Implied volatility in equity markets rose to the highest level of the last 6 months, signaling investors' unease with the latest developments around the world. Although part of this higher uncertainty stems from the geopolitical tension in the Middle East, it is the recent data on US inflation as well as the central banks' next moves that have further complicated things in financial markets and hence in investment decision-making. It is becoming clearer that the FED is in a very tight position, as it had "promised" rate cuts that now look hard to be delivered, especially in June, which was the consensus thinking until a few days ago. The US government bond market has reacted violently during the last two weeks, threatening to kill the positive mood of the equity market, which had reached expensive valuations and resides in stretched technical territory, as we explained last week. Staying invested in a defensive manner has not rewarded cautious investors this year, but perhaps this is about to change.
It all started with US March inflation being announced higher than expected. The monthly change at 0.4% surpassed expectations of 0.3% and pushed the yearly change to 3.5%, up from the 3.2% figure of February. Core CPI, which excludes food and energy, fell from the previous month to 3.8% from 3.9%, but again this was higher than the economists' expectations (3.7%). Among the components, both owners' equivalent rent (OER) and tenants' rent, which were expected to slow in March, showed little sign of that slowing (OER + 44bp — the same as in February). OER and tenants' rent combined account for roughly one-quarter of the headline CPI, and one-third of core CPI, and are among the most stable individual components. The disinflation in OER has stalled since August.
The minutes of the previous FED meeting also poured cold water on investors, as it became apparent that a June cut is by no means a "sure thing". And if we also take into account that there have been quite a few FED officials in the previous two weeks who talked about "no rush to cut rates" , we see that the current mood inside the FED is really not in favor of a rate cut, unless the economy shows significant deterioration in the next two months. As a reminder, we started the year with expectations that the FED will cut interest rates by 150bp this year, an event which we doubted back then, as such a scenario would have to include a recession. The market then moved to just 75bp, similar to the FED's own latest projections , published just a month ago. . The market is now assigning a very low probability for a June rate cut and overall it is pricing slightly above 50bp for the whole year.
But the ECB meeting was as dovish as it could get. Not only did we receive confirmation that a June cut is the most probable scenario, but we also learned that there were some members that voted for a rate cut even during last week's meeting. Of course, we should assume that those members must have included the southern of Europe (Italy, Spain, Greece, Portugal) as these are the ones who have been more warm to rate cuts publicly. At the same time, Mrs. Lagarde played down the possibility of the ECB not acting in June, along the thinking that the FED will probably not move, saying that the ECB's decisions are totally independent from other banks. However, she did mention that global monetary conditions do influence their actions.
The bond market reacted violently to all these events. The 10-year US yield rose to a high of 4.60%, before settling slightly lower to 4.53% on Friday. This is the highest level since November of last year, when the yield was dropping from the 5% high it had reached in October. German yields also fell in sympathy, despite the dovishness of the ECB. Thankfully, the market realized that Eurozone's interest rates are coming down in the following months and inflation is now "just" 2.4%, so the region's bonds rallied hard on Friday. German yields actually ended lower for the week , with the 10-year at 2.35%, after reaching 2.50% on Thursday.
Equities had a volatile week and finished mostly in the red. The US market underperformed its European peers , as the main issue is with the US inflation and what the FED will do, with the S&P500 losing 1.5% for the week. It is now about 3% lower from the recent high but on a positive note, it found an intraday support at its 50-day moving average (5110) on Friday. The EuroStoxx 50 fell 1.2% for the week and it is also about 3% lower from its recent peak. The UK bucked the trend finishing higher by 1%, as the FTSE100 index is heavily weighted towards energy and materials, which continued to move higher last week.
The first quarter corporate results are starting, which is the only catalyst left for equity markets to stabilize, given that the "FED helping hand" is no longer there for now. We should also note that we have entered the share buyback blackout period for most companies, which means that less bids will be in the markets for the next few weeks. On Friday, some of the major US banks reported with overall good results but their share prices fell. The worst performer was JP Morgan with a 7% drop, as the bank exceeded the profit forecasts with in-line revenues, but provided relatively weak guidance for the most important source of its revenues: the net interest income (NII). Wells Fargo (-0.5%) and Citigroup (-1.7%) also fell in sympathy, despite their results beating forecasts handsomely. This is a sign that current pricing in US equities assumes perfection and anything less could be met with selling.
Chart of the Week : US inflation has made no progress since last summer.
The chart shows the evolution of inflation in the US, in the last two years. After reaching 9% in the summer of 2022, inflation dropped fast, to 3% in the twelve months that followed. As we had highlighted back in the day, inflation cannot stay at levels around 9% for longer as the "base effect" will kick in and the comparison with already high prices will cause inflation to move significantly lower. But we have now reached the most difficult part of the exercise. The FED's target is for inflation to reach 2% and since July of 2023, inflation has been hovering between 3.2% and 3.5%, with signs of a slight acceleration in the coming months. The stronger-than-expected economy and the tight labor market are forces that do not help in the fight against inflation. Unfortunately, the "last mile" to get down to 2% sustainably might involve to induce more pain in the economy, and perhaps in markets.
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• Sources: Chart of the Week : FactSet, Photo:: Getty Images