A market still desperately seeking clarity on the inflation picture

Markets

After a positive start to the day, US stocks closed lower on Friday despite signs of an improving inflation picture, potential clarity on the Fed's path, and AI enthusiasm, which did lead the tape to a 2.6% gain for the week.

Equity price action passed the buck up, down, and sideways on Friday with no clear reason for the moves. Who knows whether the minor downswing results from profit-taking, positioning, changing views, or thinner liquidity because of the upcoming holiday weekend in the US? It's just how the story typically goes when testing psychological levels, as in this case, 4500 on the S&P 500, even more so with a small cohort of Mega Cap Tech painting Wall Street Green. 

On sessions like Friday, when the unknowns dominate the conversation, focusing on what we know or have learned can be helpful. And last week certainly delivered when it came to data -- but here are a few things to consider:

While the dot plot did indicate the possibility of two more rate hikes -- a hawkish surprise for markets -- FOMC participants also indicated that a more moderate pace of tightening is appropriate now that the fund’s rate is closer to its likely peak, which sees traders interpreting an "every-other-meeting" pace, hence a July hike a September Skip and a November hike. 

But a lot can happen between now and November, so we maintain our forecast for one additional hike in July for a terminal rate of 5.25-5.5%

The market seems to be pricing high confidence in future disinflation. And since the Fed linked future hikes to inflation outcomes at last week's meeting, the market has taken the projection of additional tightening less seriously beyond July, despite a large subset of the committee projecting more than one additional hike this year.

We are still seeking clarity in the inflation picture.

The main difference is that the Fed and the market primarily disagree on how fast inflation will converge to the target. The Fed and the market are one year apart, as the FOMC's 2025 PCE and real FFR projections are very close to market pricing in 2024. Hence, the markets( and the Fed)  may need some more hard evidence and clarity on the inflation picture before taking the next leap of faith higher. Or, in the Fed's case signalling a hard pause. 

This gap is not dissimilar to the one observed in March. However, there has been increasing evidence since then that (1) rent inflation is likely to decline (and (2) the labour market is no longer extraordinarily tight. And this increases the odds that the market will be closer to the mark than the Fed.

On the other hand, a minority of Wall Street shops, like Goldman Sachs, who only ascribes a 25 % chance of a US recession, think the market is excessively optimistic concerning inflation outcomes and believe investors are assuming that a sharp deceleration in growth, if not an outright recession, is needed to lead to a more rapid easing of price pressures. So, to put it another way, GS thinks market-based inflation outcomes are predicated on the market pricing a 65 % chance of a recession, a recessionary outcome they disagree with.

However, bottleneck inflation has not only unwound the entire spike from COVID but is now sitting at the lowest level since records began in the mid-1990s. And this is further corroborated by other pipeline measures, such as China's producer prices in deflationary territory. Now the key question is whether the eventual economic slowdown is deep and disruptive or whether a simultaneous improvement in the supply-side inflation leads to something more orderly.

The sentiment is improving amongst businesses and consumers.

The Philly Fed and Empire Manufacturing surveys came in above expectations with firmer underlying compositions And Friday, the U-Michigan consumer sentiment survey rose in June, and the report's measure of one-year inflation expectations dropped to its lowest level since March 2021, while the long-term measure edged down slightly. The fact that inflation is only slightly falling does push back against the optimistic inflation outlook.

The TGA Liquidity Drain appears predominately RRP-led thus far.

Treasury's operating cash balances (TGA) rose to $250bn, partly fueled by $275.5bn of net debt issuance this month ($225bn from bills and $45bn from coupons). The supply thus far has been digested remarkably well. Contrary to most expectations, bill yields (and some repo rates) have been settling above the RRP rate in many instances, incentivizing money funds to allocate away from the RRP facility to these higher-yielding alternatives. Hence there is no real drain on the market-based liquidity that could influence short-term rates even higher and hurt risk markets.

Oil markets

A Wall Street Journal article that has boosted oil prices reported that China's policymakers have been considering issuing an RMB1tn central government special bond (CGSB) for infrastructure investment.

In addition, we expect further policy-easing measures to be announced in the next few weeks to support youth employment and contain property and LGFV downside risks. Still, investors probably shouldn't get too excited about China's growth prospects as there are no quick fixes to the property market on youth unemployment. China needs to drive growth in sectors like technology, education, finance and entertainment, all of which have suffered under the security-focused leadership of Xi Jinping.

Still, China may need to import more crude as domestic rate cuts and infrastructure stimulus start working through the economy. And amid Saudi Arabia's commitment to providing a price floor by introducing additional cuts of 1 mb/d for July, with the possibility of extending this action beyond July, it does suggest a bullish setup. 

Forex markets

The ECB’s message was clear and concise: the inflation outlook is troubling, rates will be raised in July, and there is no talk of a “pause.” Even though the near-term policy outlook is not that different from the Fed, which also seems very likely to hike in July, the messaging was different and that matters in FX. As a result, EURUSD is back around 1.10 for the third time this year. So will the third time be the charm for Euro Bulls?

We are still skeptical that EUR can break out of this range with the current backdrop. First, the policy picture is more lagged than divergent. The ECB moved later and more slowly (and is only now about to start QT) and therefore has a little more ground left to cover. Second, the activity outlook, if anything, is cutting against the Euro.

Global manufacturing weakness has weighed on Euro area activity and is likely intertwined with sluggish China demand. Rising gas prices could exacerbate these challenges, even reinforcing the difficult inflation picture. With this combination, we still struggle to see how the Euro area will attract a substantial shift in capital flows.