The Federal Reserve received yet another positive surprise from the October US inflation report. Inflation surprised again to the downside, and financial markets celebrated the likely end of rate hikes by sending stocks and bonds soaring worldwide. The resulting fall in US rates, and the flight away from safe-havens and into risk assets, slammed the dollar, which fell sharply against every other major currency worldwide. Now that disinflationary trends seem to be firmly in place worldwide, the focus should shift to the economy. The key data point will be the flash PMIs of business activity for November, out on Thursday in the Eurozone and Friday in the UK and US (the latter due to the Thanksgiving holiday). The expectations for this index in the UK, and especially in the Eurozone, are quite gloomy. A positive surprise here could ease the pessimism around the European economies and add fuel to the recent rally in the euro and the pound.
Inflation data also surprised to the downside in the UK, providing welcome respite to the Bank of England. While both the headline and core rates remain at very high levels, the disinflationary trend is now clear, most notably in the latter, which fell below 6%. The labour market report numbers generally printed better-than-expected, added to the general cheer in financial markets and partly offsetting some of the bearish connotations surrounding Wednesday’s inflation print. All eyes are now on the advance business activity PMI numbers for November, the timeliest read on the current state of the UK economy. Last month’s PMIs, and Friday’s October retail sales for that matter, were consistent with an economy in recession or, at best, stalling. We probably need to see an improvement there before sterling makes further gains.
We have pointed out before the lagging nature of Eurozone economic statistics, with the notable exception of inflation. Whereas sentiment numbers are timely, hard data comes out with two months delay or longer, so it is hard to see how reliable the former are. Industrial production for September was pretty dismal, down almost 7% on the year on a workdays-adjusted basis. Investors, however, largely overlooked the disappointing data, and the euro actually outperformed most of its major peers, notably sterling. So far, hard numbers are confirming the pessimism emanating from the PMI sentiment numbers, and it appears likely that the Eurozone economy is contracting again. As in the case of sterling, it may be difficult for the euro to rally further absent some clear improvement in the November PMI numbers out on Wednesday.
The good news from the October inflation report caused an immediate 20 basis point drop in 10-year Treasury yields and sparked a flight from the US dollar. Not only did the volatile headline number edge back down to 3.2%, but the core measure has also dropped to 4% for the first time in two years. Markets have already removed any lingering chance of additional hikes from the Federal Reserve, which we see as reasonable, and now expect the first cut in rates to happen in May 2024, a less credible assumption, in our view. In spite of signs of a modest slowdown, the US economy continues to grow at a good clip and the labour market remains at, or very close to, full employment. It will be difficult for the dollar to sell-off much further until that changes meaningfully, particularly should FOMC officials continue to push back on expectations for policy easing any time soon.