Rates markets have shifted from favourable trade winds to subtly challenging headwinds

Markets

U.S. stocks continued their week-long retreat amid an extremely cautious atmosphere as investors awaited a crucial inflation report that will shape expectations for potential interest rate cuts.

Stocks buoyed by A.I. euphoria encountered challenges in the final days of February as inflation concerns resurfaced, prompting investors to reckon with the prospect of higher interest rates likely to endure for an extended period.

Indeed, investors have been in a state of cautious contemplation as they grapple with the shifting dynamics in interest rates, which have transformed from favourable trade winds to subtly challenging headwinds. 

Heading into Thursday's major risk event, the market had already factored in approximately 77 basis points of easing from Jerome Powell and his colleagues throughout the year, which didn't significantly deviate from the last Summary of Economic Projections (SEP). Notably, two-year yields are now at their highest level since December 12, signalling a hawkish about-face in market rate cut perceptions since the final FOMC meeting of 2023 when the Fed solidified the dovish pivot initially indicated by Chris Waller in late November.

Waller's position on rate cuts has changed quite a bit, even though he may not admit it openly. During a speech on February 22, he questioned, "Is there really a need to rush?" without any hint of sarcasm. The urgency arose because the markets were trying to determine Waller's impromptu timeline for rate cuts, which he suggested on November 28 could occur "in three months, four months, or five months," depending on inflation trends.

The recent slew of U.S. data overnight showed a slight uptick in inflation, a faster pace of spending, and a slight deceleration in overall growth during Q4, according to the revisions to US GDP data released on Wednesday. However, these changes are relatively minor and may not significantly alter the broader economic picture.

Still, spending was brisker than initially estimated, and the easy read-through is this uptick in spending likely contributed to an inflation impulse warmer than previously reported by the Bureau of Economic Analysis (BEA). 

U.S. Treasury yields have maintained a relatively stable pattern over recent sessions, hovering at what many consider elevated levels, with the 10-year U.S. Treasury yield holding steady around 4.3%. While unexpected positive data releases have curtailed downward movements, adverse economic reports have failed to spur rallies due to corporate and government issuance overhangs.

However, a higher yield reality is setting in as market expectations regarding Federal Reserve policy adjustments have aligned with the Fed's projections, as indicated by the dot plot. But a more immediate catalyst for higher yields is the impending release of the core Personal Consumption Expenditures (PCE) index, which serves as the Federal Reserve's preferred measure of inflation.

The upcoming release of the PCE data and the subsequent market reaction present an intriguing scenario, particularly given that the consensus expectation already stands at 0.4% and is well baked in the cake. This raises questions about whether meeting this expectation will suffice to sway the market in a more risk-unfriendly direction.

Moreover, alongside the PCE release, other economic indicators scheduled for today, such as the initial jobless claims report, could also influence market sentiment. Given its status as a real-time gauge of the jobs market, the initial jobless claims release can sway investor perceptions and contribute to market volatility.

Forex Markets

Reasons are pretty evident for the strength of the U.S. dollar. Europe, including struggling economies like Germany and Japan, is in recession, while uncertainty prevails in China. Meanwhile, U.S. exceptionalism stands out with the recent swing higher in U.S. rates, which could support the stronger for a bit longer U.S. dollar narrative.

Oil Markets

Oil futures dipped in post-inventory trading on Wednesday following the data release by the U.S. Energy Information Administration (EIA), indicating a continued increase in commercial crude oil stockpiles for the fifth consecutive week through February 23.