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Recession fears return after ECB sparks big market sell-off

euro notes with a red down arrow

Any thoughts that we might see a so-called Santa rally into Christmas suffered a significant setback yesterday as European markets fell sharply after ECB President Christine Lagarde put on her best Grinch persona to deliver a very bleak outlook for the European economy in 2023.

It was this, rather than the widely anticipated 50bps rate hike, that sent stock markets tumbling and bond yields surging as the ECB updated its inflation forecasts for this year, 2023 and 2024 all of which were pushed higher to 8.4%, 6.3% and 3.4% respectively, with the ECB saying that further rate increases will become necessary, with at least another 100bps by March.

US markets also fell sharply with many citing concerns about the Fed’s future monetary policy plans. This comes across as a stretch given that US markets only finished modestly lower in the aftermath of the Powell press conference.

The catalyst for yesterday’s declines was not so much the Fed, but weaker than expected US economic data, along with the sharp switch in tone on the part of the ECB which appears to speak to the hawks on the governing council wrestling back the initiative from the doves. It also points to monetary policy remaining restrictive for much longer than anticipated with little prospect of a rate cut much before 2025.

This appears to have prompted investors to start re-rating market expectations about the earnings outlook over the course of the next few months putting pressure on valuations.  

It also points to investors having to come to terms with the fact that Europe is likely going to have to contend with the prospect of higher inflation, but also much higher rates for longer with all the attendant risks that might have for borrowing costs in the weaker parts of the euro area, like Italy, where 10-year yields closed 30bps higher on the day.

The Bank of England adopted a much more dovish tone, while also raising rates by 50bps to 3.5%, with clear splits on the MPC between two members who wanted no change to monetary policy, to the rest who wanted to raise rates by 50bps, with Catherine Mann wanting to go by 75bps.

The splits on the MPC, while speaking to a welcome change of the groupthink of the past, also present problems when it comes to giving a steer on managing inflation expectations for the Bank of England going forward.

They also beg the question how anyone can think that leaving rates unchanged at 3% is enough to help pull inflation down from 10.7% on a sustainable basis, and let’s not even start on where RPI is.

Yesterday’s splits on the MPC saw the pound get crushed against the euro on an expectation that the ECB may well start to outpace the Bank of England when it comes to rate rises next year.

This expectation comes across as unlikely. It is true the Bank of England does have to be cautious when it comes to pushing hard on the rate hike button given the fragility of the UK housing market, as well as the UK economy. That doesn’t mean the ECB has a free hit when it comes to raising rates either given the fragility of some parts of the European economy, as well as the bond market.

Rather surprisingly ECB forecasters don’t seem to think this will be a problem, forecasting growth of 0.5% next year. This seems rather optimistic to say the least given that energy prices are likely to remain high for some time to come.

As we look ahead to today’s economic data the focus remains on economic activity and whether we are going to see further weakness in the latest flash PMIs from Europe, UK and the US, as well as UK retail sales for November.

Starting with UK retail sales, forecasts are for a modest slowdown from the 0.6% gain in October with gains of 0.3%, while flash manufacturing and services PMIs are expected to come in at 46.5 and 48.5 respectively.

France and Germany flash PMIs are also expected to remain weak with France manufacturing expected to slow to 48.1, and services to 49.1, while German manufacturing and services activity is forecast to bump along the bottom at 46.3 and 46.1 respectively.

The final EU CPI numbers for December are expected to be confirmed at 10% on the headline and 5% on core prices.

EUR/USD – pushed up to 1.0735 yesterday before closing lower, suggesting that a short-term top might be in. Finding support at the 1.0600 area, however a break below here opens up the 1.0520 area, with further support at the 1.0340 area.

GBP/USD – bearish reversal on cable after failing at 1.2450, with the potential to slip back to the 200-day SMA at 1.2110, having slipped below the 1.2280 area, which should now act as resistance.

EUR/GBP – having held above the 200-day SMA earlier this week, we’ve jumped sharply higher through the 0.8650 level and potentially opening a retest of the 0.8780 area. A break below 0.8540 opens up further losses towards 0.8480.

USD/JPY – retesting trendline resistance from the recent highs with a break above the 138.00 area potentially retargeting the 140.00 area. A concerted break below 200-day SMA retargets the lows at 133.60.

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