Central banks relying on data but unlikely to raise rates further
The US Federal Reserve (Fed) and European Central Bank (ECB) delivered rate hikes of 25 basis points as was widely expected. Financial markets that were looking for clues on what to expect in the coming months were left disappointed, however. Given the late phase of the rate hike cycle, already very restrictive base rates, and high uncertainty about the inflation outlook, neither central bank was willing to pre-commit. Instead, they emphasised that they are going to decide meeting by meeting depending on the incoming data.
We believe that the Fed and the ECB will not resume hiking rates and thus conclude their rate hike cycle with a terminal rate of 5.5% for the upper band of the Fed funds rate and 4.25% for the main refinancing rate in the eurozone.
US growth revised upwards in view of slowing price pressure
While inflation remains above target and is receding only slowly, we expect the downward trend to continue. Supply has become ample and credit dynamics have been slowing substantially in turn dampening demand, putting downward pressure on prices. Leading indicators such as the purchasing managers’ indices continue to signal that growth dynamics have been cooling off in the US and are pointing to a contraction in the eurozone.
That said, there is reason to expect rates to stay longer at high levels. Especially in the US, rising real incomes could push demand in the next three to six months. US gross domestic product (GDP) remains robust with better-than-expected GDP results in the second quarter. We revised our forecast slightly upwards to 1.9% in 2023 and 0.5% in 2024. A soft landing now seems ever more reasonable, and we adjusted the risk of a recession in the next 12 months down from 50% to 30%, although a financial ‘accident’ in the banking sector remains a possibility.
For the ECB, another hike in September remains a possibility, as certain members in the ECB council still deem it necessary to fight inflation. It is also why we expect the ECB to hold the terminal rate for longer. ECB rhetoric, however, was perceived slightly more accommodative than expected, pushing the EUR lower. At the same time, the USD profited from a better growth outlook.
Bank of Japan’s move to gain flexibility leads to spike in yields
Last Friday, the Bank of Japan (BoJ) surprised markets by adding more flexibility to its yield curve control. The central bank kept its formal target for 10-year Japanese government bond yields at approx. 0%, while the 0.5% ceiling has now become a reference point instead of a rigid limit.
While JGB yields have been priced far below the ceiling of 0.5% for months, markets immediately started to test the BoJ tolerance, with yields soon exceeding the reference point. The change in policy also rumbled through global markets, sending yields in the eurozone and the US higher. Japanese government bond yields moved towards 0.6% and the yen temporarily strengthened against the US dollar to USD/JPY 138.
With yields spiking to a fresh nine-year high in Monday morning trading, the BoJ announced that it will buy the equivalent of more than USD 2 billion bonds at market rates. The change in policy may be seen as a first tentative step towards normalising the BoJ’s ultra-loose policy amid an improving inflation outlook. However, we are more confident that a real step towards policy normalisation, i.e., hiking rates, may still take a while.
Japan strategy may put pressure on global rates but absorbed well by the yen
Given that it is now uncertain when exactly the BoJ will be stepping in with bond-buying operations to dampen rates, global bond markets should also see higher volatility. The risk is that Japanese cash invested in other countries’ debt may flow back to Japan, thereby putting global rates under upward pressure.
Overall, although the Bank of Japan shocked the market with its change in yield curve control, we were quite surprised at the very short-term impact on the currency and the stock market, which absorbed the policy shift well and resumed its upward trek. The currency is also back to where it was against the US dollar.
At this point in time, we do not think that the change in BoJ policy itself will have a sustained negative follow-through for the broad Japanese market beyond some idiosyncratic impact on certain stocks through exchange rate channels.
Earnings season unfolding modestly in Europe but very robust in US
In the US, the earnings season is moving to its late stage. Corporate America continues to surprise positively, with 74% of the companies beating earnings estimates. On an aggregate basis, companies are beating Q2 estimates by +6.2% compared to consensus expectations.
Across the Atlantic, the earnings season in Europe is also in full swing, albeit at an earlier stage than the US. Results have been rather weak so far: roughly half of the companies in the Stoxx 600 index have released their quarterly figures and only 52% have surpassed consensus earnings expectations, the lowest level since late 2019.
The difference can be partly explained by the economic surprise index, which is highly correlated to the beat ratio, and has been rather weak for Europe in the second quarter (i.e. economic data coming in weaker than expected), while showing the highest reading for the US since Q3 2020.
While the US has already gone through an earnings recession from Q4 2022–Q2 2023, European equities are not expected to head into an earnings recession until H2 2023. We continue to favour US over European equities, with a focus on quality growth names coupled with some defensive plays.