Weekly Focus: Markets turn more cautious after the CPI rally

After the rally driven by the low US CPI print, markets have traded more cautiously this week. US October retail sales growth surprised to the upside, signalling that the low inflation print did not necessarily reflect easing demand, as Fed would have hoped for. We continue to see near-term balance of inflation risks tilted to the upside, and expect the market optimism to turn out only temporary; in our latest FX Forecast Update - USD selloff to prove temporary, 14 November, we maintain our 12M EUR/USD forecast at 0.93.

Geopolitics were on the agenda in the first G20 meeting after Russia’s invasion to Ukraine. Joe Biden and Xi Jinping met for first time face-to-face after Biden became the president, and despite the past years’ tensions, the leaders struck a more constructive tone, emphasizing that neither party wants to enter a new cold war and that communications lines would be reopened. That being said, we think that especially the Taiwan issue and the recent US tech restrictions will maintain tensions elevated; see our earlier paper: Research US-China: Long-term tensions are here to stay no matter the election result, 5 October.

While the Democratic Party ended up performing better than expected in the US midterm elections, and managing to maintain the control of senate, republicans did narrowly clinch the control of house this week, ensuring a divided congress. For markets, the result is a positive (although broadly expected) outcome, as the divided congress is less likely to be able to pass potentially inflationary deficit spending measures. Markets will next focus on how the congress will be able to raise the US debt ceiling, which is expected to be hit early next year. So far, republicans’ key demands for supporting the debt ceiling raise have been related to spending cuts to social security and Medicare, which would have limited impact on the broader economy, but which could be difficult for the democratic senate to pass.

Europe will also focus on the continuation of US support to Ukraine, and while we do not expect an abrupt end to the support measures, the republican control of the house could mean that ‘America first’ style cost-cutting will be increasingly on the agenda as the recession looms. More broadly, while the war has so far united western nations to support a common ally, we see rising risks of US-EU relations turning sour going forward, see Euro macro notes - Transatlantic ties are in for a chill, 16 November.

Next week, focus turns back towards the economic growth outlook, as November Flash PMIs are released on Wednesday. We expect the Euro Area figures to provide further evidence of contraction in the Q4 as inflation is weighing on demand and companies’ order books, while we still foresee modest growth in the US economy. FOMC and ECB minutes will also be released on Wednesday and Thursday respectively, and while markets’ focus remains on more forward-looking data, we will keep an eye out for any hints of the expected hiking pace in December (50 or 75bp) as well as ECB’s view on the QT timeline.

In China, focus remains on the rising Covid-cases and on any signs of potentially changing tolerance for the spread of the virus. We will also focus on any potential new easing measures after the October growth figures once again surprised to the downside this week. On the central bank front, we expect 75bp hikes by both the Riksbank on Thursday (see more below) and the Reserve Bank of New Zealand on Wednesday.

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