ALB Limited 17.04.2023

ABD balances are strong, 'aggressive FED' pricing may continue!

Last week, data flow was particularly heavy on the US side. Firstly, on Wednesday, we received the US CPI figures. The headline number showed a decrease greater than expected, with a year-on-year decline of 5.1% and a monthly decrease of 0.1%. However, core CPI increased from 5.5% to 5.6% on a year-on-year basis, while the monthly core data was in line with expectations at 0.4%. Generally, when we evaluate the inflation figures, the decline on the headline side is quite positive and supports the view that "the US is lagging behind in inflation." However, core inflation once again proves that "inflation in the US is persistent and stubborn." Even though there was a decline in the "core service inflation excluding housing," which is the aspect of inflation that the Fed is most concerned about, both the monthly and annual levels are still quite high, confirming that inflation is persistent. On the other hand, we know that the decline in energy costs had a significant contribution to the decline in headline CPI. However, there is a risk that this decline on the headline side may not continue due to the rise in oil prices caused by OPEC+'s decision to reduce oil supply in the coming days.

The Subcomponents of Monthly Core Inflation in the US in March

Source: Bloomberg Terminal

In conclusion, after the inflation figures were announced, the market focused on the headline figure and priced in the view that "there is no need for the Fed to raise interest rates more aggressively." As a result of this pricing, there was a retreat in the dollar index and US Treasury yields, while precious metals saw a rise.
We reviewed the March FOMC minutes on Wednesday evening after the inflation data. We saw that the language in the minutes was necessarily "dovish." I say necessarily because the last FOMC meeting was held just 10 days after the banking crisis, so we couldn't expect very hawkish comments in such an environment. It is very clear from the minutes that FOMC members are worried about the banking crisis. In fact, while some members suggested that no rate hikes be made in March after the banking crisis, others suggested a more flexible monetary policy stance due to the crisis. However, ultimately, members decided unanimously to raise rates by 25 basis points because "inflation is high" and "the labor market is tight." From the minutes, it is very clear that the impact of the banking crisis on credit contraction will be important in short-term interest rate decisions, especially. In other words, it seems that the banking crisis has already become a variable in the Fed's reaction function. In this context, the size of credit contraction due to the banking crisis will be as important as the state of inflation and employment markets, especially in the interest rate decision in June, rather than May (because in my scenario, the probability of a 25 basis point hike in May has become definite). Although the market is currently pricing in that the Fed will stop rate hikes after May, there is a possibility that this pricing could change due to the reasons I explained. Therefore, the expectation that "the Fed will definitely not raise interest rates in June" is not entirely correct, and if the data is concerning, the Fed could certainly raise rates by 25 basis points in June.
The most talked-about part in the reports is the Fed members predicting a "mild recession" towards the end of this year, mainly due to the impact of the banking crisis. It is almost the first time that Fed members have talked about a recession among themselves. After this information reached the market, the sensitivity to the recession increased even more. In a way, this recession expectation also caused a dovish pricing. Because, as always, when a recession occurs, the market thinks and prices in the Fed's "helpless rate cuts". Therefore, I think that at least in the short term and especially for indices, the "good (bad) data, good (bad) market pricing" will be quite strong after this recession emphasis. I say especially for indices because I believe that they have not priced in the recession sufficiently.

After the release of the FOMC reports, we also received the US PPI data on Thursday. PPI surprised on the downside, with headline PPI declining from 4.9% to 2.7%. Both headline and core PPI also registered declines on a monthly basis in March. Core PPI declined in line with expectations, falling from 4.4% to 3.4%. As a result, the stronger pricing began to reflect the view that "inflation is receding in the US, and as a result, the Fed will stop after a 25 bp increase in May". The markets were elated after the PPI figures, with the dollar index falling to 100.4 and US Treasury yields falling to September 2022 levels. Precious metals also showed strong gains, with gold testing $2061 per ounce and gram gold reaching a historic peak of 1275 TL.
When we arrived on Friday, the excitement in the market had given way to a slight decline. Initially, we received retail sales data from the US on Friday. When both core and retail sales showed stronger than expected declines, aggressive Fed pricing further loosened. However, after hawkish Fed member Christopher Waller spoke in the afternoon on Friday saying "the economy is stronger than we expected, so monetary policy needs to be tighter," the excitement in the market began to wane. Following Waller's speech, with the March industrial production and capacity utilization rates coming in above expectations on both a yearly and monthly basis, the pricing of "the economy is strong so the Fed can become more aggressive" began to strengthen. And again, when the University of Michigan's short-term inflation expectations rose from 3.6% to 4.6% on Friday, risk appetite in the market decreased significantly. After all these developments on Friday, the dollar index rose to 101.4, and gold entered a correction phase, falling to $1,966. Gram gold fell to the 1240 level. US indices also closed lower. By the way, I should mention that last Friday marked the beginning of the first quarter earnings season in 2023 in the US. On Friday, some of the largest banks in the US, such as JPMorgan, Citigroup, and Wells Fargo, announced their earnings. All three exceeded expectations. The earnings were good in terms of high profitability for the indices, but on Friday, the pricing of "more aggressive Fed" after the good data prevailed over the good earnings, bringing sales to the indices.
As a result of all these developments, the probability of a 25 bp increase by the Fed in May on the swap side in the US strengthened from 62.5% to 78%. Especially after the strong economic data on Friday, the market began to price in that the Fed would reduce interest rates by 50 bp in the second half of the year, not 75 bp. With this pricing, after the Fed reaches the ceiling rate of 5.00%-5.25% in May, it is pricing that it will close this year in the range of 4.50%-4.75% by reducing 50 bp for the rest of the year.

Possible interest rate levels for the Fed were discussed during the March FOMC meeting.

This week, we will be following the New York Empire State Manufacturing Index data from the United States on Monday, followed by the Philadelphia Fed Manufacturing Index and weekly jobless claims on Thursday. On Friday, production and service PMI data will be released. Of course, the verbal guidance from the FED members speaking during the week will also be closely monitored. Although there may not be a lot of data flow in the United States this week, the upcoming financial reports will be significant in terms of market pricing. In this regard, if the financial reports are stronger than expected, it will have a positive impact on the indexes by reducing the likelihood of a recession. However, if the reports come out strong, it may lead to pressure on gold prices due to the "economy being strong, and therefore a more aggressive FED pricing" aspect.

There will be a lot of data flow from the Eurozone this week. The CPI and PPI figures will be significant for both countries and the Eurozone as a whole, along with the ECB's interest rate decision and the trend of the Euro/Dollar exchange rate. Currently, the market is pricing a 25 bp increase in ECB's swap rate in May and an increase in the ceiling rate from the current 2.89% to 3.55% for the year. Therefore, if the inflation data from the Eurozone comes out stronger than expected, I do not expect any changes in the 25 bp increase in May. If inflation comes out higher than expected, I believe the ECB may increase the number of interest rate hikes instead of the rate at which they increase. Thus, strong inflation will push the ceiling rate even higher.
Last week, the Euro/Dollar exchange rate broke the resistance level of 1.0950, which it had been unable to break, and settled at the 1.10 level due to the impact of the decline in the dollar index from the lower-than-expected inflation data from the United States. However, on Friday, it fell again to the 1.0995 level due to the good data coming from the United States. Strong inflation data could push the exchange rate back up to the 1.10 level. In this context, the financial reports from the United States will also have an impact on the exchange rate. Good (bad) financial reports from American companies will increase downward (upward) pressure on the exchange rate. Let's see if the exchange rate will consolidate at the 1.10 level and make attempts to reach higher levels this week.

ECB's possibility of interest rate increase