It’s the economy silly

Tuesday’s US inflation report demonstrated why the Fed is reluctant to signal the first interest rate cut. The Consumer Prices index exceeded market expectations for the second month in a row. This news will probably not change the market’s expectation that the first US interest rate cut will come in June, but it does explain the Fed’s hesitation to become too dovish.

In contrast, in the UK today, unemployment has risen to 3.9%, and at the same time, wage growth has slowed, perfect for a central bank. This provides the scenario for the Bank of England to be more open to easing monetary policy. The currency clearly demonstrated this as the dollar rose against the pound. Two-year gilt yields fell modestly; in contrast, the two-year US treasury yield rose, again reflecting fixed income sentiment reaction towards the data points. Stocks overall had a good day, as the S&P 500 rose 1.1%, topping a new record. The ninth straight week had a record close, and the Mag 7 had another good day. Even the much unloved FTSE 100 continued its recent recovery.

It’s noticeable that the recent rise in the FTSE 100 coincided with a stronger pound. Market commentators often quote a weak pound as an excuse for an FTSE rally, as so many companies in the index have international earnings; as a result, any overseas company earnings are inflated when transferred back into pounds. Conversely, a weak currency also hits returns for an overseas investor. That weaker pound-stronger FTSE 100 never seemed to work, as we can see from the index’s performance over the past few years.

US stock market sentiment continues to look stretched on the upside. Apparently, those betting on a benign environment for stocks in the coming months are increasing as speculators are buying products that payoff during periods of low volatility. That can be very painful when it goes wrong as many can testify over the years, as selloffs are quick and hard to react to.

As much as the focus remains on what the inflation data comes in, the question remains whether the Fed will risk a cut whilst the economy looks healthy, no matter what the inflation data says?