Daily Comment (February 2, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Our Comment begins with the latest Federal Open Market Committee meeting, including the decision to raise rates. Next, we cover the rate decisions of the European Central Bank and the Bank of England. Finally, we discuss Germany’s recent moves to position itself for a greener world.

Not Convinced: Fed Chair Jerome Powell insisted that the Fed will hold rates in the restrictive territory, but the market isn’t buying it.

  • The Federal Reserve raised its benchmark interest rate by 25 bps to 4.50%-4.75%, as expected. The increase was a downshift from the previous meeting and has led to speculation that the Fed is close to ending its hiking cycle. After announcing the rate hike, Powell emphasized that the central bank plans to hike more throughout the year. He argued that core services, which exclude shelter prices, and employment remain elevated and may lead to a wage-price spiral if left unchecked. He also opined that the economy is strong enough to withstand additional rate hikes.
  • Equity prices surged, and bonds rallied as investors posited that the next rate hike would probably be the last. The S&P 500 rose to an intraday high of 1.8%. Meanwhile, the NASDAQ, which tracks tech stocks, closed 2% higher than the previous day. However, the bigger news came from bonds. The yield on 10-year Treasuries dropped by 12 bps which suggests that bond traders are confident that the Fed will reverse course if inflation heats back up. The latest FedWatch tools show that 30-day fed funds futures predict another 25 bps hike in March with a 66% chance that there won’t be an increase in rates above 4.75-5.00% at the following meeting.
  • The last few cycles have shown that the Fed typically uses steps when it raises rates but takes the elevator down when cutting them. Thus, Thursday’s market reaction likely reflects investors’ hopes of a Fed pivot sometime this year. If the market is correct, we could see equities flourish. However, if it is wrong and the Fed decides to hike rates, equities may stagnate or drop. The direction of inflation will likely determine where the market will go. If inflation continues to climb, the Fed could pause or possibly cut in time to prevent a significant downturn.

Not Far Behind: The European Central Bank and the Bank of England had bigger hikes than the Fed; however, neither is committed to raising rates in a downturn.

  • The European Central Bank and the Bank of England both pushed up their respective policy by half a percentage point. The markets anticipated the moves as central bank officials had been hinting at the change for several weeks. Although the ECB maintained that it would stay the course of its policy, it signaled along with the BOE that future rate hikes will depend on economic data. The varying responses from these central banks highlight the pressures policymakers are under to consider the economy as they look to tame inflation.
  • The EUR and the GBP were sold off as investors questioned the ECB and BOE’s commitment to fighting inflation. The markets’ reactions suggest that investors believe that the central banks could end their hiking cycle as their respective economies head into recession. The spread between 10-year government bonds for Italy and Germany, a gauge of European financial stress, narrowed as borrowing costs are less likely to rise for distressed European economies. Therefore, lending conditions could improve in the Eurozone.
  • The market likely interpreted the BOE and ECB as being more dovish than they actually were. Policymakers are likely to continue pushing rates higher as long as the economy remains relatively strong. Although a recession is widely expected in both regions, stronger-than-expected GDP growth in Q4 2022 indicates that it is likely further in the future than originally thought. As a result, central bank policy may begin to tighten as these policymakers look to maintain credibility. That said, the recent comments from these banks suggest that they are not fully committed to remaining hawkish, which means that global financial conditions will likely ease throughout the year.

The German Problem: As Berlin positions its country to adapt to a new normal, it is resisting a major change in the status quo of Europe.

  • Chancellor Olaf Scholz racked up two wins in his race to refocus the German economy toward semiconductors. Apple (AAPL, $145.43) announced plans to invest $1.2 billion in Germany to set up a new European silicon design center and improve research and development. The new investment will help build out the country’s 5G capabilities and enhance its wireless technologies. Additionally, American manufacturer Wolfspeed, Inc (WOLF, $83.01) agreed to produce chips for electric vehicles in Saarland. The two investments show that Germany aims to support the country’s technological shift away from traditional manufacturing and toward greener technologies.
  • Despite attempts to improve its own industry, Germany has set up hurdles for other European countries to make the same transition. The European Union is expected to miss its March deadline for reforms to the Stability and Growth Pact. The changes would allow countries to offer subsidies to compete with the U.S. Inflation Reduction Act. Without these changes to the debt limit rules within the pact, countries will have to make painful budgetary adjustments if they want to offer energy incentives for green projects. Germany insists that any changes to the rules should not impact governments’ efforts to reduce debt loads. As a result, Europe’s Green Deal Industrial Plan will likely be put on hold as officials argue out the details.
  • Germany will always support and put its own interests first, even at the expense of its European allies. As we have mentioned in previous reports, Berlin does not want to fully align its interests with the West since it depends on commodity imports from Russia and trade with China. Germany’s reluctance is also related to wanting a head start on its European counterparts. Thus, it will also likely use the additional time to position itself as a premier European hub for energy manufacturing.

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