July 15 2022
What goes up, must come down. But not quite yet! US inflation again surprised to the upside this week, with the release for June coming out at an eye-watering 9.1%. This was up from 8.6% in May, above market forecasts of 8.8% and the highest reading since November 1981. Perhaps more concerning was that there were large increases across many components. Services (ex food & energy) prices rose 3.19%, goods (ex food & energy) prices rose 1.48%, food up 1.45% and energy up 2.98%.
The US Federal Reserve will be keen to ensure that high inflation isn’t becoming entrenched and following this figure the market moved sharply to price in a 100bp rate rise at this month’s meeting, before reverting back to a 75bp hike. The former however surely can’t be ruled out. Longer term however the market continues to believe that inflation will fall from its current lofty height. Looking at predictions based on the breakeven rates for US Inflation-Protected Securities (TIPS), the breakeven rate on the 10-year note is a little over 2.25%, whilst the same for the 5-year is a little over 2.5%. The 5-year, 5-year forward breakeven meanwhile is just over 2%.
High inflation is fuelling higher interest rate expectations. Higher interest rate expectations are fuelling concerns of an economic slowdown. Concerns of an economic slowdown, along with lower inflation expectations for next year and onwards, are keeping longer Treasury yields capped, for the time being. The spread between the US 10-year and 2-year Treasury as a consequence has moved further into negative territory.
This week marks the reporting of second-quarter earnings for many companies in the S&P 500. On Thursday we saw JP Morgan report. Earnings fell short of expectations as the bank built up provisions for bad loans. Whilst they acknowledged that the US economy and job market continue to grow, they also raised concerns. Chairman and CEO Jamie Dimon warned that:
“Geopolitical tension, high inflation, waning consumer confidence, the uncertainty about how high rates have to go and the never-before-seen quantitative tightening and their effects on global liquidity, combined with the war in Ukraine and its harmful effect on global energy and food prices are very likely to have negative consequences on the global economy sometime down the road,”
Eyes are expected to not only be focused on earnings but also on any forward guidance that companies provide. With inflation running hot and the central bank acting accordingly, coupled with rising recessionary risks, there is undoubtedly pressure building on earnings. As always, however, there will be winners in this environment and there will be losers.
Finally, the heightened interest rate expectations for the US led to further strength in the US dollar this week, with the US Dollar Index now at its highest level in over a decade. A greater landmark however was that the Euro traded at and then below parity with the US dollar for the first time since 2002. Strong dollar or weak Euro, probably a combination of the two. It could be argued that the economic outlook for Europe does not look as strong as the US, whilst at the same time investors are potentially seeking the perceived safe haven of the dollar. Only time will tell.
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