European stocks advanced Friday but were on track to finish the week with sharp losses, as investors have tried to assess inflation, central banks’ response to it and the outlook for the global economy.
Prospects for repeated rate rises throughout the rest of the year have caused investors to sell out of stocks and bonds and lent to fears that rapid tightening could dampen growth.
“The central banks, who have been our friends for a very long time, are telling us we should expect pain,” said Hani Redha, a portfolio manager at PineBridge Investments. “That inflation number is the only thing that matters right now. Even if we see growth slowing a lot, that will not be enough to cause the Fed to change course.”
Redha said it is possible that inflation could still climb further in the coming months as energy prices remain elevated.
Credit Suisse said interest rate increases by most global central banks are set to continue as inflation remains well above target in major economies.
A further rise in energy prices is likely to contribute to higher inflation in the coming quarters, while new supply constrains stemming from China could create additional price pressures in the goods sector.
“With high inflation set to persist, central banks look all but certain to remain hawkish for the foreseeable future.”
Credit Suisse expects the Federal Reserve to increase rates by another 200 basis points this year to 3.50%-3.75%, and the European Central Bank to raise rates by 150 basis points to 1%.
Inflation is expected to accelerate further in both the eurozone and the U.S. in June due to higher prices for fuel, said Commerzbank.
Inflation in the eurozone is likely to rise to 8.4% in June from 8.1% in May, while the trend in the U.S. looks similar as gasoline prices and rents accelerate. Underlying core inflation should also continue to rise over the medium term, at least in the eurozone, Commerzbank added.
“In this environment, the market is likely to revise its expectations for Fed and ECB key rates further upward. The rise in bond yields is unlikely to be over yet.”
Stock futures advanced, with major indexes likely to extend the whipsaw moves that have injected fresh volatility into markets this week. Thursday’s rout pushed the S&P 500 down to levels not seen since December 2020.
However, signs in the market remain that investors continue to seek safe-haven assets such as the dollar and U.S. government bonds.
Richard Saperstein, chief investment officer of Treasury Partners in New York, said his firm lately has been buying short-term Treasuries in an effort to temporarily park liquidity as rates rise. “At some point in the cycle, we expect to draw this liquidity to take advantage of fixed-income opportunities,” he added.
The BOE’s decision to raise interest rates by another 25 basis points was low compared with other central banks but this doesn’t necessarily put sterling at a disadvantage, said Commerzbank.
A central bank that raises rates slowly need not be perceived as weak if it is certain that it will continue to lift rates, said Commerzbank.
“And because [the BOE] formulated its will to hike further [Thursday] in a marginally more convincing manner, the pound was able to rise correctly.”
The dollar rebounded, as even recent “upsetting” U.S. data couldn’t cheer up the Fed doves in favor of looser monetary policy as they know the central bank won’t do much to support the economy before inflation eases, said Swissquote Bank.
“And unfortunately, inflation won’t soften until energy prices ease significantly.”
Credit Suisse has turned neutral on government bonds, closing its long-standing underweight position, saying inflation dynamics are expected to change, with inflation likely to trend lower for the rest of the year.
Credit Suisse said another reason for the change is that most of the monetary tightening by the Fed should be reflected in market pricing by now, reducing the risk of further hawkish surprises.
The 10-year Italian BTP-German Bund yield spread, which has narrowed on news of the European Central Bank’s planned anti-fragmentation measures, “will struggle to sustain any tightening below 200 basis points, as that’s the level at which the ECB expressed little urgency,” said Citi.
While the ECB is yet to provide details about its plans to prevent bond market fragmentation, the backstop measures should make any renewed spread widening more orderly, Citi said, sticking to the year-end target of 275bps for the yield spread.
Citi said the selloff in German Bunds over the last month has been the highest in at least 30 years and Thursday’s staggering 30 basis point intra-day range for Bunds also broke the 30-year record. It added that the market stress is even more evident in duration than in fragmentation.
“This selloff far exceeds our expectations. We still believe it is an overshoot, but a significant bullish reversal is perhaps only likely later in the year.” Citi’s year-end target for the 10-year Bund yield is 1.3%.
Pictet Wealth Management said whether the ECB will ultimately disclose the criteria defining “fragmentation” and the yield spread levels that justify interventions, remains to be seen.
“In other words, how it distinguishes ‘orderly’ spread movements from ‘disorderly’ ones,” Pictet said, suspecting the ECB will remain vague.
It expects the ECB to announce its new anti-fragmentation tool at the Governing Council’s July 21 meeting.
Oil futures inched higher, as supply issues from OPEC+ continue to keep prices hovering around $120 a barrel.
“For oil traders specifically, outside of the supply and demand issues that are well entrenched in the price, numerous questions about OPEC production commitment need to be resolved,” said SPI Asset Management managing partner Stephen Innes.
With central banks now actively targeting energy-driven inflation in their playbook, the market will need to track how consumers react to the prospect of more rate hikes, Innes said.
Gold futures edged up despite the strengthening dollar. Tina Teng of CMC Markets said while risk-off sentiment prevails across markets, safe-haven assets such as bullion will benefit.
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Base metals were mixed in early London trade as macroeconomic worries continued to compound sentiment for industrial goods.
Three-month copper was down 0.2%, approaching its second lowest level this year but aluminum edged up although it was down 4.2% for the week.
“The Western focus looks to be more on the overall weak macro,” said Marex’s Asian Metals team. It added that “with prices falling, smelters are starting to look to go into maintenance.”
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