Trick or treat? Central banks leave markets on tenterhooks

It was an uneventful session for markets at the start of this week, although there was a decidedly risk off tone, stocks fell and the dollar surged, rising nearly 0.8%, with broad based decline in both the euro and GBP. However, Monday’s sell off didn’t dent stellar monthly gains for US markets. The Dow closed more than 14%, its best monthly performance since 1976, while the S&P 500 and the Nasdaq had single digit gains. The driver was hopes of less aggressive central bank tightening after some dovish commentary from Federal Reserve and Bank of England officials in recent weeks, a less hawkish ECB and a surprise 50bp hike from the Bank of Canada, the market had been expecting the BOC to hike by 75bps earlier in October. There were some interesting patterns in October’s stock market gains: weak sectors included big tech (Meta), semiconductors and precious metals, while strong performers included casinos, hotels, trucking, and healthcare. Energy was the top performer, partly on the back of record-breaking quarterly profit for US energy producers including Exxon and Chevron. The energy sector rallied even though oil was mixed throughout the month. The dollar fell 1% last month and the 10-year benchmark Treasury yield rose from 3.8% to 4.05% - hardly the stuff that stock market rallies are usually made of, so what is going on?

The Fed pivot: the stuff dreams are made of

We believe that the upbeat performance of stocks in October was due to the central bank pivot narrative. As we start a new month, the market is focussed on whether the major central banks will now deliver less hawkish rhetoric. The Fed meeting that concludes on Wednesday is expected to deliver another 75bp rate hike, taking US interest rates to 3.75-4%. Traders will be watching closely to see if the Fed is ready to slow down its pace of rate hikes, and if another 75bp hike is coming in December. Currently there is a 48% chance of a 75bp rate hike in December, the chance of a 50bp rate hike is currently 46%, so it’s too close to call at this stage. One week ago, there was a near 60% chance of another 75bp rate hike in December, thus the market is adjusting its Fed rate hike expectations lower as we lead up to Wednesday’s meeting. However, it’s worth noting that inflation is still running hot in the US and around the world. In the Eurozone, headline CPI is 10.7%, while sticky price inflation, as measured by the St Louis Federal Reserve, is at 6.4%, its highest level since 1982! The Fed must walk a tight rope this week: on the one hand it needs to show that it is vigilant in maintaining its inflation target, on the other it doesn’t want to hike rates to such an extent that it breaks something in the economy. History has shown us that when emerging markets have halted a rate hiking cycle when inflation is running hot, this is a dangerous strategy and tends to lead to higher interest rates down the line. The Federal Reserve will not want to take a dovish pivot this week only to reverse course soon. Thus, we remain wary that a pivot is on the cards, and a more hawkish than expected Federal Reserve could trigger a sell-off in stocks and a stronger dollar.

The outlook for the BOE: ousting Truss does BOE a favour

However, there can be no doubt that a pattern is emerging when it comes to central bankers: they are becoming more dovish. The ECB and the BOC have done it, while the BOE deputy governor said that he did not think that UK interest rates would rise by as much as the market expects them to.  Right now, the market is expecting the UK’s terminal rate to be approx. 5%, we think that this could be more like 4%, and that there is a decent chance that the BOE will not hike rates by 75bps this week, instead opting for another increase of 50 bps. This is quite the turnaround, after the disastrous mini budget in September, the market had been expecting the BOE’s terminal rate to shoot up to 6% or higher. However, as the twin dangers of an inflationary tax-cutting budget, along with a huge increase in Gilt issuance subside, then a reduction in the UK’s terminal interest rate is also partly a reduction in the risk premium allotted to the UK economy. This should be supportive of UK asset prices; however, this must be balanced against the deteriorating economic back drop for the UK economy, which could limit the upside for UK gilt prices and the pound. We still think that GBP/USD will break above $1.1550 and stay there, however, growth fears could mean that the pound’s recovery does not go up in a straight line. The pound may not fall off a cliff if the BOE does raise by 50bps this week instead of 75bps, and losses in GBP/USD may be capped if we see a dovish turn from the Fed Governor Jerome Powell. It is worth noting that investment bank Goldman Sachs is expecting the Fed to stick to its hawkish mantra, and for the terminal rate to rise to 5%. Whether or not you use GS forecasts as contrarian indicators, is up to you!

An upside surprise in Payrolls?

Elsewhere, it is also worth watching October’s Non-Farm Payrolls report that is released this Friday along with a host of other top tier economic data. We are expecting confirmation that global PMIs fell sharply in October, with the decline in the service sector a sign that a key pillar of economic growth is rapidly moving into contraction mode. However, we know that the labour market in the US has been holding up well, for example, US initial jobless claims rose only slightly last week to 217k, a historically low level. Economists expect US NFPs to rise by 200k last month, which is decent growth. The bigger risk for markets is an upside surprise to payrolls, which could also lead to some questioning of the Fed pivot narrative and spark a move away from risky assets. 

Overall, this is a week where fundamentals are in focus, and the Fed is controlling the story.