It has been an eventful week on the central bank front. The Fed delivered a historical 75bp hike to a target range of 1.5-1.75% and signalled that another 75bp hike in July is possible if there are no signs inflation pressures ease. It is striking that just one year ago, the Fed did not expect to deliver any hikes in 2022. And now we are looking at the steepest hiking cycle since the 1980’s. We look for another 75bp in July as we see no sign that inflation pressure is easing in the short term. We expect it to be followed by 50bp hikes in September, November and December to take the Fed funds rate to 3.75-4.00% by year-end, which is 25bp higher than current market pricing.
Since the 75bp hike was already signalled on Monday, the market reaction was quite muted. Initially yields dropped but on Thursday they rebounded again with the US 10-year yield trading close to 3.5%. German yields increased yet again to a new cycle high at 1.83%, partly lifted by a ‘hawkish’ 25bp hike by Bank of England, and a surprise 50bp hike by the Swiss central bank SNB. Equity markets also moved lower again on concerns that the aggressive rate hikes can trigger a deeper recession than already priced.
The ECB held an extraordinary meeting on Wednesday to discuss ‘fragmentation‘ on the back of the recent sharp widening of the 10-year Italy-Germany bond yields spread, which had increased from 100bp in September last year to 240bp early this week. With the end of ECB’s purchasing programmes investors have less confidence in holding Italian bonds setting off a negative spiral. In the meeting statement, the ECB said it would a) use flexibility in reinvesting redemptions in ECB’s portfolio and b) accelerate the design of a new anti-fragmentation instrument for consideration by the Governing Council. The 10-year Italy-Germany spread has narrowed to 205bp in response. Whether the improvement will last will ultimately, depend on the details of the new instrument once it is ready.
On the data front, US data disappointed again. US retail sales was weaker than expected with total sales declining 0.3% m/m (corresponding to a real decline of 1.3% m/m due to the high inflation). Housing starts dropped 14.4% m/m in May and the Philadelphia Fed business outlook declined to the lowest level in two years. In the euro area, the German ZEW increased to -28 from -34.3 but is still at quite low level. China saw a new small covid outbreak in Beijing but seems to have it under control. Shanghai is going to test the whole city every weekend until end-July in order to catch outbreaks as early as possible and use more targeted lockdowns in order to avoid city-wide lockdowns. Chinese data on industrial production and retail sales showed a small rebound in May and they will likely recover further in June and July due to a re-opening effect and more forceful stimulus.
Looking into next week, we have a fairly light calendar with Flash PMI’s in the US and euro area as well as German ifo business confidence being the most interesting. We look for a further decline due to the strong financial headwinds currently. Fed chairman Jerome Powell will deliver the semi-annual testimony in Congress but we doubt it will provide much news. On the political front EU leaders will meet for a summit on Thursday and Friday to discuss Ukraine’s EU membership application, and economic issues. On Sunday France goes to the polls for the second round in the parliamentary election.