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Euro Area Macro

Banking sector fears have mostly subsided in Europe after a period of intense market scrutiny, but the macro repercussions could prove more persistent. Credit conditions were already looking tight even at the end of last year and there is a clear risk of a credit crunch weighing on economic activity over coming quarters. This could offset stronger economic momentum seen recently in the euro area and leave growth relatively muted through 2023.

US Fixed Income: Nearing a macro inflection point

Macro View: In our view, the next four months into the August reporting period will be super critical for assessing the outlook for the US economy. We believe that the combination of the bank induced credit crunch which is now amplifying both QT and the “long and variable lags” of the supersized hikes, all this is working double-time at slowing the economy.

Our probabilities remain high that when the NBER looks back at 2023, its likely that they will surmise that the US economy has either fallen into a recession by late Q2 or sometime over the summer towards late Q3. The window for recession is that close in our view. However, it’s going to take time to fully underwrite this view, and again, Q2 should start this process.

Since our last update the US jobs data has shown further deceleration and the weekly unemployment claims data has had a notably jump into the 240k region recently. This shift in the direction of claims was one of the criteria we were looking for to get further behind our recession call in 2023. Meanwhile inflation data is entering the peak of last year’s high prints which will result in the base-effects furthering the disinflationary trends.

Fed Policy: The one thing that has become clear in our stance on Fed policy, if the market is pricing in hikes, and Fed speakers do not push back on market pricing, as we head into a rate decision, so long as rate hike probabilities are in the 65-100% zone – they will hike. At current time of writing, the May 3^rd FOMC probability of 25bp hike is sitting at 88%. So long as nothing derails these expectations, the Fed will hike in May again.

Yet we are entering the period where the data (a quick CPI slide in Q2/Q3 plus job losses will start to stack up in our view) will give the Fed plenty reasons to pause soon enough. Either way we are relatively indifferent if they hike once again in May. In our view the cycle is coming to an end.

The Fed will at some point need to defend why they will keep rates “higher for longer” and that will likely be a harder message to convey versus the quick successions of hikes over the past year. Once you are off a program of hiking (and just waiting around to assess the damage that all of this tightening is having on the real economy) the burden to stay on hold grow. And in this world things tend to happen much faster. As we wait for a specific catalyst, the first cut can happen in September or later in the year.

Rates View: All segments of the yield curve have been trading deeply inverted to the Fed Funds (FF) overnight target rate. We do not see that changing anytime soon, in all likelihood, the inversion to FF will grow after the next rate decision. Yet the bond market remains sceptical of the Fed’s staying power at such high rates, so do we. Meanwhile the backend of the curve is coming up against some moving averages that should provide support. The 2yr could get dragged up another 10-15bps but even that tenor will probably start to stall from its recent rate rise. We advocate buying on dips and start to look at curve steepeners led by the front-end. 

FX Outlook

The US dollar on a DXY basis has declined by about 2.5% since the last Global Markets Monthly which is telling given short-term yields in the US, which declined initially have recovered all of those declines as market participants pare back the extent of monetary easing that was priced for the end of this year. 70bps of cuts have been removed by year-end. The fact that the dollar remains weaker over the same period in part reflects the expected continuation of monetary tightening in Europe. Both the ECB and the BoE are expected to hike in May and are priced for additional hikes after that when the FOMC is assumed to have paused. The recovery in yields and increased expectations of rate hikes also is in response to reduced concerns over the banking sector. We continue to expect the US dollar to weaken going forward as the pause by the Fed is followed by weakening economic data that leads to renewed increased expectations of rate cuts by year-end.

KEY RISK FACTORS IN THE MONTH AHEAD

• The primary risk to our USD/JPY view is that the current positive momentum is sustained for longer than expected. We currently expect the move higher to peter out but if the data from the US does not weaken as expected, market participants may continue to remove the pricing for rate cuts by year-end, which is now less than one 25bps cut. For the market to revert to a probability of further rate hikes further out towards year-end would require much stronger data for a longer period of time. Unlikely in our view but perhaps the primary risk to the view over the short-term. A stronger message from the BoJ that it has no intention to change YCC would also add to the risk.
• There are two main downside risks to our bullish EUR/USD bias in the month ahead. There is a risk that US rates move back to price in a more hawkish outlook for Fed policy if the fallout from the US regional banking crisis proves more modest than feared. The Fed could deliver another 25bps hike at the next FOMC meeting and leave the door open to further hikes this year. Alternatively, the USD could prove stronger than expected if fears over a US and/or global recession intensify that triggers a bout of safe have USD demand.
• Persisting geopolitical uncertainty remains an upside risk for USD/CNY in the month ahead. Huang Xilian, China’s ambassador in the Philippines said on 14th April that the Philippines is stoking the fire of regional tensions by granting the US military wider access to some of its military bases, with three facing north towards Taiwan and one near the disputed Spratly Islands in the South China Sea.