Economic cooling in the Eurozone
In our view, economic cooling is in full swing in the eurozone, and we do not see any need for further policy tightening from here. Credit growth slowed sharply and should also help in the disinflation process. Energy prices might lead to some upside risks to headline inflation in the short term, but they are not interfering with the trend in underlying inflation, which continues to move towards the 2% target. Moreover, the Governing Council is likely to look through any short-term impulses from the energy market but is at the same time not yet in the position to call victory, given the still elevated current inflation readings.
A rise for safe haven currencies
Safe-haven currencies such as the Swiss franc and the Japanese yen tend to benefit in times of elevated economical or geopolitical risks. Since the flare-up of the crisis in the Middle East, where uncertainty caused other safe-haven assets such as gold to jump, this has held particularly for the Swiss franc, which appreciated to levels beyond EUR/CHF 0.95. Its recent strength is likely attributable not only to safe-haven flows due to the crisis, but also to eurozone growth risks, though it appears to be less supported by economic drivers.
Swiss economic momentum has suffered due to exposure to the eurozone’s weakness. The only factor supporting a stronger franc is lower relative inflation, with Swiss consumer prices growing by 1.7% compared to still 4.3% in the eurozone. Prevailing uncertainty and risks of an escalation of the conflict may keep the franc strong in the short term, but a stabilisation of risk appetite would bring back headwinds from the rate disadvantage.
Bond market overwhelmed by the strength of the US economy
Despite monetary headwinds, the US economy remains surprisingly resilient, hardening the belief that US policy rates will stay higher for longer. Solid investment demand despite stricter financial conditions, helped by a supportive fiscal policy have resulted in structurally higher interest rates.
The USD is also benefiting from the rise in yields, which are expected to stay higher for longer, as the US Federal Reserve now acknowledges the ‘soft landing’ scenario. The closely followed yield of the 10-year US Treasury note crossed above the 5% level for the first time since July 2007, up 0.4% in a week’s time.
We believe there are three factors behind this rapid move:
- The bond market is overwhelmed by the strength of the US economy. The Q3 growth number due later this week should confirm an acceleration of real growth to more than 4% or even 5%.
- The normalisation of the yield curve. From July last year, the US yield curve had been inverted, as the market anticipated a recession and consequently rate cuts by the US Federal Reserve. With the risk of a recession waning, the yield curve is turning back to normal, meaning that yields at the long end are climbing above the Fed funds level.
- There is a need for fund managers to reposition. In anticipation of lower yields and rate cuts, many fund managers had added long positions that they are now selling, and the rapid rise of long bond yields is often interpreted as a sign of economic strength.
It is hard to gauge where the overshooting of the US Treasury yield will end. However, with inflation slowing towards the Fed target in 2024, the US budget turning neutral or even restrictive, and nominal growth thus collapsing towards 4% again, we see sufficient arguments for a lower yield level in the medium term.
What does this mean for investors?
The S&P 500 is expected to report a year-over-year decline in earnings for the fourth straight quarter (-0.2%), although we would argue that we are at an inflection point, as this would mark the smallest decline during the four-quarter streak. While this might be reassuring, the earnings results will likely be overshadowed by the ongoing conflict in the Middle East and bond yields. Barring any further steep up-move in bond yields or an escalation of the conflict, equity markets should be ripe for a year-end rally. We recommend staying invested.