Last week brought some relief on the inflation front on both sides of the Atlantic. In Europe, energy prices fell more than expected in December. In the US, wage increases appeared to moderate. In response, interest rates fell, and risk assets started the year on the right foot, rallying across the board. G10 currencies were mixed, but emerging market ones took their cue from investor’s optimism and rallied hard, led by Asian and Latin American ones. The Thai baht topped the charts last week, as its tourism sector is expected to be a strong beneficiary of the end of zero-COVID policies in China. Attention this week turns to the all-important CPI inflation report in the US, out on Thursday. Market optimism that the peak of inflation is behind us leaves little room for error here. Strategists and economists are mostly revising upwards their forecasts for the euro on the back of a sense that the impact of the energy crisis will be less than expected and that any recession there will be short and shallow – which has been our view throughout. UK monthly GDP figures for November and a slate of major central bank speakers, led by Fed chair Powell on Tuesday, will round out the week’s events.
Sterling had an unremarkable start of the year, but still managed to put in a decent performance near the top of the G10 performance rankings. The pound is now viewed as a risk asset and was buoyed modestly by strong markets. This week, the November GDP data stands out as we look for confirmation that the UK is in a mild recession. Consensus expectations are for a 0.3% shrinkage in economic output, but these economist forecasts have tended to be overly pessimistic in the past few months. Sentiment around the UK economy is quite bearish, and a positive surprise here could lead to a significant sterling rally, in our view.
Sentiment surrounding the Eurozone economy has improved remarkably over the past few weeks, on the back of a mild winter, lower energy prices and what looks to be a meaningful improvement in headline inflation. We caution against reading too much into last week’s inflation surprise. It was caused by direct state intervention on electricity prices, particularly in Germany and Spain, rather than a meaningful rebalancing between supply and demand. The more persistent core inflation number continues to increase and there is no sign that it has reached a peak yet. ECB officials seem to agree with us, and the tone of their communications is much more hawkish than is suggested by current market pricing of future rate increases. We maintain a positive view of the common currency based on our expectations of higher terminal rates from the ECB.
The US labour market report for December must have been pleasing to the Federal Reserve, as it was neither too hot nor too cold. Jobs continue to be created at a steady though moderating pace, and while unemployment remained near its lows, wage increases seemed to cool. Overall, the numbers are consistent with moderating inflation as well as a growing economy. In other words, a soft landing. The signs that inflation may have peaked for the short-term are more convincing in the US than in Europe, but the Fed shares the ECB’s healthy scepticism and commentary from FOMC officials remains hawkish. The dollar seems unsure of where to go, weighed down by optimism on inflation but supported by the tone of the Fed’s communications. The upcoming inflation report should provide some clarity.