Triple Hold On Rate Hikes

Here are some of the biggest stories from last week:

• The Bank of Japan further relaxed its yield curve control program.
• Eurozone inflation sank to a two-year low in October.
• The bloc’s economy shrank by 0.1% last quarter from the one before.
• The Fed and Bank of England both left interest rates unchanged.
• The sharp rise in Treasury yields over the past three years is a harbinger of a recession.
• The battery metals market is projected to be oversupplied until 2028.

Dig deeper into these stories in this week’s review.

Macro

The Bank of Japan held interest rates steady but took a big step towards ending its seven-year policy of capping long-term yields, setting the stage for bigger policy changes down the road as it sharply raises its inflation outlook. On Tuesday, the BoJ decided to allow the 10-year Japanese government bond yield to exceed 1%, marking the second revision to its yield curve control program in three months. This follows the bank’s prior commitment to purchase 10-year bonds at a fixed 1% rate, up from 0.5% in July. See, the BoJ has been under increasing pressure to end its long-running experiment with ultra-loose monetary policy, especially in the face of a weakening yen, rising bond yields, and above-target inflation. On that last point, the central bank significantly revised its inflation forecast upward on Tuesday, saying it expected 2.8% core inflation in the 2024 fiscal year, instead of its previous forecast of 1.9%.

Over in Europe, new data this week showed inflation sank to a two-year low as the bloc’s economy shrank following an unprecedented increase in interest rates. Consumer prices rose by 2.9% in October from a year ago – a marked deceleration from the 4.3% seen the previous month, and lower than the 3.1% estimated by economists. What’s more, it marked the slowest rate of consumer price gains since July 2021. Core inflation, which excludes energy and food and is closely watched by the European Central Bank as a gauge of underlying price pressures, also fell more than expected to 4.2%, down from 4.5% the previous month.

The easing price pressures come after the ECB’s 10 back-to-back rate hikes, which are bringing inflation down by slowing aggregate demand and, consequently, economic growth. Case in point: the eurozone economy shrank by 0.1% last quarter from the one before, missing estimates for stagnation. Digging into the data showed 0.1% quarterly growth in France, 0.3% in Spain, and 0.5% in Belgium, but that failed to offset a 0.1% quarterly slump in Germany (Europe’s biggest economy), no growth in Italy, and contractions in Austria, Portugal, Ireland, Estonia, and Lithuania.

After 11 hikes since March 2022, the Fed held interest rates steady for a second meeting in a row, leaving the federal funds rate at a 22-year high of 5.25-5.5%. While the central bank left open the possibility of another hike in case its fight against inflation stalls, it acknowledged that the recent sharp rise in Treasury yields reduces the need to raise interest rates again. That suggests that the Fed may be done with its most aggressive monetary tightening cycle in four decades, with traders betting on no further rate hikes after the central bank’s meeting this week. But while they’re betting on rate cuts next year, the Fed made it very clear that it's not even considering such a move yet.

Finally, the Bank of England held interest rates steady for a second consecutive meeting, leaving its benchmark lending rate at a 15-year high of 5.25%. The bank indicated that contemplating rate cuts is premature at this stage, and for good reason: Britain’s inflation rate remains triple the central bank’s 2% target, and is the highest among the Group of Seven nations. However, the BoE also issued a warning that the economy would stagnate over the coming year, raising new doubts about how long it can hold rates at the currently elevated levels.

The BoE’s projections showed that, should rates remain constant, inflation would return to target in early 2025 – at least six months sooner than the timeframe estimated based on market expectations for rate cuts beginning in August. The central bank wasn’t very upbeat about economic growth, with GDP now projected to be flat in 2024, down from the 0.5% expansion previously expected, and to register a paltry 0.25% gain in 2025. The growth estimate for the current year remains at 0.5%, unchanged from August. Additionally, the unemployment rate is predicted to rise at a faster pace, concluding the year at 4.3% instead of the earlier forecast of 4.1%, as businesses enact further job cuts to cope with higher rates.

Bonds

Many investors are puzzled by the resilience of the US economy given the rapid rise in Treasury yields, and for good reason. Historically, when there's been such a swift increase in bond yields, it has often preceded economic downturns. Over the last three years, the 10-year Treasury yield, which serves as a benchmark for the cost of money across the financial system, has surged by over four percentage points. Last month, it briefly crossed above 5% for the first time in 16 years. This kind of escalation is reminiscent of the early 1980s, when efforts to combat inflation led to a similar run-up in Treasury yields and plunged the US into back-to-back recessions.

Monetary policy was more restrictive back then, sure. Adjusted for inflation, the real 10-year Treasury yield stood at approximately 4% as the second downturn began in mid-1981. Currently, it's about 1%, but many investors expect that to go higher as inflation falls and nominal yields rise further. The latter is being driven by two factors. First, the unexpected robustness of the economy, which has increased conviction that the Fed will keep interest rates elevated for a while. Second, the government’s ballooning budget deficit, which has flooded the market with new Treasuries at a time when traditional buyers, such as the Fed and other major central banks, are stepping back from bond acquisitions.

Commodities

Since the beginning of the year, lithium prices have fallen by nearly 70%, nickel prices have dropped by 40%, and cobalt prices remain just above their all-time lows. A significant factor behind the decline in these key battery metals is a surge in supply combined with slowing demand growth for fully electric cars in China, the world’s biggest EV market. Sales doubled in the first nine months of 2022 over the same period the previous year, but that growth rate has slowed to 25% this year. On top of that, consumer electronic sales in China are set for two consecutive years of double-digit percentage declines. Taken altogether, the lithium, nickel, and cobalt markets are projected to be oversupplied until 2028, according to consultancy CRU Group.

The price drops reverse some of the huge gains witnessed in 2021 and 2022, when excessive hype supercharged the battery metals market. And so the return back to earth will come as a big relief to car companies and battery manufacturers that suffered an increase in cell prices last year for the first time in well over a decade. What’s more, the fall in input prices should help reduce the cost of EVs considering that the battery accounts for somewhere between one-fifth and one-third of the price of the car. However, raw material price drops can take months to feed through, depending on the contract terms between miners and customers.

Next week

• Monday: Eurozone sentix economic index (November), China trade balance (October).
• Tuesday: Japan household spending (September). Earnings: Uber Technologies, Rivian Automotive, Gilead Sciences, Occidental Petroleum.
• Wednesday: Eurozone retail sales (September), China loan growth (October). Earnings: Disney.
• Thursday: China inflation (October).
• Friday: UK GDP (Q3).