After a positive start to the year in January, the month of February jolted financial market participants out of complacency as macroeconomic concerns made a comeback. Investors had to make a quick adjustment from expectations of a ‘soft-landing or no-landing’ scenario to a potential ‘hard landing’ scenario and the retreat was most pronounced in the best performing areas of January. In a classic case of ‘good news is bad news’, the stronger-than-expected economic data put together with hotter-than-expected inflation measures renewed investors concerns that expectations of policy rate pivot might be premature. The apathy towards the hawkish message from the US Federal Reserve Chair, Jerome Powell, soon disappeared as jobs and inflation data corroborated the earlier message that the Central Bank’s work is far from over.
The headline inflation number in the US was at +6.4%, though down from +6.5%, but higher than expected +6.2%. The Fed’s preferred measure of inflation indicated by the US Personal Consumption Expenditure Price Index also jumped to +5.4% against the expected and prior number of +5.0%. This, along with better-than-expected retail sales of +3.0% month-over-month against the expected +2.0%, and lower-than-expected jobless claims at ~192k against the expected ~200k, provided support to the notion that consumer demand is still healthy, and the job market remains too strong. In Canada, however, the headline inflation number reported during the month tracked better and fell to +5.9% from +6.3%.
Taking note of the recent data and continued hawkish message from the US Central bank authorities, the equity and fixed income markets retreated after investors discounted the possibility of more rate hikes and higher interest rates for longer. This was evident from the probability of interest rates (implied by the Fed Funds Futures data) by the end of this year in the range of 5.25%-5.50% increased to ~38.5% as of the end of February from almost negligible as at the end of January (See Figure 1). The bond yields jumped by ~40-to-60 basis points in the US and ~40-to-48 basis in Canada across the 2-yr to 10-yr tenures.
Figure 1: Target rate probabilities for December 2023
The higher the interest rates and longer they stay at the level, the more strain there is on economic activity, ultimately leading to an economic recession. Given that the monetary policy tightening works with long and variable lag, the case for recent strength in economic data to dissipate can be made, in our view. A few leading indicators (e.g., Consumer Confidence and The Institute for Supply Management's Purchasing Managers’ Index) are already signalling a contraction ahead. We believe the softening of economic data coupled with receding inflation could prove to be a tailwind for risk assets. Nevertheless, the pace of change of narrative from January to February underscores our belief that the path ahead is likely to stay bumpy for some time and therefore we advocate staying selective in risk asset exposures.