Market Mood Swings

European stocks edged lower in early trading on Monday with caution apparently the order of the day ahead of the big raft of central bank meetings this week. The Federal Reserve is a slam dunk pause, the Bank of England is likely to do what it hopes is one last hike and the Bank of Japan has the potential to be a something of a wildcard as it plays catch up having suddenly realised inflation is not going to be transitory. Markets will also be on watch for China’s loan prime rate decisions on Wednesday.

The FTSE 100 traded flat just above 7,700 having delivered its best week since January thanks to miners and energy stocks, whilst the DAX and CAC were around a third of a percent lower in early trading. Yields are on the move this morning with the 10yr Treasury above 4.35%, whilst crude and gold are firmer, and the dollar struggled to make any headway. US futures are a tad firmer following a decline for Wall Street on Friday saw the S&P 500 and Nasdaq close the week lower.

Fed's Forecast Frenzy

The Fed is a certainty to pause – 99% implied by fed funds futures. The main question overhanging the meeting is on the dot plot. With the latest round of economic projections due we will see whether policymakers still see one more hike this year. If the dots are the same as June, markets could move to price in a higher likelihood the Fed hikes in November and push back on when the Fed starts to cut. If the median dot is lower than the 5.6% forecast in June, then it could be the signal to the market that the Fed is done, with the current target rate at 5.25-5.50%. This may be taken as a dovish signal so Powell would need to sound hawkish in the presser to counter.

Inflation Insights: The Hot and Cold

Should the Fed feel comfortable? CPI was up 0.6% on a monthly basis, driven by higher gasoline prices. Super core was still rather hot – core services ex-shelter at +0.5% mom from +0.2% in July. Year-over-year the core came down to 4.3% as expected from 4.7% which ought to be positive for the Fed.

Friday’s data was certainly encouraging. UoM year-ahead inflation expectations fell to 3.1% from 3.5% last month. The reading is the lowest since March 2021 and is just above the 2.3-3.0% range seen in the two years prior to the pandemic. Long-run inflation expectations came in at 2.7%, falling below the narrow 2.9-3.1% range for only the second time in the last 26 months. In comparison, long-run inflation expectations ranged between 2.2 and 2.6% in the two years pre-pandemic.

Inflation Intrigue: The Fed's Balancing Act

But the Fed is also coming up against an addiction to cutting – since last September financial conditions have loosened since rather than tightened.

This makes it incredibly difficult to force inflation much lower – partly it’s about the emergency response to the banking crisis in March, which has refilled the liquidity tank, and partly it’s because the market continues to price in cuts next year.  As I’ve mentioned a few times here, there is a big question about what the Fed and other central banks are prepared to tolerate. BofA notes that “.. if Fed done and first rate cut in June, current trends indicate US headline & core CPI will be between 3-4% next June, an implicit admission Fed tolerating a higher inflation target .. which again could be interpreted dovishly especially in an election year.”

So, one of the main tasks for the Fed and its chair, Jay Powell, is going to be to reiterate the higher for longer message and three-line whip the the 2% inflation target. 

Global Banking Ballet: A Dance of Decisions

What about the Bank of England? It’s a much tougher spot – stagflation. Markets are less certain with around 25% chance of a pause implied. But the broad consensus is that the MPC votes for another 25bps hike to take the Bank Rate to 5.50%. Governor Bailey told the Treasury Select Committee on Sep 6th: "I think we are much nearer now to the top of the cycle”, and then expressed concern that if the BoE hikes too far then it might need to cut too quickly. So the message is “higher for longer, but not too high to warrant pricing in cuts, lads!”

Inflation data is out on Wednesday and this could be critical. There is a chance of a surprise in the data that moves the market ahead of the decision announcement on Thursday – even if it doesn’t actually move the needle for the MPC.  Back to Bailey’s comments: "it is possible that we will get a tick up in the next [inflation] release, because fuel prices went down in August last year and up a bit in August this year" before concluding "but I do not see that as essentially changing the path. Actually, that is in our forecast."

The Bank of Japan also meets this week and is likely to sound hawkish and a surprise move cannot be ruled out entirely – only three meetings this year and Ueda has already signalled he wants to move soonish.

“Is the door open or is the door closed? You know, there was a beautiful theatre play by De Marivaux, who said that a door has to be either opened or closed. But this is theatre...” Christine Lagarde meant Musset, of course, not Marivaux. And she forgot to mention that a door can be very much ajar….which it is, but only just. The ECB hiked last week and signalled it’s done, but sources were out swiftly after to say don’t rule out another hike in Dec if wages and inflation is stickier than thought. Speeches on Wednesday from Lane and Schnabel will be important to guide expectations. I’d expect the emphasis to be on the “sufficiently long duration” of restrictive policy.

China’s interest rate decision (loan prime rate) is also on Wednesday – markets looking for more easing.

GBPUSD has cracked and continued lower, but has paused for breath this morning

It was not quite the blitz finish for the FTSE on Friday, fading a bit as the US session got underway, in the end it couldn't break the Fib resistance but still on a par with the best weeks since January at +3%. Breached trend and 200-day SMA resistance.