May 2023 Monthly

 | May 01, 2023 01:25AM ET

May will feature likely rate hikes by the Federal Reserve, the European Central Bank, and the Bank of England. The banking stress that erupted in March appears contained, though one regional bank's dramatic loss of deposits saw it rekindle at the end of April. What makes the May rate hikes important is that the derivatives markets are confident (again) this is the last hike for the Fed. The swaps market anticipates two more hikes from the BOE and the ECB. Headline CPI in the UK has been above 10% for seven consecutive months through March. The ECB, which was slower than the others to initiate the tightening cycle, is understood not to be quite finished either.

Before the bank stress emerged, the market had priced in a peak Fed funds rate of nearly 5.75%. Now, the May hike to 5.25% is expected to be the top. Similarly, the swaps market had the ECB's target rate rising to 4.0% by the end of September, and now it sees the peak between 3.50% and 3.75%. The market thought the Bank of England's base rate would top between 4.75% and 5.0% in Q4 22. After pulling back to 4% in late March, the swaps market finished April back near its pre-stress levels. 

We suspect the market is under-appreciating the risk of a Fed hike after May. Indeed, the futures market has moved dramatically in the other direction, pricing in a cut in Q3 and for the year-end rate to be about 4.50%. That implies 75 bp in cuts over five FOMC meetings that remain after this month., which seems unreasonably aggressive. It would likely take more than a quarterly contraction to deter the Fed. It would imply some kind of shock. The economy was contracting when the Fed began the tightening cycle. 

The median Fed forecast in December was for the economy to slow to 0.5% year-over-year this year. This was shaved to 0.4% in March. Those are downbeat numbers and may be about as close as the central bank gets to projecting a recession. In March, the Fed's staff warned that a mild downturn is likely later this year. The preliminary official estimate was that the US economy expanded by 1.1%, almost meeting this year's Fed growth forecast in the first quarter.

China's economy expanded by 2.2% in Q1 23 after stagnating in Q4 22, before its pivot from zero-Covid. Even though this was above expectations, many seem disappointed with the reopening of the economy and see the price weakness as a sign of weak demand. In some sectors, like autos, falling prices seem to be a function of excess capacity in the industry and intense price competition. The IMFs updated forecasts see China growing by 5.8% this year, and the median estimates in Bloomberg's survey project a 5.3% expansion. After the GDP figures, some economists revised their forecasts for above 6%.

Economic activity in the eurozone and Great Britain has fared better than expected. The periphery has done well in the eurozone, and the banking stress did not spur widening in the intra-EMU yield differentials. The relatively higher German inflation can bolster the competitiveness of the periphery. Ironically, the German center-left coalition government shows more strains than the rightist Italian coalition. The UK economy is defying recession calls, including previously by the central bank, and appears to have expanded in Q1.

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Japan's economy is expanding slowly. Industrial production has been held back by weaker exports. However, the spring pay raise and government energy subsidies have bolstered consumption while lowering inflation. Still, the underlying picture is unsettled as the CPI measure that excludes fresh food and energy reached a new cyclical high in March. Surveys show the majority expect the new leadership of the Bank of Japan to adjust policy in the June-July period.

The Bank of Canada acknowledged that growth was stronger than expected this year but not enough to move it from its "conditional pause" in its tightening cycle. It expects the economy to slow for the rest of the year. The Reserve Bank of Australia joined the Bank of Canada, pausing its hikes. Despite improving trade ties with China, the economy is struggling. Governor Lowe's (NYSE:LOW) term ends in September, and it is still being determined whether he will be granted a three-year extension like his two predecessors. 

As a topic for discussion, the dollar's future is always lurking in the background. In the mid-to-late 1980s, some thought the large Asian country with a chronic trade surplus was the challenger, but the Japanese yen never took hold. Then some thought that if Europe had a common currency, it could rival the dollar. The euro is the second largest reserve currency, but it is hardly larger than the sum of its parts (the legacy currencies, like the Deutschemark, French franc, Italian lira, etc.). Now, the Chinese yuan is suggested as the dollar's replacement. 

The issue resurfaced following the meeting between Saudi Arabia and China late last year and again in interviews with French President Macron after returning home from a visit to Beijing and meetings with President Xi. Within a fortnight of Macron's visit, Brazil President Lula visited Xi and repeated his interest in reducing the reliance on the dollar. Technological advances in payment systems have lowered barriers to entry. The sanctions on Russia and Iran have also spurred the use of alternatives to the dollar, including the Chinese yuan and the UAE dirham (pegged to the dollar). 

The US dollar continues to be overwhelmingly used for trade and investment. Yet, a yuan bloc could form. Russia and Iran are the obvious initial members. There could be a few more members over time, but ultimately if this club forms, China would draw not the countries that wanted to dump the dollar but those who were kicked out, as it were, via sanctions. Moreover, given the interest rate differentials, Chinese exporters are in no hurry to sell the dollars they earn. Ultimately, the key to the dollar's role is a store of value (the depth, liquidity, and transparency of the US Treasury market), not a means of exchange (trade settlement).

Last September, investors struck against the attempt by a new UK government to fund its proposed fiscal stimulus in the face of a recession forecast with debt. As a result, the Bank of England took measures to support the Gilt market. As sterling was sold to record lows, pundits said the UK was an "emerging market," and the Economists called it "Britaly."  We recognized it as a reflection of extreme market sentiment. In a similar vein, we suspect that the deluge of articles in the social and mainstream media about the demise of the greenback is more a reflection of psychology than substance.

The G7 Summit (May 19-21) will be held in Japan's Prime Minister Kishida's home city, Hiroshima. The opposition to Russia's invasion of Ukraine has been a galvanizing principle. French President Macron is preparing a peace proposal with China as mediator, but we suspect this will not garner broad support. The US will shortly announce new limits on American business investment (broadly conceived) in China, especially high-tech (e.g., semiconductors, artificial intelligence, and quantum computing. Yet, even though the Biden administration couches its actions on the elastic national security umbrella, it looks to many as an attempt to hold back the development of a rival superpower. Other G7 members may be reluctant to fully embrace the American position without greater provocation.

Greece holds its parliament election on May 21. Greece is one of the fastest-growing European economies in the post-Covid period, has lower inflation than Germany, and is likely to record a primary budget surplus (excludes debt servicing costs). The New Democratic Party is expected to retain its majority. The UK has local elections on May 4. In the previous contest in 2019, the Tories lost around 1000 council seats, and the party chair now warns of losses of similar magnitude. Labour also lost seats and councils in 2019 as the Liberal Democrats performed best. On a national level, the Tories have narrowed the gap with Labour, but it remains wide. A general election is likely next year.

Turkey's national elections (parliament and president) are on May 14. A run-off will likely be necessary on May 28. Erodgan has drawn on his power of incumbency. In the run-up to the election, he has raised the minimum wage, offered subsidized loans, and eliminated the age requirement for retirement benefits (based on years of work rather than age). There will be significant economic and geopolitical implications if Erodgan loses. Chile (May 7) and Thailand (May 14) also have general elections.

In April, emerging markets as an asset class were little changed. The JP Morgan Emerging Market Currency Index was slightly softer (~0.3%), while the EMBI spread over Treasuries was virtually unchanged, a little above 400 bp. A year ago, it was closer to 380 bp. The MSCI Emerging Markets equity index eased by around 1.8% in April, while the MSCI index of developed equities rose by about 1.5%.