Twin Hikes

New data out last week showed business activity across the eurozone took a further dip at the start of the third quarter – but that didn’t stop the European Central Bank from going ahead with a widely expected 25-basis-point rate hike. It was joined by the Fed, which also increased interest rates by a similar magnitude. The US central bank said that it believes it can engineer a soft landing for the economy – a sentiment echoed by the International Monetary Fund (IMF) last week. What’s more, in its latest World Economic Outlook, the IMF raised its 2023 outlook for the global economy while lowering its inflation forecast. Helping matters is fresh data last week showing the US economy, the world’s biggest, growing faster than expected last quarter.

Elsewhere, strategists on Wall Street are being forced to revise their year-end calls for the S&P 500 upward after the strong rally this year caught many of them by surprise. In the FX world, the euro’s so-called nominal effective exchange rate, which compares it to the currencies of the bloc’s trade partners, reached an all-time high last week. Finally, traders have very different attitudes toward two other major currencies: they’re rushing to exit negative bets on the yen while increasing their bearish bets on the dollar to a record high. Find out more in this week’s review.

Macro

The eurozone economy sank into a mild technical recession in June after two consecutive quarters of contraction. And now, according to a closely watched business survey out last week, the block’s downturn deepened even further at the start of the third quarter. The eurozone purchasing managers’ index (PMI), a measure of business activity in the bloc, fell to an eight-month low after a sharper than expected slowdown in services and a steeper decline in manufacturing in July. By dropping to 48.9 in July from 49.9 a month earlier, the composite PMI fell further below the 50 mark that separates contraction from expansion. The services sector remained in growth territory, despite a drop in its PMI reading to a six-month low of 51.1, while the manufacturing sector's decline deepened further, with its reading falling to a 38-month low of 42.7.

Elsewhere, the International Monetary Fund (IMF) raised its 2023 outlook for the world economy last week, asserting that risks have diminished in recent months after the US government successfully avoided a default and authorities managed to prevent a banking crisis in both Europe and North America. According to the IMF’s latest World Economic Outlook, global GDP will expand by 3% in 2023 – 0.2 percentage points higher than the fund predicted three months ago. This comes after a stronger than expected first quarter, yet marks a decline from last year's growth of 3.5% and falls below historical averages (the global economy experienced an average annual growth rate of 3.8% during the two decades prior to the Covid-19 pandemic). The IMF anticipates that growth will continue to be sluggish over the next five years, partially due to subpar improvements in productivity. The fund left its global growth expectation for next year unchanged at 3%.

On the inflation front, the IMF anticipates global price gains will decelerate to 6.8% this year from 8.7% in 2022. That’s a slight decrease from the 7% forecast in April. However, the fund raised its 2024 inflation projection by 0.3 percentage points to 5.2%. It attributes this to the expectation that core prices, which excludes volatile food and energy components, will ease at a slower pace than previously projected. In fact, the fund reckons core inflation will only very gradually return to the longstanding 2% targets most central banks focus on, leading headline inflation to remain above target in 89% of economies with such thresholds next year.

Finally, the IMF also highlighted ongoing risks to financial stability, including higher interest rates, a recovery in China that is slower than anticipated, debt struggles in emerging economies, and trade threats resulting from geoeconomic fragmentation. The latter have been exacerbated by the Russia-Ukraine conflict and rising tensions between China and the US. On the flip side, the fund reckons that the odds of a soft landing in the US – in which inflation comes down but the economy doesn’t enter a recession – have increased after price pressures eased in recent months.

And in case you needed any proof that the world’s biggest economy is showing few signs of a recession, new data out last week showed US GDP increased at a 2.4% annualized rate during the second quarter. That marked a rebound from the 2% expansion recorded in the first quarter, and was well above the 1.8% rate predicted by economists. All in all, it goes to show that in the face of persistent calls for a recession, the US economy is showing surprising resilience despite the Fed’s most aggressive rate-hiking campaign in decades. While forecasters are split on the odds of a recession, a strong labor market, resilient consumer spending, and easing inflation have all fueled hopes that the US will avoid a downturn.

Central banks

After a short pause in June, the Fed resumed interest rate hikes last Wednesday, with the US central bank raising its benchmark federal funds rate by a quarter of a percentage point to a target range of 5.25% to 5.50% – its highest level in 22 years. What’s more, Fed chair Jerome Powell left open the possibility of a further hike at the central bank’s next meeting in September, which he emphasized will depend on incoming data. Traders in the interest rate futures market are currently betting on a roughly 50-50 chance of another interest-rate increase later this year to mark the end of the Fed’s tightening cycle. Lastly, Powell kindled hopes that the Fed could orchestrate a soft landing, highlighting that the central bank's own economists had retracted their prediction of the world's biggest economy entering a recession.

A day later, the European Central Bank (ECB) raised interest rates by a quarter of a percentage point, marking its ninth consecutive hike since July last year. That took the central bank’s deposit rate to 3.75%, matching a record last reached in 2001 when it was trying to boost the value of the newly launched euro. The ECB repeated its warning that inflation was still expected to remain “too high for too long”, and, similar to the Fed, committed to follow a data-dependent approach to future rate decisions. A slim majority of economists polled this month by Bloomberg still predict a 4% peak in the deposit rate, though they’re not convinced policymakers will be able to stick at that level for as long as they want.

Stocks

Despite the year being just over halfway through, the market has already surpassed most end-of-year predictions for the S&P 500 made by Wall Street. This strong rally occurred in spite of the pessimism fueled by recession risks, elevated inflation, and surging interest rates. And now, strategists on Wall Street are being forced to revise their year-end calls for the S&P 500 upward. But make no mistake, the strategists are still bearish, with 18 of the two dozen investment banks covered by Bloomberg’s regular survey expecting the S&P 500 to decline between now and the end of the year.

FX

By some measures, the euro is currently at its most expensive level on record, which could lead to a decline if it starts to negatively impact the eurozone economy and prompts the ECB to adopt a more dovish stance. The euro's nominal effective exchange rate, which is a measure of the value of a currency against a weighted average of several trade partners, reached an all-time high last week. What’s more, the common currency is currently close to its highest level against the yuan in three years, which could potentially reduce the attractiveness of the region's exports to China at a time when the world’s second-biggest economy is stagnating. This matters because Europe sells a considerable amount of products to China, and so any decline in exports would directly impact economic growth in the bloc.

Elsewhere, investors have very different attitudes toward the yen and the dollar. Asset managers reduced their negative bets on the yen by the most in over three years last week, as inflation continues to put pressure on the Bank of Japan to ditch its ultra-loose monetary policy. At the same time, traders are hedging for a stronger yen, as shown by increased demand for call options to buy the currency compared to put options to sell it.

Meanwhile, bearish dollar bets among asset managers increased to a record high last week, fueled by growing speculation that slowing inflation in the US will prompt the Fed to end its 16-month run of rate hikes. Institutional investors – including pension funds, insurers, and mutual funds – increased their net short position on the greenback by 18% to 568,721 contracts, according to data on eight currency pairs from the Commodity Futures Trading Commission.

This week

• Monday: Eurozone GDP (Q2), Japan retail sales (June).
• Tuesday: Japan unemployment rate (June), Reserve Bank of Australia interest rate decision, eurozone unemployment rate (June). Earnings: Caterpillar, Pfizer, AMD, Starbucks, Uber Technologies.
• Wednesday: Earnings: Kraft Heinz, PayPal, Qualcomm, Shopify.
• Thursday: Bank of England interest rate announcement. Earnings: Moderna, Airbnb, Amazon, Apple, Block, Coinbase.
• Friday: US labor market report (June), eurozone retail sales (June).