Last week, the 10-year US treasury yield rose to levels not seen since last November. The catalyst was the higher-than-expected US Consumer Price Index (CPI) print several weeks ago, which caused markets to change their collective mind about Federal Reserve policy this year.
That view was reinforced by last week’s retail sales report, which rose well above expectations, as well as hawkish Fed speak from a cast of Federal Open Market Committee members.
Meanwhile, prices for West Texas Intermediate crude oil fell last week from recent highs despite tensions in the Middle East.
First of all, US oil production has been a game changer in terms of softening the impact of Middle East geopolitical risks on the price of oil. According to the US Energy Information Administration, the United States has been the largest producer of crude oil since 2018. Its 2023 production of 12.9 million barrels per day was far higher than the second-largest oil producer, Russia, at 10.1 million barrels per day, and Saudi Arabia at 9.7 million barrels per day.
In addition, while Middle East tensions are high, they are not as high as many feared.
Also, the new conventional wisdom that rates will be higher for longer is expected to cause some level of demand destruction, which I believe has exerted some downside pressure on oil prices as well.
Rapid disinflation in the UK
The most recent CPI print in the United Kingdom supported the thesis that UK inflation will remain sticky. Services inflation eased, but not as much as market watchers would have liked. In addition, UK wage growth has also slowed less than expected. This caused markets to change their collective mind on when the first Bank of England rate cut will occur.
I, however, hold out hope for a rate cut before the end of the second quarter. The significant increase in unemployment in the UK from 3.9% in January to 4.2% in February helps make the case for easing sooner rather than later, in my opinion.
In the eurozone, year-over-year inflation for March was 2.4%, down from 2.6% in February and 2.8% in January. This is impressive progress considering that a year ago, the inflation rate was 6.9% year-over-year.
Core inflation, excluding food and energy, was also unrevised at 2.9% year-over-year for March – and, excluding tobacco as well, was 2.6%. In my view, this trend virtually ensures that the European Central Bank will enact a rate cut at its June meeting.
US consumer headwinds
A substantial amount of data supports the view that the US economy is quite strong. This is reflected in high yield spreads, which have actually tightened in the last several months. They are well below the 30-year average spread of 4.93% – and far below the 7.5% level that has historically coincided with recessions.
However, some data suggests consumers – at least lower-income households – are starting to experience some headwinds. For example, US credit card delinquencies in the fourth quarter reached their highest levels since the Philadelphia Fed started tracking such data in 2012. Some credit-card-issuing banks are more exposed to rising delinquency rates than others.
Any significant rise in unemployment could have a corresponding impact on lower-income households, especially given the low level of savings they have – which means they lack a buffer against economic headwinds if they increase. This is not my base case, but we need to resist complacency in our views.
It’s also worth noting that China’s gross domestic product print for the first quarter positively surprised, coming in above expectations. This suggests targeted fiscal stimulus is improving confidence and having a beneficial impact on the economy.
Meanwhile, Canada’s federal budget for 2024 was released last week. While there are some interesting proposals that could boost economic growth and help increase household financial stability, it also raises concerns about government debt and the high cost to service that debt.
Asset class implications
Risk assets are clearly under pressure and likely will continue to be with higher yields. However, I believe this too will pass.
I still believe a Fed rate cut in June and a total of three rate cuts for the year are very real possibilities. But markets likely won’t change their minds – and therefore pressure likely won’t come off risk assets – until there is significant data that shows more disinflationary progress and a “less hot” economy.
There is reason for optimism once we get more evidence of the US disinflationary trend. I think the pullback we have experienced is healthy, and it renders valuations on risk assets more attractive. And there is still significant cash on the sidelines that could move into markets.
Kristina Hooper is chief global market strategist at Invesco.
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