The Fed Calls A Timeout

In an epic tale of three central banks, the People's Bank of China, Fed, and European Central Bank all took different interest rate decisions last week, with one cutting, one pausing, and one hiking borrowing costs. The Fed’s decision to pause was supported by data out last week that showed US inflation slowed more than expected in May to hit its lowest level in more than two years. The UK also got some good news last week, with new data showing the British economy returned to growth in April. Elsewhere, implied stock market volatility has fallen to pre-pandemic levels, potentially signaling that investors have become too complacent and are starting to ignore downside risks. Implied bond market volatility, after all, is flirting with levels typically associated with crises. That might not come as such a surprise when you consider the growing strains within the fixed income market. And in case you need clearer evidence of this, then look no further than the $1.4 trillion US junk loan market, which has seen a surge in defaults this year, according to a new analysis out last week. Find out more in this week’s review.

Macro

Last week, China’s central bank cut the seven-day reverse repo rate and its one-year loan rate by 10 basis points each to 1.9% and 2.65% respectively, marking the first rate cuts since August 2022. The moves caught many market participants off guard, and indicate that officials are growing more worried about sluggish economic growth and are intensifying their efforts to stimulate the recovery as a result. After all, recent economic indicators showed inflation remained near zero in May, manufacturing activity contracted, and an early rebound in the property market has petered out. That’s fueling speculation that the central bank will have to cut interest rates even more this year.

But while rate cuts may help sentiment in the short term, economists say more needs to be done to boost confidence for businesses to invest. Corporate China’s reluctance to invest is most evident by looking at borrowing demand, which remains very weak. All in all, that’s why many China watchers expect the government to eventually announce a broad package of stimulus measures to support areas such as real estate and domestic demand.

Over in the UK, new data out last week showed the British economy returned to growth in April as strong consumer spending offset a slowdown in construction and manufacturing. Gross domestic product (GDP) rose 0.2% after a 0.3% decline in March, when heavy rains and strikes kept consumers at home. The expansion, which was in line with expectations, left the economy 0.3% bigger than before the coronavirus hit in 2020. But while the positive start to the second quarter reduces the risk of recession (for now), traders are betting that the Bank of England will have to keep raising interest rates through the summer to tame inflation that’s running at more than four times the 2% target. And those higher rates only raise the prospect of an economic downturn later in the year.

However, not everyone is convinced by the prospect of an imminent downturn. In fact, the GDP figures come just a few days after Britain’s two biggest business lobby groups both said they see the UK economy expanding slightly this year, backtracking on their previous predictions for a recession. That comes after falling energy prices and stronger-than-expected spending helped to support growth in the first half of 2023. The Confederation of British Industry is now forecasting GDP growth of 0.4% over 2023 and 1.8% in 2024. Those figures are up from previous predictions for a 0.4% contraction this year and 1.6% growth next.

The British Chambers of Commerce, meanwhile, also upgraded its forecasts, saying the UK would avoid a recession with growth of 0.3% this year instead of its earlier estimate for a contraction of that size. But despite the better-than-expected performance so far this year, Britain is still lagging behind its major peers, with its economy not expected to return to 2019 levels until mid-2024.

Across the pond, new data out last week showed US inflation slowed more than expected in May to hit its lowest level in more than two years. Consumer prices were 4% higher in May compared to the same time last year – a step down from the 4.9% jump registered in April and marking the lowest increase since March 2021. Economists were expecting May’s inflation rate to come in at 4.1%. Meanwhile, core consumer prices, which strip out volatile items like food and energy, increased by 5.3% last month from a year ago – slightly above economist estimates for a 5.2% gain but a step down from April’s 5.5%. On a month-on-month basis, headline and core inflation came in at 0.1% and 0.4% respectively – both in line with forecasts.

The better-than-expected inflation data supported the case for Fed officials to pause their run of aggressive interest-rate hikes, and that’s exactly what they did at their most recent meeting. The Fed decided to pause its rate-hiking campaign last week following 10 consecutive increases since March 2022, but signaled that it would likely resume tightening at some point to cool inflation. According to the updated “dot plot” published on Wednesday, most policymakers are projecting two additional quarter-point increases this year in a move that would lift the federal funds rate to a range of 5.5% to 5.75%. Most officials forecast that the federal funds rate will decline to 4.6% in 2024 and 3.4% in 2025, both above their respective March estimates, suggesting that the Fed intends to keep monetary policy tighter for longer in an effort to tame inflation once and for all.

Finally, to complete a heavy week of interest rate announcements, the European Central Bank (ECB) went ahead with a widely expected 25-basis-point hike last Thursday, taking its main deposit rate to 3.5% – its highest level since 2001. And unlike the Fed, the ECB signaled that it’s not thinking about pausing, instead strongly hinting at another hike in July. It also confirmed that it would stop reinvesting the proceeds of its asset purchase programme from July – a move expected to help shrink its balance sheet by €25 billion a month. Finally, in fresh quarterly projections, the central bank slightly raised its inflation forecast and marginally trimmed its growth prediction for the next three years.

Stocks

The VIX – a volatility index popularly known as Wall Street’s “fear gauge” – measures the options-implied volatility of the S&P 500 over the next 30 days, and is used to assess the level of anxiety in the market. A low reading indicates tranquil markets, whereas a high one indicates investor panic. And last week, the VIX fell to 13.5 – its lowest level since January 2020, shortly before the pandemic shut economies all over the world and spooked global financial markets.

A VIX reading this low is usually an indicator of extreme calm, and often coincides with rising stock prices. Powered by a handful of tech stocks, the S&P 500 returned to bull market territory earlier this month after surging more than 20% from its October low. And the last time the stock index experienced a one-day drop of more than 1% was on February 3. But a very low VIX, in and of itself, can serve as a warning sign too: it’s what happens when investors become too complacent and start to ignore downside risks. And there’s definitely no shortage of risks these days, from the future direction of interest rates and inflation, to falling economic growth and escalating strains within the banking system.

Bonds

Bond markets, in comparison, are relatively turbulent. The Intercontinental Exchange’s MOVE Index of implied volatility, which is to bonds what the VIX is to stocks, is flirting with levels typically associated with crises. The index has come down from the highs it hit in March following the collapse of Silicon Valley Bank, sure, but it remains 60% above its 10-year average. So if you believe the old Wall Street saying that the bond market is smarter than the stock market, you might want to exercise some caution right now as there could be volatile days ahead.

In case you needed clearer evidence of this growing fixed-income volatility, then look no further than the $1.4 trillion US junk loan market, which has seen a surge in defaults this year. That comes as sharply higher interest rates intensify the strain on risky companies that loaded up on leveraged loans – debt with floating borrowing costs that move with prevailing interest rates – when the Fed slashed rates close to zero at the peak of the Covid crisis. The Fed has raised rates by five percentage points since then, leaving borrowers with much higher interest rates just as slowing economic growth squeezes earnings.

All in all, there were 18 debt defaults in the US junk loan market between the start of the year and the end of May totaling $21 billion – greater in number and total value than for the whole of 2021 and 2022 combined, according to a Goldman Sachs analysis out last week. May alone saw three defaults totaling $7.8 billion – the highest monthly dollar amount since the depths of the Covid crisis three years ago. Things aren’t looking up either, with bank analysts and rating agencies expecting defaults to rise further as interest rates stay higher for longer and economic growth creeps down.

This week

• Monday: Chinese central bank one-year loan prime rate announcement.
• Tuesday: US housing starts (May). Earnings: FedEx.
• Wednesday: UK inflation (May), Canadian retail sales (April).
• Thursday: Bank of England interest rate announcement, US existing home sales (May). Earnings: Accenture.
• Friday: UK retail sales (May), Japanese inflation (May), eurozone, UK, and US PMIs (June).