With investor confusion rife, it’s been a rocky few days for financial markets: Erratic equities moves, wild corrections in bond markets and the EUR/USD exchange rate dropping to below 1. The question now is whether central banks can remove some of the many uncertainties and curb market volatility in the coming weeks.
The sharp swings in (particularly European) equity markets and the euro’s stuttering performance against the dollar could be a reaction to the perceived increased likelihood of recession in the eurozone over the energy crisis. Meanwhile, the significant rise in long-term bond yields seems to contradict a poor short-term economic outlook.
Poor business surveys
The flash purchasing managers’ indices for the eurozone and the US released on 23 August disappointed, especially in the services sector. The US marker fell to its lowest since May 2020, at 44.1 down sharply from 47.3 in July.
The drop in the eurozone PMI was less severe due to manufacturing activity holding up better than expected (figures in green, Exhibit 1). Composite PMIs (manufacturing and services) fell in France, Germany and for the eurozone as a whole and now stand at below 50, pointing to a contracting economy.
In the last few days (23, 24 August), despite the poor PMIs, bond yields have risen to levels not seen since the end of June – with the US 10-year T-note yield reaching 3.1% and the yield on the German 10-year Bund 1.37%.
These moves largely undid the fall in yields between 14 June and 1 August, which came in the wake of disappointing PMIs for July. Understandably, the opposite market reactions to equally poor numbers is confusing investors.
Mixed messages from surveys
Recent national business surveys have surprised to the upside. The French business climate appears to be stabilising at above its long-term average (despite the figure for manufacturing weakening).
There was a smaller-than-expected decline in Germany’s Ifo index. However, at 80.3 in August, the index of companies’ expectations is at its lowest since April 2020 due, in particular, to higher production costs. The Ifo Institute highlighted that ‘uncertainty among companies remains high’ and concluded that ‘the German economy as a whole is expected to shrink in Q3’.
For the eurozone as a whole, the modest rebound in consumer confidence in August from its all-time low in July left the index still slightly below the low reached during lockdown in 2020.
The EUR/USD exchange rate fell to below parity on 22 August, continuing a downward trend that seems likely to last some time, unlike the one-off move in mid-July.
Risks to eurozone growth, investor positioning in the currency and questions about the ECB’s monetary policy all suggest that the euro could continue to depreciate.
Gas prices threaten European growth
The continued rise in the price of natural gas poses a risk to growth in Europe. While the build-up of gas stocks ahead of winter has been quicker than planned, many uncertainties remain including:
- How severe will the weather be this winter?
- What is the likelihood that Russia imposes a complete cut-off of gas supplies? What is the impact of announced pipeline maintenance?
- What is the availability of substitute products after recent heatwaves reduced production?
Europe’s benchmark gas price at the Dutch TTF hub rose to above EUR 300/MWh on 25 August. That threshold had not been crossed since early March following the invasion of Ukraine.
At the same time, after a virtually uninterrupted decline since early June, oil prices bounced back this week after the Saudi energy minister hinted at a possible cut in production by OPEC and its partners.
Inflation back to the forefront?
Recent moves in energy commodity prices have been accompanied by a slight rise in inflation expectations as reflected in the 5-year/5-year inflation swap rate.
This may not bad news for central banks. This might be preferable to the ‘pivot’ scenario that had dominated markets in July. Talk of recession capping inflation had led to a rise in equities as well as an easing of bond yields and financial conditions since mid-June.
We believe central banks will to continue prioritising their inflation targets. They do not really have a choice. For most, this is their one and only mandate. While the US Federal Reserve has a ‘dual mandate’ (‘to foster economic conditions that achieve both stable prices and maximum sustainable employment’), we believe that right now, it clearly considers the main risk to be high – and seemingly entrenched – inflation. We expect it to act accordingly.
Convincing investors – not only by words but also by action in the coming monetary policy meetings – appears to be the only way that central banks can clear the fog that is making judgment calls complex and limiting the effectiveness of the rise in key rates.
Adjusting our bond exposure
The sharp rise in bond yields in the US and the eurozone has prompted us to make another adjustment to our short positioning in considering valuations and profit-taking.
We have tactically raised (especially European) duration in a move symmetrical to the one we decided upon at the start of August.
Extreme market volatility offers opportunities that we want to take advantage of. However, our fundamental analysis has not changed and argues for remaining strategically short.
We are convinced that central banks will raise their key rates to beyond what the markets currently expect. At the very least, they will hold rates at the higher terminal level for longer than expected before considering a policy pivot in the face of slowing activity.