The financial environment has become slightly more relaxed since the beginning of November. This fact is manifesting itself on the market in the form of falling yields and rising share prices. From August to October, financial conditions were tightening continuously. This week, two indicators relating to the US economy in particular could provide clues as to the sustainability of this trend since the beginning of the month: retail sales and consumer prices.
Soft landing
The technically positive correlation between government bond yields and share prices is currently an important interplay. The rapid exit from the central banks’ zero interest rate policy represents an interest rate shock that has put pressure on the valuation of future company profits (i.e. share prices) and dampened economic growth.
In this context, indications of a so-called “soft” landing of the economy would constitute a positive environment for the financial markets. This scenario would come with a rapid decline in inflation, an only moderate rise in the unemployment rate, and a foreseeable cut in key-lending rates (i.e. in the first half of 2024).
Strong growth
As of the end of October, the initial estimate of real economic growth in the US for the third quarter was at 4.9% on an annualised quarterly basis (Source: Bureau of Economic Analysis, bea.gov). This is a very high number.
At the same time, the data on the still very tight labour market indicate only a slight easing. The unemployment rate has risen from its low in January (3.4%) to 3.9% in October.
Source: LSEG Datastream; please note: past performance is no reliable indicator of future value development.
Consumer price inflation decreased to 3.7% in September, having peaked at 8.9% in June 2022. This means that inflation remains considerably above the central bank target of 2%. There are also signs of a certain degree of inflation persistence. The preliminary November report on consumer sentiment from the University of Michigan indicated an increase in long-term inflation expectations to 3.2%, i.e. the highest level since the rise in inflation during the pandemic. This highlights the risk that the anchoring of long-term low inflation expectations could be loosened. In this case, an even more restrictive monetary policy would be required to achieve the inflation target.
Source: LSEG Datastream; please note: past performance is no reliable indicator of future value development.
Finetuning
Despite strong growth, a tight labour market, and indications of inflation persistence, the bandwidth for the key-lending rate was left at 5.25% – 5.5% at the central bank meeting on 1 November, as expected. The statements made by Fed Chairman Powell were also interpreted as dovish (i.e. business-friendly) as opposed to hawkish (i.e. inflation-fighting).
As a matter of fact, market expectations for interest rate cuts in June 2024 rose in the days that followed. In a speech a few days ago, Jerome Powell tried to set the market interpretation straight by emphasising the central bank’s inclination to raise rates: “The Federal Open Market Committee (FOMC) is committed to keeping monetary policy tight enough to bring inflation down to 2% over time; we are not confident that we have achieved this. […] Should it be appropriate to tighten policy further, we will not hesitate to do so.”
Conclusion: focus on inflation and consumption
Yields on government bonds will only fall sustainably if and when the indicators point to a significant slowdown in economic growth, a rise in the unemployment rate, and a further decline in inflation. Given that economic growth is largely driven by private consumption, the publication of retail sales for the month of October next Wednesday will provide an important insight into economic momentum.
Also, consumer price inflation for the month of October will provide an update on inflation momentum next Tuesday. In the base-case scenario, it is too early to bet on further signals of a soft landing of the economy. This is mainly the case because the risks associated with inflation are pointing upwards.
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Legal note:
Prognoses are no reliable indicator for future performance.