It has been our view for some time now that traders were getting ahead of themselves pricing in central bank cuts generally, and particularly so in the case of the Federal Reserve. Last week we saw further vindication of this view, as the strength of US economic data continues to surprise markets, notably the latest retail sales and initial jobless claims figures, and FOMC officials push back against an early start to cuts. The 2024 dollar rally picked up steam, and the greenback rose against every major currency worldwide, as bets on a March Fed cut receded to a year low of 40%.
Economic data will be front and centre this week, together with the ECB’s January meeting on Thursday. Wednesday will see the release of the PMIs of business activity for January in the major economies. These numbers are particularly important in the Eurozone, given the absence of other reliable timely indicators. US PCE inflation for December will be another important reference for markets on Friday, as will the fourth quarter GDP report on Thursday. We think that generally positive data will continue to allow central banks to push back against the notion of early interest rate cuts.
December inflation ran significantly hotter than expected in both the headline and core indices. In particular, annual core inflation stayed above the 5% level. The data suggest that the ‘last mile’ of the inflation fight will be the toughest in the UK, as well as elsewhere, and consequently expectations for Bank of England cuts continue to be pushed back.
A nagging concern for investors remains the rather fragile state of Britain’s economy. Friday’s retail sales report was particularly soft, with sales posting their largest monthly downturn since 2021, i.e. when the pandemic restrictions were still in place. It remains a coin toss as to whether a technical recession will be confirmed for Q4 when the official GDP data will be released in mid-February. If last week’s data is anything to go by, a mild recession appears more likely than not. This week’s PMI data is expected to be far more upbeat and remain well above the level of 50 that denotes expansion, which should support sterling.
Eurozone industrial production data remains bleak, partially attributable to disappointing Chinese growth. Last week’s November report showed an annual contraction of nearly 7%, and the sector is dragging the economy into a technical recession. However, ECB officials have continued to push back against market expectations of aggressive and early cuts in rates, suggesting that inflation is not beaten and that cuts in rates will have to wait until the summer.
This week´s ECB meeting offers the central bank an opportunity to clarify where it stands and what it needs to see in the data before it can start cutting rates. We think that the bank will again strike a rather hawkish tone and say that now is not the time to start thinking about cuts. We could also see a rather more direct message on rates from President Lagarde, who last week said that she didn’t expect the bank to start easing until the summer.
A slew of second-tier data (retail sales, industrial production, housing starts and weekly jobless claims) all came out strong and above economists’ expectations, underlining the continuing strength of the US economy. The labour market, in particular, continues to perform remarkably well, with last week’s jobless claims data not only coming in well below expectations, but also its lowest level since September 2022. Unsurprisingly, rates continue to rise across the curve and the dollar is reversing last year´s sell-off.
This week´s PMI, GDP and PCE inflation data, the Fed’s preferred measure of price growth, will provide further clarity on the state of the US economy. However, this is unlikely to change the Fed´s apparent view that market expectations for rate cuts are still too aggressive. We would expect the FOMC to dampen expectations for cuts at its upcoming meeting next week, which should take a March start to easing almost entirely off the table.