Inflation in the US last month came in at 7.5% year-on-year (YoY), topping the ~40-year high of 7.0% recorded for the month of December. Core inflation also made new highs, coming in at 6.0%, compared to 5.5% in the prior month. The momentum in price increases i.e., month-on-month (MoM) change in both headline and core CPI, remained steady even with the pickup in Covid-19 cases due to the Omicron variant in the US. Both CPI and core CPI rose by 0.6% MoM, same as that in December.
The underlying drivers of inflation were broad based and spanned both goods and services. There were indications that goods inflation broadened out beyond the initial drivers like new and used cars – goods excluding food and energy rose by 1.0% MoM (1.2% in December), even though MoM price increases for both new and used cars decelerated. The impact of the Omicron wave was felt but only in hotels and airfares, which could see some rebound in the upcoming spring and summer season.
Overall, the January CPI report presented evidence that the inflation trajectory could be less benign for the whole of 2022 and crucially significantly different from the Fed’s previous assumptions, which could drive a shift to an even more hawkish stance at the next FOMC meeting in March.
Pricing in the rates market indicates that the market now sees the probability of the Fed hiking by 50bps in the upcoming March FOMC meeting as fairly high.
We believe that the Fed will update its inflation assumptions following the latest report and will adopt a more hawkish stance in response. We have thus revised our forecasts for rates across the tenors upwards, most notably increasing our 12-month forecast for the 10-year US Treasury yield from 1.90% to 2.35%. We also expect five hikes in total this year, where the fed funds rate will increase by 25bps in March, May, June, September and December.
Against a backdrop of inflationary pressures, increasingly hawkish Fed policies and geopolitical risks relating to Russia and Ukraine, investors are increasingly concerned about what the flattening of the yield curve is signaling.
While these uncertainties could result in near-term economic headwinds and further market volatility, we do not see an impending inversion of the yield curve or a recession, especially if we consider that quantitative tightening by the Fed is expected to keep yields at longer end of the curve supported.
The move in long-end rates will, at the margin, challenge risk asset valuations, especially for long duration assets like early-stage high growth technology stocks. Investors should be watchful of their net exposures to these sectors in their portfolios, as we expect the volatility to continue until longer end rates find a footing.
The Fed is not alone in its hawkish pivot, as the changes in stance by the European Central Bank (ECB) during its policy announcement in February also signalled a significant change in policy direction.
Our chief economist now expects the ECB to announce the end of its quantitative easing this year, setting the stage for the ECB to increase interest rates in December this year.
As a result of the ECB’s hawkish stance, the 10-year German bund yield has moved into positive territory for the first time since the pandemic, and our macroeconomic team has also turned more positive in our forecast for the EUR.
The continued pressures on periphery bond spreads and the threat of the Russian-Ukraine conflict are however mitigants from an outright EUR-positive story. Nonetheless, we believe that investors will need to consider switching out of EUR as a funding currency.
In our asset allocation strategy, we continue to prefer Asia ex-Japan equities, underpinned by increasingly positive risk-reward in the Chinese equity markets.
The January total social financing data in China is encouraging. Total social financing grew by 10.5% in January, with most the increases coming from an increase in government bond issuance and an uptick in corporate bond issuance and medium-to-long term loans. Government bond issuance points to a continuing push on infrastructure spending by policymakers to fill the gap in investment activity from the slowdown in the real estate sector.
In addition to the rate cuts, Chinese policy makers are also easing financial conditions via a number of administrative changes. Regulators have announced that they plan to expand the “registration-based” IPO system used in China’s smaller venture board to the mainboard this year. This is expected to give more freedom to issuers and promote much needed equity financing for companies in China, freeing up resources for the credit crunch in the corporate sector.
For the important real estate sector, we continue to see a gradual unwinding of the restrictive policies. Last week, the People’s Bank of China and China Banking and Insurance Regulatory Commission announced that affordable rental housing loans will be excluded from banks’ real estate loan concentration management limits.
These represent a continuation of the government’s piecemeal approach to adjust its regulation of the sector that will take some time to play out and take effect.
As China broadly enters a new expansionary credit cycle, we believe that this will, over the medium term, begin to reverse the slowdown in the Chinese economy and will prove to be beneficial for the outlook for Chinese risk assets.Disclaimer applicable to recommendation
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