Equity markets spooked by hawkish Fed and ECB policy updates despite dialled-down 50bps hikes. Safe haven flows drive lower US 10-year rate and USD surges. Strong NZ GDP catches rates market off guard; NZ rates driven much higher

The net outcome of a deluge of central policy meetings and data has been “risk-off”, with hawkish updates from the Fed and ECB scaring equity investors and currency traders seeking the safe haven of the USD. The NZD and AUD have been two of the weakest performers overnight, the latter down over 2%.  GBP also underperformed following the message of a divided BoE MPC and lower UK rates going against the grain of a surge in euro area rates. NZ rates surged after the strong Q3 GDP release. US Treasuries show further modest inversion, with longer rates supported by safe-haven flows.

Soon after we went to press yesterday, the Fed increased the Fed Funds target range by 50bps to 4.25%-4.5%, as expected, with the projections revised 50bps higher for the peak rate next year to 5-5.25%, implying another 75bps of hikes to come this cycle. There was a more hawkish “feel” to the projections, with the skew of rate projections weighted towards an even higher peak and, despite the higher rate projections, GDP forecasts were revised lower and inflation projections were revised higher. Chair Powell was suitably hawkish in the press conference emphasising that there was “still a ways to go” in meeting its inflation objective. While he noted that the Fed was getting close to a sufficiently restrictive rates level, this level would likely need to be held for a sustained period.

The initial market reaction was a higher and flatter yield curve and stronger USD but that wasn’t sustained for long as the market digested the news. The market simply wasn’t prepared to price in the Fed’s more hawkish outlook, given the recent downside misses on CPI inflation and leading indicators suggesting that inflation will head significantly lower over the coming year.

After the market settled, the net change in Treasuries was near zero but overnight there has been some curve inversion, with the 2-year rate up 3bps to 4.24% and the 10-year rate down 4bps to 3.43% – the former perhaps a case of second thoughts after digesting the hawkish Fed and the latter likely seeing safe flows as risk appetite has turned decisively negative overnight, not helped by a hawkish ECB update. The S&P500 fell over 1% into the close yesterday post-Fed and there has been another 2½% downside overnight, with the Euro Stoxx 600 index down nearly 3%.

The ECB delivered the anticipated dialled-down 50bps hike in the deposit rate to 2.0% and indicated that interest rates will still have to rise “significantly” at a steady pace. Bloomberg reported that more than a third of the Governing Council pushed for a larger 75bps hike at the meeting.

ECB President Lagarde didn’t mince words, saying “anybody who thinks that this is a pivot for the ECB is wrong…we should expect to raise interest rates at a 50bps pace for a period of time” and compared the outlook to the Fed, where she said the ECB “had more ground to cover”, implying that she saw the policy rate needing to be raised by at least another 100bps, after the Fed’s projection of 75bps more. On top of this, quantitative tightening will begin from March at an initial rate of €15b per month until the end of June, with the pace after that yet to be determined. 

After that hawkish missive, the market moved to price more tightening into the curve, from a previous peak deposit rate of 2.84% to 3.07%, driving rates higher across the curve with more inversion. Germany’s 2-year rate rose 22bps while the 10-year rate rose 14bps.  EUR surged higher, peaking around 1.0735 before retreating. As we go to print it has slumped back to 1.06 as safe haven flows drive a stronger USD.

The Bank of England hiked by 50bps to 3.5%, as expected, but with a split vote three ways, with six members voting for 50bps, one more hawkish at 75bps and two more dovish at unchanged. The forward guidance noted “the majority of the committee judged that…further increases in bank rate may be required”. The two doves on the committee warned that the effects of tightening monetary policy to date had not been fully felt by households and companies. Market pricing has been aggressive for further tightening for some time and a little of that was pared back after the announcement, with the 2-year rate down 6bps against a backdrop of higher short-term rates in the US and euro area, while GBP underperformed, slumping 1.7% overnight to below 1.22.

In other currency moves, the NZD and AUD have felt the full force of weaker risk sentiment, with the NZD down 1.9% overnight to 0.6325 and the AUD down over 2% to below 0.67. The yen has also been on the weaker side of the ledger, with USD/JPY up to 138. NZD crosses have been mixed. After going sub 0.94 yesterday, NZD/AUD is back up to 0.9460. The NZD is relatively flat against GBP and JPY but has slumped over 1% against EUR and CAD, to 0.5970 and 0.8640 respectively.

US data released overnight were mostly weaker than expected. Retail sales fell by 0.6% m/m in November, the largest fall in 11 months, and ex auto and gas sales fell 0.2%. After adjusting for inflation the figures are even weaker. Industrial production fell 0.2%, boosted by higher utilities, with manufacturing production even weaker at minus 0.6 m/m. The Philly Fed index rose to -13.8, but new orders slumped to -25.8. Initial jobless claims went against the grain of weaker data, coming in at an improved 211k, but likely impacted by seasonal factors around the Thanksgiving holiday.

In yesterday’s news, NZ GDP surged 2.0% q/q in Q3, much higher than anyone forecast, including the RBNZ’s 0.8% estimate. The detail showed soft domestic demand continuing, with strong net exports the key contributor, with the return of tourism being a driving force. The stronger data will keep the RBNZ on the front foot regarding further tightening in monetary policy, given its current penchant for steering the economy through the clear rear vision mirror of hard data than the foggy front windscreen of softer lead indicators. Much higher GDP in Q3 suggests a larger positive output gap that the RBNZ will feed into its model.  In isolation, this would suggest higher inflation pressure compared to its November forecast, but there are offsetting factors to consider such as the NZ TWI running more than 4% higher than projected.

There was little reaction to the NZD from the release, but an outsized move in the rates market caught wrong-footed. OIS pricing was up 5-9bps for the next few meetings, with the February meeting now almost fully priced for another super-sized 75bps hike to 5.0% and the peak rate closing above 5.5% for the first time, at 5.55% for the May 2023 meeting. The 2-year swap rate surged 16bps to 5.33%, back to near the peak rate traded during October/November. The curve inverted further, with the 10-year rate up 13bps to 4.48%, driving 2s10s to minus 85bps. Much of the NZGB curve was up 15bps, with larger increases for the ultra-long end, at 19-22bps for 2041s and 2051s.  It was bad timing for the government’s bond tender, which saw dampened demand despite no more issuance for over a month.

Australia’s employment report showed very strong employment growth in November, but with rising participation keeping the unemployment rate unchanged at a historically low 3.4%. Stronger wage inflation will keep the pressure on the RBA to tighten policy further next year.

China monthly activity data were weaker than already weak market expectations, reflecting the COVID-related lockdowns and growth momentum is likely to get worse before it gets better as the easing of restrictions has unleashed a wave of infections that have scared the consumer into submission. The market is prepared to look through this short-term hit on an improved medium-term outlook as the country gets used to living with the virus like everyone else.

In the day ahead, the NZ manufacturing PMI will be released with some interest in whether it remains in economic contraction territory. Global PMIs are released tonight with the consensus picking little change from prior levels which show manufacturing and services sectors contracting across Europe and the US, although for the latter the market places less weight on these than the preferred ISM indicators.