Yesterday’s US CPI report for December, while positive for the narrative that inflation is falling back sharply, as well as reinforcing the belief that the Fed will implement another downshift in the pace of their rate hiking cycle to 25bps, also presents the FOMC with a problem.
It is welcome that headline inflation has fallen back again, along with core prices, however given that most of the decline came as a result of sharp declines in gasoline prices, there is a risk that the market is missing the wood for the trees and becoming complacent that this trend can continue.
The markets still appear to be pricing the prospect of a rate cut this year, with the sharp fall in 2-year yields presenting a huge problem for the central bank's credibility in not allowing financial conditions to loosen too much.
If that were to happen inflation could well take off again, and while Philadelphia Fed President Patrick Harker, who is a voting member, said that a step down to 25bps was now appropriate, we haven’t heard any Fed official argue for a terminal rate that is anywhere below 5.25%.
Richmond Fed President Thomas Barkin was slightly more equivocal, saying that inflation was still way too high, while also arguing that the Fed can afford to slow the pace.
St. Louis Fed President James Bullard said he was still in favour of getting rates above 5% as soon as possible and front-loading rate hikes, in a clear sign that splits were starting to open up about the future size of a move in February.
The market appears to have already made up its mind that they are getting 25bps, with the potential for a pause in March, which at this point seems somewhat premature with such a tight labour market.
Nonetheless the fact that inflationary pressure has continued to slow also had a positive effect on markets in Europe which continued their strong start to the year yesterday.
The FTSE100 had yet another strong session and has risen by over 4.5% since the start of the year buoyed by strong gains from retailers and housebuilders, as the UK blue chip index looks to close in on the record highs of 7,903 set back in 2018, briefly pushing above 7,800 and, closing at a 4-year high.
The DAX also had a strong session, closing above 15,000 for the first time since February last year,
The strong start to the year appears to be a result of a combination of falling prices, warmer weather, and better than expected trading statements from a host of companies, after the widespread pessimism that characterised a lot of the narrative in the lead up to Christmas.
Of course, challenges still remain, not least what happens to commodity prices as the Chinese economy reopens.
This morning's China trade numbers merely serve to showcase the damage done by the various restrictions, lockdowns, and the relaxation that caused the virus to let rip in December. This decision to let the virus rip through a largely unvaccinated population is likely to have consequences over the next few months, which could act as a brake on Q1 economic activity, as we look towards Chinese New Year at the end of this month.
As for the December trade numbers, exports were expected to slow by -12%, and imports set to decline by -10%. Today’s actual numbers came in at -7.5% for imports and -9.9% for exports, more or less guaranteeing an economic contraction for the Chinese economy in next week's Q4 GDP numbers. While the numbers were slightly better than expected and will improve in January they still point to an economy that is experiencing with significant economic disruption as a result of the virus.
This morning we get the latest November GDP numbers for the UK economy, which are expected to point to the UK economy already being in a modest recession. With the economy contracting in Q3, it is quite likely we might see a further contraction in Q4.
Monthly GDP in October rose by 0.5%, although on a rolling 3-month basis the economy contracted by -0.3%. This rolling 3-month figure isn’t expected to change in this morning’s November numbers with another figure of -0.3%, while the monthly number is expected to decline by -0.2%.
All sectors of the economy are forecast to show a contraction in November, manufacturing and industrial production are expected to slow by -0.2%, construction output by -0.3% and index of services of -0.1%.
This is perhaps why the pound has underperformed in recent days, in that markets feel the Bank of England doesn’t have as much scope to raise rates given how fragile the UK economy appears to be, with both the Federal Reserve and the European Central Bank considered to have more headroom.
EUR/USD – moved through the June highs at 1.0787, opening up the prospect of a move towards 1.0950 which is a 50% retracement of the move from the 2021 highs to last year’s lows at 0.9536. A move through 1.0950 opens up a move towards 1.1110.
GBP/USD – moved above the 1.2200 area, but the rallies aren’t convincing, despite the recovery off 1.1830/35. The next big resistance lies at the 1.2350 area. We need to hold above the 1.2000 area for further gains to unfold.
EUR/GBP – looks set for a move through the 0.8870/80 area, which could see a move towards 0.9000. Support remains at the lows this week at 0.8770/80 area. A move below 0.8770 opens a move back to the 50-day SMA at 0.8700.
USD/JPY – the move below 129.50 looks set to see further losses towards 126.50 which is the 50% retracement of the up move from 101.18 to the highs at 151.95. Resistance remains back at the highs of last week at 134.80. Above 135.00 targets a move towards 138.00.