Fed guidance on interest rates and trade developments will determine the near-term market direction
Euro area business surveys fell short of expectations in December, with the composite PMI decreasing by 1.4 pts to a 4-year low of 51.3 (consensus: 52.8), overall pointing to GDP growth of circa 1.2% qoq annualized in Q4:18 (0.6% in Q3 and 1.6% in H1:18). However, the decline was negatively affected, inter alia, by one-off factors (weakness in the autos sector due to the adoption of stricter production standards, protests in France).
ECB policymakers continued to deem risks to the outlook as broadly balanced, but acknowledged that rising trade tensions and geopolitical uncertainty could be a challenge. The ECB proceeded with only modest changes to its GDP growth forecasts (-0.1 pp for both 2018 and 2019, to 1.9% and 1.7%, respectively). Core inflation is expected to accelerate gradually towards the ECB’s target, on the back of rising wages, albeit at a slower pace than previously estimated (see Economics).
The ECB confirmed that net QE purchases will cease in December 2018 and reiterated its guidance that rates will remain at present levels (MRO: 0%, DFR: -0.4%), at least until the summer of 2019. Reinvestments of principal payments from maturing bonds will continue “for an extended period of time” past the date of the first rate increase, supporting financial conditions. The euro was flat on Thursday (ECB meeting), but declined by 0.7% wow against the USD to $1.130.
The Fed is expected to proceed with a rate increase (by 25 bps to 2.25%-2.50%) on December 19th. Investors will mostly focus on policymakers’ guidance for the future path of monetary policy (current Fed forecasts: 3 interest rates hikes by end-2019 to 3.25%).
Indeed, markets expect the Fed to err on the side of caution in 2019, due to: a) slower growth; b) elevated geopolitical risks and financial market volatility; and c) pressure from President Trump, as investors price-in only one hike for next year (see graph). The FOMC statement will probably alter the forward guidance of expecting further gradual increases in the policy rate, as the Fed will turn more data-dependent.
The Bank of England will likely remain on hold on December 20th due to the ongoing uncertainty surrounding Brexit (policy rate: 0.75%), despite inflation running above the target of 2% and a strong labor market. As the UK is due to leave the EU in March 2019, the deadlock in the UK parliament has raised concerns for a “no-deal” Brexit. Despite winning a party leadership challenge (albeit after pledging to step down before the 2022 election), PM May will likely hesitate to bring the Withdrawal Agreement to the UK Parliament before ensuring a majority, thus prolonging market uncertainty (GBP: +0.7% against the euro after PM’s win, -0.4% wow to €0.898).
Growth concerns in view of weak euro area and Chinese economic data (see Economics), continued to dent risk appetite in the past week, offsetting the positive impact of some goodwill gestures in the US-China trade negotiations (e.g. promised reductions in auto tariffs by China). Indeed, global equity markets (MSCI ACWI) declined by 1.1% wow (-9% ytd). At the same time, government bond yields were mixed for the week (UST 10Yr: +4 bps wow to 2.89% | GE Bund 10Yr: stable to 0.25%) but declined by circa 5 bps following Monday’s equity sell-off (SPX down by 2%).