Risk barometer: what’s driving markets now

There is a risk off tone across the board in financial markets on Thursday. US indices reversed earlier gains to add to the losses from Wednesday, with the Nasdaq and the S&P 500 both lower by approx. 1%. As we move to the end of the week, fears about a higher terminal rate from the Federal Reserve and some large declines for Alphabet’s share price, are all weighing on market sentiment. Added to this, the US yield curve (the 2-year yield – the 10-year yield), took another lurch lower on Thursday and is currently at -81 basis points. This is the most inverted the curve has been since 1980 and is a key recession indicator. As we wait for some to tier economic releases from the US, including US CPI data that is scheduled for release on Tuesday, the market will wait with bated breath, to see if the inflation data can pump some life back into the stock market rally, that took traders by surprise at the start of tis year.

Federal Reserve: Bets rise for a higher terminal rate, but only just

The main driver of weaker stocks on Thursday, aside from Google, was a growing fear that the strong jobs report for January would force the FOMC to hike rates above the 5-5.25% expected to be the Fed’s terminal rate by mid-year. According to the CME’s Fedwatch tool, there is now a 34.6% chance that the Fed will hike rates to 5.25-5.5% by July, this is roughly the same probability as last week, however, the probability of rates peaking at 5-5.25% by July, has declined this week, from 47.6%, to 46.37%. These are not large margins, there are rumours that some large hedge funds are buying options that would cash in if the terminal rate hits 6%. However, so far these bets have been small fry, in the tens of millions of dollars, and it is perfectly normal for hedge funds to use out of the money options to make an outrageous bet on the Fed Funds Rate. However, markets are so reliant on the narrative that the Fed is close to pausing, that even small shifts in sentiment can cause upheaval in the stock market.

FX dodges the FOMC rate hike hype

What is interesting as we move towards the end of the week, is that the FX market has not moved in line with the risk off tone that has caused US stocks to sink, Bitcoin to fall nearly 5% and volatility to spike. The dollar is down across the board today, usually it rises when volatility spikes. Instead, the euro and pound were higher, GBP/USD is one of the best performers in the G10 FX space on Thursday, even though arch dove at the MPC, Tenrayo, said that interest rates should be cut immediately. The driver could be an expectation of a weak inflation report from the US next week, and the potential for a small positive surprise from tomorrow’s UK Q4 GDP report. The market is expecting GDP to remain flat in Q4, although month on month GDP is expected to fall by 0.3% in December. Aside from the headline numbers, we will be watching the index of services and the business investment figures closely. If these data points can beat expectations, which, in fairness, are low to start with, then the pound could catch a prolonged bid, in our view.

Short term FX levels to watch

The technical view for the FX space is mostly focussed on EUR/USD and GBP/USD as we move to the end of the week. In EUR/USD, it is continuing to trade around the $1.0730 level, although this pair is more than 1.5% lower on the week. We expect this pair to meet some stiff resistance around the $1.0750 mark ahead of next week’s US CPI report. For GBP/USD, this pair has eroded losses from earlier this week, and is now down approx. 0.8% since Monday. It is back above $1.21, which is most likely due to some positioning ahead of Friday’s GDP report. If GDP data surprises on the upside, then expect a decent rally back to the $1.2450 level, a key resistance level that dates to late December. Overall, we are impressed by the FX market’s ability to filter out the speculation of the Fed Funds rate jumping to 6%, and instead, focussing on the data points which will ultimately decide what the Fed does next.

Google’s epic fail

Elsewhere, Alphabet, the Google parent, saw its share price tumble further on Thursday and closed nearly 5% lower. It is barely recovering in the early pre-market on Friday; however, its demise is worth watching closely after its latest bit of AI tech, called Bard, failed to impress investors. Bard is a conversational search tool, and in its first demo to investors it answered a question about the first images of exoplanets wrong. This will likely go down as one of the biggest and costly marketing fails of all time, but it highlights that AI capability is a key driver of big tech’s stock prices after 2022’s rout. The demo fail, is a sign that Bard may not be ready yet to boost Google’s search function, which is a problem for Google from a competitive perspective. It’s rival Microsoft has invested heavily in ChatGBT and will integrate ChatGBT into its Edge web browser and Bing search function. Thus, Microsoft looks like it has won the AI race, for now. While Microsoft’s stock was higher on Wednesday, it could not manage this feat on Thursday, and its share price dropped by more than 1%. However, Microsoft is still outperforming Alphabet, and we expect this to continue, as the focus of making search more effective by using voice technology, is the next phase of the tech wars.