Global Economy & Markets, Weekly Roundup 04/07/23
Short-term government bond yields have increased significantly, as markets price in higher-for-longer policy interest rates
Key Takeaways
The recent hawkish rhetoric from central banks was corroborated during the ECB’s annual Forum on Central Banking in Sintra, Portugal. President Lagarde stated that a +25 bps hike in policy interest rates in the July 27th meeting is highly likely. Euro area inflation for June, with core CPI increasing by +5.4% yoy, likely cements such a prospect (see Economics).
Looking forward, officials’ comments also suggested that the case for another hike as soon as on September 14th is gathering some steam, albeit the euro area real GDP announcement for Q2 (due on July 31st) is expected to shape their views significantly. Following a “technical recession” with two consecutive quarters of marginally negative growth (-0.1% qoq), a weak print for Q2 could increase the trade-off central bankers face between stabilizing output and inflation.
In addition, the Bank of England’s Governor Bailey pushed back against market expectations for interest rates cuts starting as soon as in early-2024, as core inflation was proving much stickier than expected. Following these comments, market pricing according to overnight index swaps suggests that the Bank Rate (current: 5.0%) will reach 6.25% by March 2024 and start falling in H2:2024.
Moreover, Federal Reserve Chair Powell left the door open for consecutive +25 bps hikes in the federal funds rate (current range of 5.0% - 5.25%) in the next two meetings (July 26th and September 20th), to reach the level assumed in June’s FOMC projections for end-2023 (median estimate for 5.6%).
At the same time, the trade-off between the price and financial stability objectives has taken a back seat, with the Federal Reserve’s annual supervisory stress test results in the past week providing some further reassurances. In the event, a severely adverse scenario was assumed, which entails, inter alia, the US unemployment rate peaking at 10% in Q3:24 (3.7% in May 2023) and real GDP declining by 8.7% from Q4:22 to a trough in Q1:24.
The post-stress common equity tier 1 (CET1) capital ratios of the 23 large US Banks subject to the tests, remain well above the required minimum levels both at the aggregate and the individual bank level. According to the results, cumulatively these 23 large banks have sufficient capital to absorb more than $540 bn in losses and continue lending to households and businesses under such stressful conditions.
The stress test results supported US bank equities (S&P500 Banks: +3.8% wow), leading the headline S&P500 index higher by +2.3% wow and by +16% YtD. With corporate profitability slightly better-than-expected, S&P500’s 12-month forward Price to Earnings ratio has increased by 2.5 points year-to-date to 19.3x, significantly above its 20-year average (see graph below). Other major bourses followed suit, with the MSCI ACWI at +2.0% wow.
Government bond yields edged higher, especially in shorter-term tenors (+10 bps to +15 bps in the 2-year spectrum, see graph page 3) due to the prospect of higher-for-longer policy interest rates, eased banking stress and sticky inflation. US 2-Year yields (4.94%) have retraced circa 90% of the SVB-induced decline and Schatz yields (3.33%) hover at their highest levels since 2008.
Key Takeaways
The recent hawkish rhetoric from central banks was corroborated during the ECB’s annual Forum on Central Banking in Sintra, Portugal. President Lagarde stated that a +25 bps hike in policy interest rates in the July 27th meeting is highly likely. Euro area inflation for June, with core CPI increasing by +5.4% yoy, likely cements such a prospect (see Economics).
Looking forward, officials’ comments also suggested that the case for another hike as soon as on September 14th is gathering some steam, albeit the euro area real GDP announcement for Q2 (due on July 31st) is expected to shape their views significantly. Following a “technical recession” with two consecutive quarters of marginally negative growth (-0.1% qoq), a weak print for Q2 could increase the trade-off central bankers face between stabilizing output and inflation.
In addition, the Bank of England’s Governor Bailey pushed back against market expectations for interest rates cuts starting as soon as in early-2024, as core inflation was proving much stickier than expected. Following these comments, market pricing according to overnight index swaps suggests that the Bank Rate (current: 5.0%) will reach 6.25% by March 2024 and start falling in H2:2024.
Moreover, Federal Reserve Chair Powell left the door open for consecutive +25 bps hikes in the federal funds rate (current range of 5.0% - 5.25%) in the next two meetings (July 26th and September 20th), to reach the level assumed in June’s FOMC projections for end-2023 (median estimate for 5.6%).
At the same time, the trade-off between the price and financial stability objectives has taken a back seat, with the Federal Reserve’s annual supervisory stress test results in the past week providing some further reassurances. In the event, a severely adverse scenario was assumed, which entails, inter alia, the US unemployment rate peaking at 10% in Q3:24 (3.7% in May 2023) and real GDP declining by 8.7% from Q4:22 to a trough in Q1:24.
The post-stress common equity tier 1 (CET1) capital ratios of the 23 large US Banks subject to the tests, remain well above the required minimum levels both at the aggregate and the individual bank level. According to the results, cumulatively these 23 large banks have sufficient capital to absorb more than $540 bn in losses and continue lending to households and businesses under such stressful conditions.
The stress test results supported US bank equities (S&P500 Banks: +3.8% wow), leading the headline S&P500 index higher by +2.3% wow and by +16% YtD. With corporate profitability slightly better-than-expected, S&P500’s 12-month forward Price to Earnings ratio has increased by 2.5 points year-to-date to 19.3x, significantly above its 20-year average (see graph below). Other major bourses followed suit, with the MSCI ACWI at +2.0% wow.
Government bond yields edged higher, especially in shorter-term tenors (+10 bps to +15 bps in the 2-year spectrum, see graph page 3) due to the prospect of higher-for-longer policy interest rates, eased banking stress and sticky inflation. US 2-Year yields (4.94%) have retraced circa 90% of the SVB-induced decline and Schatz yields (3.33%) hover at their highest levels since 2008.