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Big week for central banks as China falls into deflation

Markets in Europe finished higher again last week, with the DAX up for the sixth week in a row, while the FTSE 100 returned to levels last seen on 19 October, after the latest US jobs report came in better than expected, and unemployment unexpectedly fell to 3.7%.

US markets also finished the week strongly, with the S&P 500 pushing above its summer highs to close at its highest level this year, with the Nasdaq 100 not too far behind, with the tech sector once again instrumental in achieving the bulk of this year’s outperformance.

The catalyst for the strong finish was a solid US jobs report which showed 199,000 jobs were added in November, while the unemployment rate slipped to 3.7%. With the participation rate returning to 62.8% and wages remaining at 4%, the idea that the Federal Reserve will be compelled to cut rates aggressively underwent a bit of a setback, with yields moving sharply higher, as 2024 rate cut expectations got pared back.

The apparent resilience of the US economy against a backdrop of a sharp fall in inflation expectations from the latest University of Michigan confidence survey has helped craft a narrative that despite the sharp rise in interest rates delivered over the past 18 months, the US economy will be able to avoid a severe recession.

This scenario does present some problems for the Federal Reserve when it comes to managing market expectations of when rate cuts are likely to come, with the recent sharp fall in yields globally speaking to a widespread expectation that rates may well be cut sharply as we head into 2024. As far as the US economy is concerned aggressive rate cuts at this stage look a little less likely than they do elsewhere where we’ve seen sharp CPI slowdowns in the pace of inflationary pressure.

Earlier this month the latest EU inflation numbers showed headline CPI slow to 2.4% in November, while German CPI was confirmed at 2.3% as month-on-month prices declined by 0.7%, the second month in a row, CPI went negative. Germany isn’t unique in this either given that PPI inflation had already given plenty of indication of the direction of travel when it came to price deflation.

In China over the weekend headline CPI also went negative in November, only in this case it was on the annualised number to the tune of -0.5%, for the second month in a row and for the third month in the last five. PPI inflation also remained in negative territory to the tune of -3%, the 14th month in succession, as the world's second biggest economy grapples with deflation, and slowing domestic demand.

This deflationary impulse appears to be already making itself felt in Europe, and truth be told has been doing so for some time, the only surprise being how blind to it certain parts of the European Central Bank have been to it. These concerns over deflation while slowly starting to be acknowledged don’t appear to be being taken seriously at the moment, although in a welcome shift we did hear Germany ECB governing council member Isabel Schabel admit that they had been surprised at how quickly prices had slowed over the past few months, even as economic activity stumbled sharply.  

Consequently, this week’s central bank meetings of the Federal Reserve, European Central Bank and the Bank of England are likely to be crucial in managing expectations when it comes to the timing and pace of when markets can expect to see rate cuts begin now, we know the peak is in. Of all the central banks, the Fed probably has the easiest job in that they have more time to assess how the US economy is reacting to the tightening seen over the past few months. 

The ECB has no such luxury given that the two biggest economies of Germany and France could well be in recession already, and where prices could slide further as we head into 2024. The fear for central banks is that a lot of the slowdown in inflation has been driven by the recent slumps in crude oil and natural gas prices and could well be transitory in nature, and with wage inflation still elevated will be reluctant to signal the “all clear” too soon.

The Bank of England has a similar problem although the UK economy isn’t showing the same levels of weakness as those of France and Germany, and furthermore inflation in the UK is almost double that of Europe, with wage costs and services inflation even higher.

As we look towards a new trading week, and probably the most consequential one this month, European markets look set to open slightly higher as investors look back at the inflation numbers from the weekend and extrapolate that 2024 may well be the year that rates start to come down, with the main risk being in overestimating by how far they fall.   

EUR/USD – slid down towards the 200-day SMA on Friday, stopping just short at 1.0724, with a break below 1.0700 targeting the prospect of further losses toward the November lows at 1.0520. We need to see a move back through 1.0830 to stabilise.

GBP/USD – slid to the 1.2500 area but remains above the 200-day SMA for now, with only a break below 1.2460 signalling a broader test of the 1.2350 area. Resistance currently at 1.2620 area. 

EUR/GBP – still range trading between the 0.8590 area and the lows last week at 0.8550. While below the 0.8615/20 area the risk remains for a move towards the September lows at 0.8520, and potentially further towards the August lows at 0.8490.

USD/JPY – finding a level of support at the 200-day SMA at 142.50 after last week’s steep fall. We need to see a daily close below the 200-day SMA to open a test of 140.00 and then on towards 135.00. Resistance back at 146.20.

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