Will Yields Push Back Risk Assets This Week ?

MARKETS

Equities surged to new record highs last week across several markets, spanning from Europe to Japan. The North American rally, in particular, was propelled by Nvidia's impressive earnings report on Wednesday. The report sparked broader enthusiasm regarding the potential benefits of artificial intelligence (A.I.), driving investor sentiment to new heights.

The problem, however, is that the recent surge in the stock market has the potential to rejuvenate broader consumer confidence and could further bolster economic growth, partly through the wealth effect. Additionally, the equity rally may stimulate business capital spending. However, it's important to note that, thus far, the benefits of the A.I. boom have primarily been reflected in stock prices, with only a limited portion translating into actual business expenditures. 

Despite the lack of significant macro developments, the U.S. economic data for the week remained generally positive. Jobless claims fell again to a mere 201,000, indicating no signs of stress in the labour market. Additionally, the S&P PMI showed an improvement in manufacturing this month, reaching its highest level since the fall of 2022 at 51.5. While the leading indicator declined for the 23rd consecutive month (essentially since the onset of Fed rate hikes), the Conference Board suggested that the index is now out of recession territory as more than half of its underlying components have shown an upward trend over the past six months.

Will the real U.S. inflation report please put up your hand!!

The recent U.S. inflation report reveals a notable 0.4% increase in core CPI prices, maintaining the yearly rate at 3.9% in January. Of particular concern is the significant 0.8% surge in core services prices, excluding rents, indicating persistent inflationary pressures in labour-intensive sectors grappling with ongoing worker shortages.

Moreover, alternative measures of inflation, such as the Cleveland Fed's trimmed-mean and weighted-median CPI, also recorded increases of 0.5% last month. This suggests that the rise in core prices is not solely attributed to temporary anomalies but reflects broader underlying inflationary trends.

While it's important to note that one month of data does not establish a definitive trend, the surge in core producer prices further compounds the concerning inflationary outlook. Although some of January's price increases may reverse in the coming months, achieving the Federal Reserve's price stability objective could remain challenging unless service costs substantially moderate.

While it's true that the Federal Reserve focuses on the Personal Consumption Expenditures (PCE) deflator rather than the Consumer Price Index (CPI), the divergence between the two measures is notable. The core PCE prices experienced a modest annualized increase of 1.9% in the latter half of 2023, just below the target rate. In December, the yearly core PCE deflator moderated to 2.9%, a percentage point lower than the core CPI rate.

Even if prices exhibit a 0.3% to 0.4% rise in January, the yearly rate could decrease slightly due to a favourable comparison with the previous year. Consequently, the gap between core inflation measures may widen to 1.2 percentage points, marking the most significant disparity over 22 years and three times the long-run median since 1960.

This divergence raises questions about the accuracy and reliability of inflation metrics, especially concerning the Federal Reserve's assessment of price stability and monetary policy decisions.

Could risk-sensitive assets finally fall under U.S. rate pressure this week?

The recent equity rally driven by Nvidia's performance may encounter headwinds as interest rates rise. In light of this, high-beta currencies could be vulnerable to corrections.

Federal Reserve speakers have reiterated the sentiments expressed in the FOMC minutes following their publication. Their communication has shown a cautious stance on the inflation outlook, especially in light of the recent higher-than-expected Consumer Price Index (CPI) readings. They have emphasized the risks of cutting interest rates too early or aggressively.

Risk-sensitive assets typically experience downward pressure due to a more cautious approach to monetary easing. However, in the equity markets, the prevailing narrative is one of outperformance driven by the technology sector, particularly in response to the impressive financial results reported by Nvidia, which is muting normal market dynamics. 

If stocks do not fall his week, which should happen leading up to a high-risk PCE event, I might stop speculating for a while, at least until the Bank of Japan signals it will hike rates.

As the impact of Nvidia's positive influence wanes, one plausible argument is that equity markets may confront increasingly stretched valuations, especially as U.S. rates continue to climb. The 2-year and 10-year Treasury yields have retraced approximately half of the gains observed from late October to late December, trading approximately 50 basis points higher than their levels at the end of 2023. Despite this, the S&P 500 has recorded a 6% increase year-to-date.

Although we had been betting early in the year for the U.S. economy to U-turn, I've conceded the trajectory is unlikely to undergo a significant reversal in the next few weeks. The release of the Personal Consumption Expenditures (PCE) data on February 29 is anticipated to be a touch hotter, which could further diminish expectations for rate cuts.

Considering current conditions, high-beta currencies are overpriced in the short term. The possibility of shaky risk sentiment and a stronger dollar before this week's PCE suggests could trigger this view, but the S&P 500 would need to roll over, so perhaps that will be the key.

For the record, this is a sentiment also echoed by several banks.