Markets are bravely assuming the inflation battle has been won. Risk assets extend higher

By Stuart Talman, XE currency strategist

The new week has started positively, risk assets adding to Friday’s gains on a brighter growth outlook for the global economy. Last week’s two-day sell-off looks to be a minor blip for a January risk rally that is based on expectations of a less-aggressive Fed, mild recessions for developed economies and China’s progress towards a full re-opening.

Commencing the new week in the 0.6460’s, the New Zealand dollar caught a bid straight out of the gate, climbing back to 0.65 during a quiet Asian session. Chinese markets are closed this week in observance of the Lunar New Year holiday.

Burrowing back down through 0.6440 ahead of overnight action, the Kiwi has hopped back towards 65 US cents during the New York morning, US equites dangling the carrot to open up further upside for the Kiwi.

Ok, that’s enough of the year of the rabbit references.

The sign of Rabbit is a symbol of longevity, peace, and prosperity in Chinese culture. 2023 is predicted to be a year of hope.

US equities and other risk sensitive assets are pinning their hopes on the US economy being able to weather the Fed’s historically aggressive tightening cycle. The slowdown in economic activity has been evolving over the past 6 months, credit sensitive sectors of the economy, such as housing, the first to be impacted by the steep trajectory of rate hikes.

The 425bps of tightening through 2022 now having a noticeable impact on household spending as evidenced by last week’s retail sales release – the largest monthly decline in 12 months.

More important readings on the state of the US economy are released this week starting with today’s preliminary readings of manufacturing and services activity, Markit economics’ PMIs for January expected to fall further into contractionary territory.

Markit’s PMIs are also released for the Australian, UK and eurozone economies.

If the data-flow continues to print in the goldilocks zone, representing an orderly slowdown in activity and continued easing of inflationary pressures, the upside bias that originated in mid-October is likely sustained.

It’s a big if.

The bears predict a deeper, prolonged recession ahead due to inflation not falling to the Fed and other central bank’s targeted levels as quickly as desired, therefore requiring policy rates to be maintained at elevated levels for longer, resulting in far greater (than expected) collateral damage for developed economies.

US company earnings will also be a key driver of near term sentiment, fourth quarter earnings starting to heat up this week with Microsoft and Tesla the headliners.

The bears’ call that inflation will remain persistently higher than targeted levels is at odds with the market’s current mindset, evidenced by both the risk rebound and market pricing for ~50bps of Fed cuts through the second half of 2023.

Whilst inflation has peaked and is receding (for most developed economies), the inflation battle has not been won.

China’s re-opening could be the catalyst for a 2023 inflation surge.

The price of crude oil and other energy markets received a lot of airtime through 1H 2022, WTI crude peaking at just shy of US$130/barrel in March before another upside surge in June lifted the price through $120/barrel.

WTI bottomed near $70/barrel on 09 December, recession concerns driving the price lower through 2H 2022.

A solid base has now formed, WTI trading in the low $80’s, poised for a bullish break above its 100 day moving average.

A full re-opening of China’s economy will be a springboard for the energy complex in addition to ongoing fundamentally tight supply.

Crude ascending back through $100 and a potential re-test of 2022 highs could be a likely development in mid-2023, re-igniting the inflationary wildfire, tipping the global economy into an ugly recession in late 2023 or early 2024.

This week brings important updates to the inflation environment, tomorrow delivering a trans-Tasman double header – 4Q CPI for both the local and Australian economies. Headline inflation for AUS is expected to tick up to 7.5% (from 7.3%), whilst NZ headline inflation is expected to ease to 7.2% (from 7.1%).

Later in the week we receive US personal consumption expenditures (PCE), expected to fall for the third consecutive month. The PCE Price Index is the Fed’s preferred gauge of inflation, as it more accurately reflects consumers’ spending habits than the Consumer Price Index (CPI).

Looking to the day ahead the aforementioned Markit PMIs will be the focus.

The risk rally may be challenged should these key readings of manufacturing and services activity show a larger contraction than consensus estimates.

The New Zealand dollar level that we’re currently fixated on – 0.6530. If last week’s high is surpassed, with price action consolidating above 65 US cents, this increases the likelihood of a new leg higher and a potential test of the April highs above 70 US cents.

We’re sceptical that this current risk-on wave has the stamina to lift the Kiwi this high in the medium term....perhaps a 2H development should the bears be proven wrong.

Stuart Talman is Director of Sales at XE. You can contact him here.