The two big uncertainties unsettling financial markets

Since the start of this year optimism in financial markets about the outlook for inflation and interest rates has been reflected in surging markets for risk assets and sliding bond yields. This month, however, some of that optimism has leaked out of the markets as economic data has started to contradict the narrative of receding inflation provided by the headline inflation rates.

On Friday the US Federal Reserve Board’s preferred measure of inflation, the core monthly personal consumption expenditures index that reflects spending on goods and services but excludes food and energy, was released.

Wall Street has been going backwards in February.
Wall Street has been going backwards in February.Credit:AP

The index rose 0.6 per cent in January, above market expectations and its biggest increase in nearly two years. That took the year-on-year increase to 4.7 per cent, well above of the average forecast of 4.3 per cent.

Expectations of the path of interest rates for the rest of this year have been evolving this year.

Last month the markets, buoyed by the decline in the headline rate of inflation, had been pricing in a peak for the federal funds rate (the US equivalent of the Reserve Bank’s cash rate) of about five percent by mid-year. They now expect the rate to peak around 5.5 per cent and remain there until at least late in the year.

The unexpectedly strong inflation number on Friday caused the US sharemarket to fall, the US dollar to strengthen and the yields on US government bonds to rise.

Even before the latest data there was a more brittle and anxious tone developing within markets that had begun the year confident that the end of the rate-hiking cycle was within sight.

The US sharemarket had risen almost 10 per cent for the year when it hit its most recent peak at the start of this month and the yields on two-year Treasury notes and 10-year bonds had been sliding.

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Then, after the Fed announced its latest 25 basis point rate rise at the start of the month and US employment data showed the economy adding jobs in January at a rate far higher than economists had predicted, the markets started to slide.

The sharemarket has fallen back five per cent and the yields on the two-year notes and 10-year bonds have climbed about 50 basis points.

Globally, the fight to lower inflation is proving to be more difficult than anticipated.
Globally, the fight to lower inflation is proving to be more difficult than anticipated.Credit:Bloomberg

It is now apparent, whether it’s the US, Europe or Australia, that core inflation is yet to be tamed and the end point for the interest rate cycles in those economies is uncertain.

Markets that had been pricing in peak rates by mid-year have realised that the central banks are being forced into “higher for longer” stances that will damage economies and asset prices.

The questions of how high, and how long, have yet to be resolved, so it isn’t surprising that, in markets that had been pricing in a fair degree of central bank precision and perfection, confidence has waned.

There are flow-on effects to the rest of the world from the level of uncertainty now pervading the key US markets.

The strengthening of the dollar reflects inflows of capital from the rest of the world, with developing economies in particular – which had been seeing big inflows when the appetite for risk-taking surged – now seeing outflows.

It’s not just developing economies – the Australian dollar has depreciated by nearly six per cent against the US dollar since the start of this month.

There is a spate of US economic data due this week, including jobs data at the end of the week, as well as number of Federal Reserve officials scheduled to speak. Every bit of information will take on greater significance and be of greater market sensitivity in this environment.

While it is the likely course of inflation and interest rates that is the primary narrative that has influenced financial markets so far this year, it’s not the only one.

In the background the impasse over the US government’s debt ceiling, while receding somewhat from the limelight in recent weeks, is still a potential flashpoint for global markets.

There is growing uncertainty about when we will see the end of the rate-hiking cycle.
There is growing uncertainty about when we will see the end of the rate-hiking cycle.Credit:Peter Rae

Last week’s release of the minutes from the Fed’s Open Market Committee meeting at the start of the month showed that a number of its officials were concerned that if negotiations over raising the debt limit were prolonged, there could be significant risks for the financial system and economy.

The Biden White House is adamant that it is not going to make any concessions to the now Republican-controlled House, which is demanding swingeing spending cuts in return for supporting an increase in the $US31.4 trillion ($46.7 trillion) debt ceiling.

Given the unusual make-up of the Republican majority in the House – there some rather odd characters and factions – there is concern that the latest of the regular bouts of brinkmanship over the debt limit may not end in the last-minute deal that has in the past always averted disaster.

That anxiety is evident within the short end of the US bond market, where yields on three-month, six-month and 12-month government bills have been spiking to levels last seen a decade and a half ago.

The yield on six-month bills is 5.09 per cent, the first time it has been above 5 per cent since just before the 2008 financial crisis. Earlier this month those bills were yielding 4.7 per cent. Bond investors are being told by investment firms that they should stay away from the short end of the market until the debt issue is resolved.

For the moment the US Treasury is operating using “extraordinary measures” to avoid a US government default on its debts and chaos in global financial markets. The US bond market – the market for the government’s debt — is the biggest, most liquid and most influential financial market in the world.

By freezing some of its discretionary spending the administration can keep paying its bills until mid-year. Beyond that, the timing of a potential default would probably depend on the level of cash inflows from tax receipts, which are unpredictable.

In a bond market which has already shown some signs of illiquidity this year, the twin uncertainties of where central banks rates will end up and fate of the debt ceiling are threats to its stability and liquidity, with significant and destabilising spillover effects to other markets and jurisdictions if those uncertainties linger.

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Source: Thanks smh.com