Currencies little changed, consolidating after their recent big moves. UST 10-year rate continues to grind lower and 2y10y yield curve reaches its most inverted level since early 1980s, warning of recession next year

After the burst of optimism over the past week, as investors digested the downside surprise to US inflation, markets have traded with a more cautious tone overnight.  US equities are lower, giving back a little of their recent strong rally, while the US 10-year is down to 3.71%, its lowest level in six weeks.  Currency moves have been more restrained, with the USD largely consolidating after its recent big move lower.  The NZD is back to around 0.6150.

The overriding theme dominating markets at present is ‘peak inflation’, with markets extrapolating the downside surprise to core CPI in October as the start of the long-awaited normalisation in inflation.  Since that data, the S&P500 is up 6.5%, the BBDXY USD index is 3.3% lower, and the US 10-year rate is down 31bps.  Equity markets are slightly lower overnight, the S&P500 down 0.5% and the NASDAQ 1%, although this looks more like consolidation after a what has been a big mover higher in a short space of time.

There has been volatility over the past 24 hours related to the news yesterday morning that a Russian-made missile had killed two people in NATO member Poland.  The market’s initial assumption was that it might have fired from Russia, risking a major escalation in the war, however Poland and NATO have subsequently downplayed the incident, with the missile likely having been fired by Ukrainian troops at an incoming Russian projectile.

In economic data, US retail sales were much stronger than expected, with the ‘control group’ measure that feeds into GDP increasing by 0.7% in October and prior months revised higher.  The retail sales data are nominal, so high inflation explains some of the strength in spending.  Households have also been running down their huge stock of savings accumulated during the pandemic, estimated to still be in the region of US$1.4t.  While retail spending has been resilient so far, the impact of Fed tightening is clearly visible in the housing market, with the US NAHB Housing index falling to 33, near its early-2020 lows.

While the US retail sales data for October were strong, US retailer Target warned of a “meaningful” slowdown in spending in recent weeks as “stressed” consumers responded to higher interest rates and rising inflation.  Target’s share price slumped almost 15% as it lowered guidance for the current quarter and said it would need to discount heavily to clear excess inventory.  Signs of shifting consumer behaviour were also evident in Walmart’s stronger-than-expected results yesterday, with the US retail giant benefiting from consumers trading down to lower cost goods and staples.

Fed officials continue to sound hawkish, despite the recent downside surprise to US inflation.  San Francisco Fed President Daly, seen as a ‘dove’ on the committee, told CNBC that she thought the Fed Funds rate will likely need to reach “somewhere between 4.75 and 5.25”, which would be higher than the Fed’s most recent interest rate projections.  Kansas City Fed President George said while she supported a step down in the pace of rate hikes next month, the “real challenge” was to avoid stopping the tightening cycle too early.

The strong retail sales data and still-hawkish Fed commentary have seen US short-term rates rebound slightly, with the US 2-year up 2bps overnight to 4.36%.  However, longer-term rates continue to grind lower, the US 10-year rate down 6bps, to 3.71%, the 10-year German rate 12bps lower, and the implied yield on the 10-year Australian bond future down around 10bps since the NZ market closed.  The net result is significant curve flattening, with the US 2y10y curve falling to -65bps, its most inverted level since the early 1980s and warning of likely recession next year.

In currencies, the USD has largely consolidated after its recent sharp decline, the BBDXY index little changed over the past 24 hours.  The EUR pushed up to above 1.04 overnight, although it has given back some of its gains over the past hour – now back to 1.0380, 0.3% higher on the day – after a Bloomberg report that the ECB will likely step down to a 50bps next month.  The GBP is also on the stronger side of the ledger over the past 24 hours, up 0.3% to around 1.19, after a stronger-than-expected UK CPI report (see below). Commodity currencies have underperformed slightly against a backdrop of more cautious risk appetite, the NZD drifting down to 0.6150 and the AUD falling back to 0.6740.  Both currencies remain significantly higher (around 4.5%) than where they were before the US CPI data and news that China would ease some Covid restrictions.

UK headline CPI was much higher than expected, with annual inflation accelerating to 11.1%, a more-than 40-year high.  The main reason for the sharp increase in headline inflation, 2% on the month, was down to higher electricity and gas prices (+24.7% on the month) after Ofgem raised the price cap. The increase to electricity and gas prices would have been even greater had the government not implemented its energy price cap in October.  Economists think this might be the peak in annual headline inflation, with energy prices now capped for the next six months.  Even so, underlying inflation remains very strong, with core inflation running at 6.5% y/y and services inflation (typically sensitive to wage growth) 6.3% y/y.  The market is pricing an almost 50% chance of another 75bps hike by the BoE next month, despite Governor Bailey saying at the last meeting that the market was overpricing the likely extent of tightening.

In Canada, annual CPI was steady, at 6.9%, while the average of the Bank of Canada’s three core inflation measures ticked up to 5.4% y/y, still way above target.  The Bank of Canada is one of several central banks which has recently slowed the pace of tightening.

In Australia, the Australian Wage Price Index (WPI) showed faster than expected wage growth, with private sector wage growth increasing 1.2% on the quarter, its fastest pace since 2012.  The RBA has consistently maintained that Australian wage dynamics are more benign than other countries, such as the US and UK, but the WPI data suggests Australia may be catching up now amidst the extremely tight labour market.  The Australian employment report is released today, with the unemployment rate expected to remain near record lows, at 3.5%.  Despite the strong wage data, the market is only pricing around an 80% chance of a 25bps hike by the RBA next month and a terminal rate below 4%, well below that expected in the US, UK, and NZ.

In the domestic rates market, rates were lower again yesterday, taking their lead from global moves.  Swap rates were down 3-4bps across the curve while the 10-year bond rate was 1bp lower, at 4.18%.  NZ rates remain highly correlated to those in the US and Australia, so we should expect further falls today.  The market continues to price a slightly better-than-even chance of a 75bps hike from the RBNZ next week.

It looks set to be another busy session ahead.  Australia releases its labour market report, with consensus looking for the unemployment rate to remain unchanged, at an ultra-low 3.5%. There are more US housing data released tonight, expected to show a continued slowdown in building activity as the sector adjusts to higher mortgage rates, while the Philly Fed business survey and jobless claims are also released.  Several Fed officials are out on the speaking circuit, with the market likely to pay most attention to Bullard, who has been a consistent hawkish voice on the committee for some time.  The UK Chancellor will also unveil the Autumn Statement tonight, likely to include significant tax rises and spending cuts.