European markets finished the first month of 2023 sitting on some decent gains, although recent momentum has stalled in the last two weeks over concerns that a brighter economic outlook could prompt a more aggressive European Central Bank monetary policy response tomorrow.
US markets have also got a new lease of life in the last two weeks, with the best start to the year for the S&P 500 since 2019. The Nasdaq 100 has also enjoyed a stellar second half of the month, gaining 10.6%, with yesterday’s strong finish set to translate into a positive European open.
Judging by these January gains, it would appear that US investors have made up their minds that the US Federal Reserve is about to hit the pause button today, as it gets set to raise rates by an expected 25bps. This would push the Fed Funds rate to 4.5% to 4.75%, which is still well below what several policymakers have insisted consistently over the past few months is somewhere between 5% and 5.25%.
It is this disconnect between the Fed’s rhetoric and what the market is pricing which makes today’s FOMC rate decision, and Powell's press conference, very much a “live” meeting. How does Powell square how the Fed sees the path of future rate rises and the markets belief that the central bank will start cutting rates again before the year is out? While Fed officials have insisted that rates will stay high for some time to come, the markets simply don’t believe them, especially when several key inflation indicators have shown that prices are still coming down on a steady trajectory. Yesterday the employment cost index for Q4 fell to 1%, and the lowest level since Q4 2021.
This is what makes today’s Powell press conference such a tricky proposition when it comes to market positioning. The danger for the Fed is in allowing the market to continue to think that rates are likely to come down this year, which in turn could see inflation take off again, especially with the labour market being as tight as it is. Powell simply can’t afford for financial conditions to loosen and for the inflation genie to get out of the bottle again. Something needs to give to reset the narrative with the market pricing in a 25bps rate hike followed by a pause, although given the tightness in the labour market, the Fed could surprise with a 50bps move, but that would be a surprise.
Today’s ADP employment report for January is expected to reinforce this tightness, coming in at 180,000, down from 235,000 in December. The wages data will also be closely monitored given that in December came in at an average of 7.3%, with hospitality and leisure seeing wage growth of as much as 10.1%.
We do know that both Patrick Harker of the Philadelphia Fed, and Lori Logan of the Dallas Fed, have said they would be comfortable with a 25bps rate move, and both are voting members on the FOMC committee this year, while Fed governor Christopher Waller, who has in the past leant towards the hawkish side, has echoed those sentiments. On the other hand, we have Neel Kashkari of the Minneapolis Fed, who has said the Fed funds rate needs to go to 5.4% before a pause, so it is clear there is a divergence of views. This suggests that while there is a growing caucus on the committee for a slowdown in the pace of rate hikes, there could be differences starting to open up about where policy needs to go, or the differences could merely be over the speed. Nonetheless, the recent vocalisation for another slowdown in the pace of rate hikes has helped pull market expectations of the terminal rate below the Fed's target of 5% or above.
With the Fed funds rate currently set to be raised from 4.25% and 4.5%, and financial conditions loosening, there is a risk that inflation could become slightly stickier in the coming months, unless the Fed resets market expectations. They can still do this even if they hike by 25bps today, by delivering hawkish guidance, and saying that more hikes are coming, and that rates would be staying at current levels for some time to come. They could also increase the pace of balance sheet reduction, or QT, which is running at $95bn a month. This number could be raised above $100bn a month.
The ECB is facing a similar problem, albeit inflation is much higher in the euro area, as shown by the surprise rise in core CPI in Spain earlier this week to a record high of 7.5%.Today we get the latest flash EU CPI for January, and markets are pricing another step down, with expectations of a fall to 8.9% from 9.2%. The main focus will be on core prices, which are expected to step down from 5.2% to 5.1%, although this could surprise to the upside if this week's Spain numbers are any indicator.
The latest final manufacturing PMIs are expected to confirm a pickup in economic activity in January to 49.5 in Italy, 48 in Spain, 50.8 in France and 47 in Germany. The UK is expected to be confirmed at 46.7, and the US at 46.8.
EUR/USD – still range trading between resistance just above the 1.0900 area at 1.0930, and support at 1.0820. The main resistance remains at the 1.0950 area which is 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 – the recent lows at 1.2260 remain a key support after another failure last week at the 1.2450 resistance area. We need to see a move through the 1.2450 area to target further gains towards 1.2600. A move below 1.2250 could see a move towards 1.2170.
EUR/GBP – appears to be heading back to the 0.8850 area and last week’s highs. Key support remains at the 50- and 100-day SMA which we saw earlier this month at the 0.8720/30 area. Below 0.8720 targets 0.8680.
USD/JPY – needs to break through the 131.00 area to target a move back towards 132.60. While below 131.00 the risk is for further declines towards the lows at 127.20. We have trend line support at the 129.00 area initially.
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