previous month but also probably symptomatic of the slowdown in the property sector and general apprehension about the risk of lockdowns.

UK GDP data showed the economy contracted 0.1% in Q1, which was a marginally better result than economists had forecast. The UK economy is expected to rebound in Q3, but the market’s focus is on the widely anticipated recession starting later in the year after energy companies are allowed to raise gas tariffs.  The Bank of England recently forecast the UK economy to shrink for five consecutive quarters, and by around 2% cumulatively, starting in Q4.

In domestic data, the Manufacturing PMI index returned to expansion territory, at 52.7, although the index remains below its long-run average.  NZ food prices were very strong in July, rising 2.1% on the month to be 7.4% higher than they were a year ago.  Somewhat offsetting this, from an inflation perspective, rent inflation was lower than we had pencilled in, rising only 0.2% on the month, possibly a sign that the slowdown in the housing market is seeping through into rental inflation.

NZ rates were sharply higher on Friday, playing catch-up to the big moves seen the previous night in offshore markets.  Swap rates were 10-12bps higher across the curve, similar to the moves seen in Australia on the day.  The 2-year swap rate rebounded to 3.96% as the market increased its RBNZ OCR expectations.  The market now sees the peak in the OCR around 4%, now closely aligned with the RBNZ’s most recent projections from May.

The RBNZ’s OCR forecast track is set to be a key focus of this week’s MPS.  A 50bps hike is seen as a done deal by both markets and economists and would take the cash rate to 3%.  The market’s main interest lies in how much more tightening the RBNZ projects for this cycle (its last forecasts had a peak of around 4%) and whether the RBNZ suggests the size of future hikes might become more data dependent (as the RBA and Fed have recently implied).  On our side, we’re expecting a similar OCR track to the one published in May and we’re expecting the Bank to retain its hawkish messaging, not least because we doubt it would want to encourage any further falls in fixed mortgage rates.

As for offshore markets, it is a quieter week for US data, with retail sales on Wednesday night the main highlight.  Earnings reports from major US retailers Walmart, Home Depot and Target will also be in focus, as a health check on the state of the US consumer.  In Australia, wage growth is expected to pick up to an annual rate of 2.7% (but labour cost indicators signal much higher wage growth lies ahead) while the monthly labour market report is expected to show the unemployment rate remained at a record low of 3.5% last month.  Monthly Chinese activity data takes centre stage today.