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Markets Tiptoe Higher After Yesterday’s Bruising Session

The dollar is trading on a firmer footing and Treasury yields are steadying this morning after risk-sensitive asset classes suffered the worst losses in four months yesterday.

The pound is coming off its lows after the Bank of England held rates steady for a fourth consecutive meeting and the nine-member Monetary Policy Committee split into three different blocs, with two members voting for additional hikes, while one member cast the first vote for a rate cut since the pandemic. The hawks: Jonathan Haskel and Catherine Mann, warned that rising household incomes and tight labour markets could translate into more durable inflation pressures. Swati Dhingra, the lone dove, noted that the lagged impact of prior tightening efforts has yet to hit the economy, meaning policy should be eased now to avoid negative economic consequences. Governor Bailey said “We need to see more evidence that inflation is set to fall all the way to the 2 percent target, and stay there, before we can lower interest rates”.

Odds on a rate cut at the European Central Bank’s March meeting are under pressure after Eurostat reported that core inflation fell more slowly than expected in December. Consumer prices excluding food, energy, alcohol, and tobacco rose 3.3 percent on a year-over-year basis, down from 3.4 percent in the prior month, but above the 3.2 percent expected in markets. When set against firmer-than-expected growth readings and still-nascent wage pressures, we suspect monetary policymakers are unlikely to conclude that disinflationary momentum has grown strong enough to support rate cuts until June – a date flagged by both President Lagarde and Chief Economist Lane in recent comments. The euro is inching higher against the dollar as rate differentials narrow in the common currency’s favour.

The broader rates landscape is still shifting in the aftermath of yesterday’s events. Futures-implied odds on a March rate cut are down to one-in-three – far below December’s near-certain levels – after Federal Reserve officials expressed satisfaction with the disinflation they’re seeing, but said they need to see it continue for longer before beginning to cut rates.

Chair Jerome Powell poured cold water on the idea that the central bank would obey canonical policy rules – like the Taylor Rule – in lowering interest rates at the next meeting. “In theory, real rates go up as inflation comes down,” he said. “But that doesn’t mean we can mechanically adjust policy as inflation comes down. For one thing, we look at more than just the Fed Funds rate – we look broadly at financial conditions. In addition, we don’t know with confidence where the neutral rate of interest is. That also doesn’t mean we wait around until we see the economy turn down. We’re in risk-management mode”.

“I don’t think it’s likely that the committee will reach a level of confidence by the time of the March meeting,” he warned. A March rate cut is “not the most likely case or the base case”.

But markets remain convinced that policy rates will be much lower by year end – and this conviction grew during yesterday’s session – suggesting that problems at New York Community Bank may be undermining belief in the “soft landing” thesis that has undergirded market behaviour for months. If well-known issues in commercial real estate markets become more acute, hurting collateral values and slamming credit creation, the impact on risk appetite could be severe and long-lasting.

Ironically, the mix of underlying forces on display during yesterday’s session is probably good for the Canadian dollar in the short term. Still-robust demand among US consumers should help support Canada’s export industries, delivering more results like those seen in yesterday’s November gross domestic product report. And falling long-term yields could help ease financial conditions, giving the all-important housing sector fuel to grow. Renewed gains could be in the offing, unless risk appetite weakens more profoundly.


Still Ahead

FRIDAY

The US job creation engine probably kept decelerating in an unusually-cold early January, with fewer than 170,000 jobs added – still above population growth, but below the levels reached last year. Downward revisions in the November and December numbers could see the unemployment rate pushing higher to 3.8 percent from 3.7 percent, while putting modest downward pressure on wage growth indicators. (08:30 EDT)

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Higher for (even) longer