As expected, the Federal Reserve Bank raised its benchmark interest rate by a further 0.25%. It now stands at 5.25% – its highest level for 22 years. Fed Chair Jerome Powell has been careful not to declare victory against inflation just yet. The Fed, he emphasised, bases its actions on data and has not made any decision regarding further interest rate hikes.
It will be able to digest additional CPI inflation readings and two US jobs reports between now and 20 September (the next Federal Open Market Committee meeting). However, Powell did acknowledge that US inflation has come down significantly from its peak: headline CPI inflation fell from 9.1% in June 2022 to 3% in June 2023. Core inflation, on the other hand, remains elevated (4.8%) – services demand has remained robust and wage growth is still stubbornly high.
The Fed is therefore likely to exercise extreme caution, continuing with its hawkish rhetoric and maintaining the idea that additional rate hikes might be required to bring core inflation down further.
The European Central Bank also raised its interest rates by 0.25%, bringing its benchmark deposit rate up to 3.75% – its highest level since 2001 when it was trying to boost the value of the newly launched euro. ECB president Christine Lagarde echoed Jerome Powell's words, undertaking to keep an open mind regarding any future hikes. Indeed, inflation is still 5.5% – nearly three times the central bank's 2% target. It has, however, dropped. And a further slowdown is expected for July.
Bank of England policymakers next meet on 3 August, and the market is expecting a further interest rate hike of a quarter of a percent. This is down from the expected half percent rise that was pencilled in prior to the last inflation data reading (a pleasantly surprising 7.9%). The UK base rate stands at 5%, and the market expects rates to peak at around 5.8% in March 2024.
Although headline inflation has been falling (slower than elsewhere), the stubbornness of core inflation and ongoing wage pressures are more cause for concern. Demand is clearly still too strong relative to supply, so tighter monetary policy is what is required.
This, combined with the Bank of England's willingness to tolerate weaker economic activity means that the outlook for short-term growth looks less than stellar. And recession risks remain greater in the UK than elsewhere.
As the battle to tame inflation continues, credit rating agency Fitch believes that the UK will incur the highest debt interest rate costs of any country in the developed world. The rising interest rate costs have been extremely prominent in the UK: interest payments on a 12-month basis reached £117 billion in May – that's twice the level that they reached in the 12-month period to September 2021. The UK Treasury, it estimates, will spend £110 billion on debt interest in 2023. That would be around 10.4% of total government revenue – the highest of any high-income country.
This will most certainly become a more contentious issue as the General Election draws near (sometime between now and January 2025). Although likely to rise further, interest rates are predicted to fall towards the end of next year and the beginning of 2025.
Perhaps the biggest surprise in the financial markets last week was the Bank of Japan’s announcement of its intention to significantly tweak its monetary policy. It is set to increase “flexibility” around its yield curve control target. And as expected, it revised its forecast for consumer price inflation upwards for fiscal year 2023.
This is significant: the Bank of Japan has been using its yield curve control mechanism to keep the 10-year bond yield down for seven years now. And the current target of 0.5% has been in place for seven months. Greater flexibility in relation to its government policy could allow the yield on its benchmark bond to rise to 1%. Furthermore, the Bank of Japan will offer to buy 10-year Japanese government bonds at a level as high as 1% on every business day through a fixed-rate purchase strategy. This is essentially quantitative easing.
On the face of it, this might not appear relevant. But it actually matters. The immediate reaction in the bond markets was the US benchmark 10-year Treasury bond yields surging back up to around 4%. US bonds have been attractive to Japanese investors for years. This is because of the low cost of borrowing US dollars on short-term rates and the significantly higher yield for longer-dated US debt compared with the returns that could be achieved in Japan’s bond and equity markets. But has this now changed as a result of the Bank of Japan's actions?
The repercussions were also felt on the FX market: the US dollar started to trade lower, while the euro was significantly down. Admittedly, the latter might have more to do with Christine Lagarde’s recent monetary policy decisions.
The good news is that yield curve control was always a desperate measure that sabotaged the Japanese market. This increased flexibility has therefore been welcomed as a positive move. Japan's economy is now emerging from decades of despair, and by reducing the liquidity flowing out of Japan (buying overseas assets), the central bank's job should get a little easier. Whatever the short-term outcome, the long-term results should be positive.
Recently, there has been a rush to invest in AI as major tech companies continue to launch artificial intelligence services. An important component in all of this is the microchip. While global chipmakers are busy setting up factories, Germany plans to invest around €20 billion in the semiconductor industry over the coming years amid concerns that the current supply chain is fragile and highly exposed to geopolitical risks.
Dependency on the world's largest and most valuable semiconductor manufacturers (the Taiwan Semiconductor Manufacturing Company and Samsung) has led to countries such as the US, Germany and even the UK increasing their own chip manufacturing capabilities. Recently, for example, US chip manufacturer Nvidia has benefited enormously from the recent frenzy around AI and cryptocurrency.
We are now midway through the Q2 corporate earnings season in the US. So far, 254 companies have reported, with around 79% topping their earnings expectations and 63% exceeding their revenue estimates. That said, a fall of around 6.4% (based on a blended growth rate) is the expected overall quarterly result. If this is the final outcome, then it would be the biggest contraction seen since 2020’s third-quarter earnings season. As far as individual sectors are concerned, six of the eleven have reported year-over-year earnings growth, while five have reported a year-over-year decline.
While the move higher in the markets this year has its roots in enthusiasm over AI, the focus has been Wall Street. The Dow Jones Industrial Average has recently notched up its longest winning streak since 1987. The S&P 500 Index is on track for its fifth positive month in a row, and the Nasdaq has been propelled along by the aptly named “magnificent seven” group of tech companies.
The markets appear to believe that the Fed and other central banks may be nearing the end of their rate hikes. This, combined with resilient growth and moderating inflation are all helping to create a positive backdrop, supporting the bull market that began back in October 2022. Thus far, this rally has been rather narrow in terms of company and sector participation. But we expect it to broaden out over the coming months, with economically sensitive sectors of the market contributing their own momentum.
