Lower US inflation paves the way for a ‘one and done’ rate hike

US inflation slowed more than expected in June, supporting the view that the inflation story is now history. Last week, the growth in the US producer price index for trade services – one of the pain points during the monster wave of inflation of 2022 – dropped below the pre-pandemic average of the past decade.

Other indicators, such as underlying measures of shorter-term price dynamics or producer price inflation, also showed that not only is inflation slowing faster than expected, but also that the decline in inflation is quite broad-based and is being driven by lower prices for primary products.

Yet there is still an appetite in some areas of the Fed for another rate hike at its next meeting on 25–26 July – due among other things to the still-high core inflation rate and the still-tight labour market. A look at China might offer some inspiration as to how to move forward, as the country is an example of what happens when policymakers allow a tight policy regime to persist. The lack of impetus in the Chinese economy spurs falling prices and thanks to a softer currency, China is exporting deflation to the rest of the world.

We are now much more confident that the Fed will be done with rate hikes after the July meeting and will keep rates on hold until at least the first quarter of 2024 before responding to lower inflation and weaker economic growth with rate cuts.

Adjustment to ‘one and done’ causes weakness in US dollar

The tide has turned for the USD, as confirmed by data this summer. The June US employment report, with the first disappointment in job growth in months, and Tuesday’s US consumer price index data sparked a repricing of US rate expectations that caused considerable currency volatility. The US dollar dropped broadly against most currencies, reaching our three-month target of EUR/USD 1.12.

Our Technical Analysis team has downgraded the USD rating to Negative, with the prospects of the USD hitting the 2021 lows. This would be another 10% downside. Despite last week’s rapid moves, however, we are sceptical that the dollar will continue to weaken swiftly much further from here.

Our fundamental currency strategist rightly points to the strength of the US consumer and limited downside in the short term. First, the adjustment of Fed rate-hike expectations seems to be more or less complete. Second, US data with positive economic surprises continues to outperform eurozone data with more negative surprises. Furthermore, given the ongoing growth uncertainties due to higher interest rates, we do not expect a strong risk-on environment in the near term. Finally, the US dollar will continue to enjoy a substantial interest rate advantage over the euro.

That given, for the time being we will maintain our EUR/USD outlook at 1.12 for the 3- and 12-month horizons.

Time to focus on hard currency segment in emerging market bonds

Central banks in Latin America were among the first to start their hiking cycles in an effort to fight high inflation. They hiked fast and aggressively, with the five main economies delivering accumulated rate hikes of 4,850 base points since the end of 2020.

The tight monetary policy negatively impacted growth in the region. But now the time has come to reap the benefits and lower the high real rates. Headline inflation has peaked and is on a sustainable downward path. We expect central banks in major Latin America economies to embark on easing cycles, with Chile leading the pack and cutting rates already at its July meeting, followed by Brazil in August, Colombia in Q4, and Mexico in Q1 2024.

The development in Latin America bodes well for emerging market (EM) bonds more broadly. The case for our Overweight rating of EM hard-currency bonds appears balanced: the USD weakness and the oil price have recently helped, or at least stabilised, after a break. However, the important Chinese reopening theme has not fully materialised as expected and is indeed becoming a headwind now. As such, we would keep the Overweight rating for the EM hard-currency segment at this juncture.

Bank of Japan not expected to raise rates until early 2024

While inflating is easing in the US and the eurozone, it has returned to Japan. June inflation was reported this week at 3.3%, surpassing the US rate of 3% for the first time since October 2015.

An outperforming demand backdrop and higher-than-usual wage increases are increasingly calling into question the appropriateness of the Bank of Japan’s (BoJ) easy monetary policy. However, in our view, the BoJ is in no hurry to change its current policy. The BoJ seems likely to take a risk-management approach when reviewing monetary policy, requiring a degree of certainty that the deflationary backdrop in Japan has been overcome. We expect the conditions to be in place for the BoJ’s policy of yield curve control to be abandoned in early 2024 and for rate hikes to take place only in mid-2024.

The yen is expected to benefit from this policy shift but will remain attractive as a funding currency for the carry trade and other adventures given the still low short-term interest rate in Japan.

Is clean energy becoming a victim of its own success?

Clean energy is a booming business these days. Solar, wind, and battery technologies are cost-competitive solutions, the business is mature, and governments are highly supportive. Nevertheless, the investment theme has been underperforming global equities since the beginning of the year. The reasons remain elusive. The market mood remained rather risk-friendly overall and offered substantial valuation support for other growth themes, except for clean energy. For once, financial markets appear more rational than emotional.

The scepticism could reflect the emerging headwinds. Firstly, the substantial investments in manufacturing capacity will eventually weigh on product prices and margins. Generous subsidies, such as those offered by the US Inflation Reduction Act, will only accelerate these dynamics. Secondly, the strong growth in solar and wind generation will eventually depress electricity prices. In Europe, the past weeks’ and months’ sunny days came with excess solar generation, leaving a marked dent in electricity prices and weighing on power producers’ revenues and cash flows. Finally, energy is moving from scarcity to abundance. Global natural gas and coal prices have already eased substantially, and the start-up of export projects beyond 2025 should lead to a period of depressed natural gas and electricity prices.

The clean energy business therefore risks becoming a victim of its own success. These market dynamics could lead to another period of consolidation, like in the early 2010s. The structural trends of decarbonisation and the energy transition are strong, but investors should not forget that clean energy is an inherently cyclical business. Based on this outlook, we downgraded our view to Neutral last week and closed our investment idea.