US Services PMI slumps further into contractionary territory, raising the market's recession concerns. Markets brush off hawkish Fed speak, but not ECB

Equities were down again on Friday as investors reduced risk heading into year end.  Weaker than expected US PMI data drove a sharp steepening in the US yield curve, with short-end rates falling and the US 10-year rate nudging up close to 3.50%.  European bond rates, especially Italy, were higher again as markets continued to digest the hawkish ECB meeting from the previous night.  The USD was generally stronger amidst the risk-off backdrop, with the two notable exceptions being the JPY and (surprisingly) the NZD.  The NZD/AUD cross has powered up to 0.9535, now at its highest level in over a year.  NZ short-end rates were lower on Friday, reversing some of their illiquid move higher after the upside surprise to GDP the previous day.

The US PMIs typically get much less attention than the more widely followed ISM surveys, but they turned out to be a market mover on Friday.  The Services PMI slumped to 44.4, well below expectations of 46.9 and now close to its lowest level since mid-2020, at face value pointing to contraction in services activity.  The ISM Services index, at 56.5, continues to paint a much healthier picture of the US services sector at present and its divergence with the PMI index isn’t unprecedented.  However, with market concerns around recession risk heightened, the PMI data caused a sharp fall in US short-term rates and an abrupt steepening of the yield curve.  The US 2-year rate fell from around 4.30% immediately before the data was released to 4.18%, ending 6bps lower on the day.  The US 10-year also fell from its intraday highs but ended 4bps higher on the session, just below 4.50%, continuing its choppy range trading pattern this month.  The US 2y10y yield curve remains deeply inverted, at -70bps, warning of almost certain recession next year, but it is now some way off the extreme levels reached earlier in the month.

Fed officials were out in force on Friday, backing up the hawkish message from Chair Powell at the Fed meeting earlier in the week.  NY Fed President Williams alluded to the possibility that the Fed could need to take the cash rate higher than the 5.1% median projection set out in the dot plot if inflation proves more persistent than expected. San Francisco Fed President Daly, historically one of the more dovish voices on the committee, said markets were “pricing for perfection ” in expecting a rapid normalisation in inflation next year (the market prices US annual CPI inflation of 2.4% at the end of 2023).  Daly said she saw the risks around inflation to the upside and expects to hold rates at restrictive levels for longer than markets price in.  The hawkish Fed comments fell on deaf ears, with the market continuing to price two rate cuts in the second half of next year and further monetary policy easing beyond that.

In contrast to the US, the European PMIs unexpectedly rebounded in December, with the manufacturing index increasing from 47.1 to 47.8 and the services index increasing from 47.8 to 48.8.  This continues the recent trend of European economic data proving not as dire as feared.  That said, both services and manufacturing remain in contractionary territory, consistent with the very challenging economic backdrop in the region.

European bond rates were sharply higher on Friday for the second session running, as the market continued to digest the very hawkish messaging from the ECB meeting.  German 2 and 10-year rates were 7bps higher, with the 2-year rate hitting a fresh post-GFC high of 2.43%.  Italian bonds remain under pressure, with the market conscious of the ECB’s plans to start unwinding its vast bond portfolio from March, which will require private sector investors to absorb significantly more Italian bond issuance.  The Italy 10-year rate was 14bps higher, seeing its spread to Germany widen to 215bps.

In currencies, the USD was generally stronger amidst the risk-off vibes, with the DXY index pushing 0.25% higher on the day.  After its big pullback over the past two months, in part due to investors unwinding consensus USD long positions, the USD appears to have found some support over the past week.  The EUR was down 0.4%, to back below 1.06, failing to benefit from the widening in EU-US rate differentials.  The JPY was the star performer, with USD/JPY increasing 0.9% to 136.60, against a backdrop of more cautious risk appetite.  The NZD was the only other currency to appreciate against the USD on Friday, surprising given it is typically highly correlated to risk appetite.  The NZD was up 0.6% to 0.6380, rebounding after its sharp fall the previous night.

With the AUD falling 0.3% on Friday, this made for a big move higher in NZD/AUD cross, which blasted up to 0.9535, its highest level in over a year.  The rally in the cross is consistent with the widening in short-term NZ-AU interest rate differentials over recent months, as the RBNZ has taken a much more forceful approach to tightening than the RBA.  We would be careful about extrapolating the recent moves though; position adjustments at this time of year can make for some unpredictable moves in what are less liquid conditions than usual.

Equity markets were lower on Friday, with the S&P500 falling 1.1%, the NASDAQ down 1% and the EuroStoxx 600 index off by 1.2%.  The weaker-than-expected US PMI data was a factor behind the falls in equities, with investors wary of the likely hit to corporate earnings if the economy slumps into a recession next year, as seems likely.

Chinese state media reported that the government would prioritise domestic demand next year, with the authorities calling for “more forceful” fiscal position and “forceful” monetary policy.  The government is expected to set a GDP growth target of 5% for next year, as it shifts focus away from Covid containment back towards economic growth.  Separately, the South China Morning Post reported that the China-Hong Kong border would “fully reopen” early next month for the first time in three years, which would represent another move away from the zero-Covid policy.

The US government said it would purchase 3 million barrels of crude oil to replenish its Strategist Petroleum Reserves (SPR).  The US has sold around 180m barrels from the SPR since the Ukraine war started, part of an effort to dampen oil prices and broader inflationary pressures.  However, with the SPR having now been substantially depleted, the administration is now seemingly looking to replenish its stocks.  The news didn’t provide much support to oil prices on Friday, with markets preoccupied by recession risk, Brent crude selling off 2%, to just below $80 per barrel.

In domestic data, the Manufacturing PMI slipped further into contractionary territory, at 47.4, while new orders slumped to just 41.8.  While weakness in manufacturing is a global phenomenon, as consumers switch spending from durable goods back to services, the data is consistent with the impending recession we see coming for New Zealand.

NZ short-end rates were lower on Friday, partially reversing their illiquid moves higher after the GDP data on Thursday.  The 2-year swap rate was down 6bps, to 5.27%, although the market continues to price a terminal rate for the RBNZ just above 5.50%.  5 and 10-year swap rates were 1-2bps higher on the session, seeing the yield curve steepen sharply from its deeply inverted levels.  We should see further yield curve steepening today given the moves in the US Treasury curve on Friday night.

Foreign investors increased their holdings of nominal NZGBs by just over $4b in the month of November, the biggest monthly increase on record.  Foreign investors bought $1.7b of the inaugural 2034 maturity green bond during the month, with much of the remaining $2.4b of inflows likely related to NZGBs joining the WGBI bond index on 1 November.  We had previously estimated there might be around $2b of offshore inflows into NZGBs on the first month of WGBI entry, based on the recent experience of Israel.

It will be a much quieter week ahead as the market winds down ahead of the Christmas break.  The Westpac consumer confidence index and PSI (the services equivalent of the PMI) are released today while the ANZ business survey is worth keeping an eye on tomorrow.  Last month’s ANZ survey showed a further fall in pricing intentions, potentially foreshadowing the long-awaited normalisation in CPI inflation, and negative employment intentions, suggesting the RBNZ is starting to get traction with its ultra-aggressive hiking cycle.  Offshore there is the release of the RBA minutes, Japanese CPI and the BoJ meeting (no policy changes expected) and various second-tier US data.