Euro inflation key to size of next ECB hike

Flash PMI’s for November turned out to be a mixed bag. US data disappointed as the manufacturing PMI dropped to 47.6 from 50.4 and service PMI pushed lower as well to 46.1 from 47.8. It is broadly in line with our view that the US economy is heading into a mild recession in early 2023. Investments still look resilient as durable goods orders were decent in October. However, leading indicators suggest investments will slow down soon. For once the picture was a little more positive in the euro area as both PMI manufacturing and service were better than expected. The German ifo business confidence also surprised to the upside rising to 86.3 from 84.5. Despite the improvement the indicators are still at low levels and point to a euro area recession. But on the margin it is positive and fits with our view that the recession will not be deep, although it could be protracted as we have yet to feel the full effects of the sharp rise in bond yields and ECB policy rates.

The PMI’s also showed easing price pressures and a further normalisation of delivery times, which is a further sign that goods price inflation is in the process of normalising on the back of a sharp drop in freight rates, easing supply chain problems and lower commodity prices. Oil prices turned lower again this week to USD85 per barrel, a decline of USD35 per barrel from the peak in June. Despite easing pressures, inflation will likely stay elevated for some time as some industries have yet to pass through previous price hikes and wage inflation are pushed up by tight labour markets.

With more signs of easing price pressures in the medium term, central banks increasingly consider to lower the pace of hikes. Minutes from the recent Fed meeting and Fed speeches suggest a majority within the Fed lean towards lowering the size of Fed hikes to 50bp from 75bp. However, we still have another jobs report and inflation print ahead of the meeting on 14 December, which will be key for the size of the rate hike. The ECB may also move to a 50bp pace but it depends a lot on how next week’s inflation for November turns out. Another high print would likely trigger a 75bp hike on the 15 December meeting, but our baseline scenario is a 50bp rate increase.

In China tweaks to the zero-covid policy led to more widespread outbreaks triggering restrictions in more than a third of China’s provinces. China could be facing a chaotic winter as it is hard to contain covid without reacting fast and forceful. Unless, they are willing to live with more spread of the virus, the result could eventually be harsh lockdowns during the winter to knock down the covid waves. Our baseline is that China will not open up fully until summer next year. But uncertainty prevails around which strategy China is going to follow after they took the first steps towards leaving the zero-covid policy.

Stock markets got a lift this week from the softer tone from central banks and easing price pressures, which also pushed bond yields lower. EUR/USD has also seen a lift on the back of better risk sentiment and markets pricing a central bank pivot.

Next week focus turns to US payrolls and Euro inflation. We expect US job growth to decline from 261k to a still decent 220k (consensus 200k). We look for euro inflation to rise to 10.8% y/y from 10.6% y/y but that core inflation holds steady at 5.0% y/y.

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