Thu, Mar 30, 2023 @ 07:15 GMT
HomeContributorsFundamental AnalysisHigher Yields Weigh on Equity Valuations as Inflation Heats Up

Higher Yields Weigh on Equity Valuations as Inflation Heats Up

Europe is not having a good week in terms of economic news.

Today, investors will be focused on the flash CPI estimate for February, but there is not much suspense about the fact that the data will disappoint. On Tuesday, the data showed that French inflation hit a record, Spanish inflation ticked higher as well, and yesterday, it was Germans’ turn to announce the bad results. Inflation in Germany ticked higher to 9.3% last month, even after the country limited household heating costs. Therefore, it’s very likely that the Eurozone CPI, due this morning, is not going to hit the 8.2% mark expected by analysts.

The euro depreciation is to blame.

But the pricing in European markets already reflect, at least, a good part of the inflation disappointment: the European Central Bank’s (ECB) peak rate is expected to reach 4% into next year, and some ECB members now back the idea of a more rapid reversal in bond buying to tighten the financial conditions faster. Bundesbank Nagel is one of them. He also thinks that the ECB should speed up the rate hikes and reach the peak rate around September.

As a result, the hotter-than-expected inflation data pushes the European yields higher. The higher yields support recovery in the euro. The EURUSD spiked to 1.0690 yesterday, while the European stocks fell after the German CPI figures and the disappointing PMI data flashed the bulls out of the market.

Note that today’s inflation data may not make things worse; we could even see ‘buy the rumour sell the fact’ type of move, where the yields soften, the euro gives back some strength and equities rebound.

But the medium-term outlook for the European yields remains tilted to the upside. The latter should support the euro, but not the stock valuations.

The grass is not greener elsewhere

Across the Atlantic Channel, the news is not great, either. The ISM manufacturing index revealed a slower contraction in February, but the improvement compared to the last month was less than expected.

A slowing economic growth is not bad news for the Federal Reserve (Fed), but the mounting price pressure is. This is what the ISM report revealed yesterday.

Fed’s Neel Kashkari, who was once one of the most dovish Fed members, said that he may back a 50bp at this month’s FOMC meeting, while Raphael Bostic said that the Fed should hike the rates to 5-5.25% territory, and keep them there until next year.

Activity on Fed funds futures now gives more than 30% chance for a 50bp hike at the next meeting, and Fed swaps price in a peak Fed rate of around 5.5%. This number was around 4.9% at the start of the year.

Consequently, the US 2-year yield continues its steady climb toward to 5% mark, and the 10-year spiked above the 4% psychological level yesterday.

The S&P500 tested the critical 200-DMA to the downside. There is major speculation about an aggressive selloff below this 200-DMA level. And given the persistent positive pressure on the yields, clearing the 200-DMA support is not a matter of if, but a matter of when.

The higher yields are supportive of the US dollar. The dollar index swings up and down, above the minor 23.6% Fibonacci retracement on the September to February retreat.

If the dollar’s reaction to the hawkish Fed expectations is not more aggressive, it’s certainly because other major central banks are also gearing up the rate talk. The Bank of Japan’s 8BoJ) Ueda said he would consider normalizing policy if inflation remained sticky in Japan, while the Bank of England’s (BoE) Bailey warned that if they do ‘too little with interest rates now’, they will ‘have to do more later on.’ Sure thing. The latest BRC report showed that shop prices in the UK indeed hit a record. But traders are not necessarily in to keeping the pair above the 1.20 level. The next natural target for the Cable bears stands at 1.1920, near the 200-DMA, and if cleared could pave the way for a further slide to 1.1650/1.17 region.

In energy and commodities, US crude jumped more than 1% yesterday as the EIA data was much less scary than the API data released a day before. While the API hinted at around a 6-mio-barrel build in US inventories last week, the EIA printed a 1.2-mio-barrel build.

But the 50-DMA is still not cleared, and even if it did, offers into the 100-DMA, slightly below the $80pb level, still look particularly strong.

As a result, the energy stocks were the worst performing in February, despite their record profits. There are worries that the Chinese reopening may not be enough to push prices higher… after all, and latest news suggest that Western companies are racing to quit the country, as tense geopolitical relations with China, and Xi Jinping’s economic and political agenda don’t inspire confidence.

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