Market Data Resets Thinking to Higher Peaks Then a Pause — Not Cuts

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Eurozone Market Update

February’s more forceful language from the ECB brought an expected 50 bps hike to 2.5%. Another 50 bps will follow in March. There has been a major market repricing, taking out the wrongly anticipated rate cuts.

Europe had unexpectedly strong February Purchasing Managers Index (PMI), employment and wage data — raising hopes of avoiding a technical recession. But inflation remains far above target.

February’s €36.6 billion in targeted longer-term refinancing operations (TLTRO III) early repayments were at the lower end of the market forecast (€35 billion to €100 billion). These had little impact, but the market believes there could be a very large repayment in March as it represents the last window to repay before the June expiration of TLTRO III. This may see many banks paying back most of their remaining TLTROs.

UK Market Update

The main ‘shock’ for February’s tenth consecutive rate hike (50 bps) was the MPC voting split — with a 7-2 split for 50 bps and 0 bps, respectively. Market interpretations that the peak is near and that cuts will follow from June were wrong-footed. Figures for the UK growth rate point to a narrowly missed ‘technical recession’. Jobs growth significantly overshot expectations. February’s PMI data proved resilient, with a rise from 48.5 to 53.0 despite expectations that the cost-of-living crisis would see services declining.

The economy is more robust than the market expected. Overly strong employment data suggests neither a hard- nor a soft-landing recession. Instead, a ‘no-landing’ of low but positive growth will likely be sustained. Pricing is now based on BoE rates being kept tighter for longer, with a higher peak possible.

The Chart of the Month shows how much the total priced in for the year has changed in response to stronger data. It represents the cumulative impact of policy.

US Market Update

The FOMC raised its policy rate by 25 bps. Chair Jerome Powell noted that progress has been made in lowering inflation, but he emphasised that more needs to be done ¬— and further rate increases will be necessary to restore price stability. He doesn’t expect rate cuts this year and reiterated that it is more difficult to manage the risk of not tightening enough than that of tightening too much.

Market data throughout February supported this view, with headline inflation rising by 0.5% and core inflation by 0.4%, while year-over-year inflation numbers moved to 6.4% and 5.7%, respectively. The tight labour market continued, with non-farm payrolls increasing by 517,000 (versus 188,000 expected) and consumer spending showing no signs of slowing, with retail sales up 3%. Given the data and continued hawkish comments from Fed members, Fed funds futures moved the terminal rate to 5.4% and priced in three additional hikes in 2023.

Global Outlook

The month started with the FOMC raising its policy rate by 25 bps, and the BoE and ECB followed by hiking 50 bps. Yet the market continued to enforce its ‘pivot’ narrative. As the economic data released during February evolved, the market was forced to re-examine its stance. This led to a repricing of peak interest rate expectations, a significant reduction in expectations for 2023 rate cuts and expectations of 2024 cuts pushed further out.

We believe the market’s rate expectations are now more plausible and aligned with our long-held view that once the central banks reach their peak rates, there will be a prolonged pause. We continue to closely scrutinise the central banks’ narratives. If dovish data emerges, central bank rate pauses will be followed by a period of assessment and then action; previously priced-in cuts clearly jumped the gun.

Chart of the Month: Data Forces Re-Examination of Market’s Expectations

_{Source: Bloomberg. As of 28/02/2023}

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