Uncertainty stalked markets last week amidst a raft of rate hikes, but the focus on inflation shifted from the US – where the news was ostensibly quite good – towards Europe, where inflation pressures continue unabated. The headline US CPI Print, and even the core (ex food and energy) measure, were both down and below expectations at 0.1% and 0.2% respectively (a mere 1.2% and 2.4% on annualised basis). Initially the market reacted positively, and the US market was up almost 5% by Tuesday morning, but two things then happened which left markets down for the week. Jerome Powell’s press briefing, just after announcing an expected 0.5% rate rise, sounded a more hawkish (tough on inflation) note than had been expected. As analysts delved into the underlying drivers it became clear that the US Federal Reserve remains concerned about elements of domestic services inflation which is feeding into very tight labour markets. This raises the spectre of a wage price spiral reminiscent of the 70’s. Most would agree that we are a long way from there, and many transitory post-Covid pressures are already abating, but the difference this time is that the much larger amounts of government, corporate, and private debt in circulation make the impact of a smaller structural rise in interest rates much more severe on the economy.

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This appears to be why central banks seem to be so worried about any lingering services inflation and tight labour markets, and the ECB is arguably in an even tighter situation with even greater debt levels, lower structural growth and less fiscal flexibility and co-ordination amongst countries. This tenuous balancing act was probably why the ECB doubled down on the hawkish rhetoric in the following days when announcing its own 0.5% rate rise. The Bank of England then followed suit, although there was a striking lack of consensus in the committee’s votes, with some members voting for higher rates and some for a pause. On the surface, central banks appear resolute, but this is a reminder that no-one really knows the right answer, and there is significant scope for policy errors in 2023, and perhaps no easy choices. This growing sense of uncertainty left US and emerging markets down 2% for the week, Europe down by more than 3%, Australia down slightly and the UK just in positive territory. In Asia, there was evidence that China’s more rapid than expected reopening would prove complicated, as health services are already under pressure and partial lockdowns are being reinstated. Once again US markets were the lightning rod for risk appetite, even when the news flow originated elsewhere.   In this environment, bond markets in the US were quite stable, while long-term rates rose in Europe and by a significant 0.5% for German Bunds. Overall, this suggests that markets are assuming that central banks will follow through with higher short-term rates, having the effect of slowing economies and snuffing out inflation so that longer term rates don’t need to rise by as much. Australia is becoming a bit of an outlier in that respect in that RBA’s relatively dovish stance implies slower rate rises, but the market thinks rates will then have to be higher for longer.

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The RBA may be hoping that the Fed will do the heavy lifting by invoking a global recession that helps curb domestic inflation, while avoiding the need to further harm the domestic housing market with higher short-term rates. After a solid 6 weeks, credit spreads started to ease out again, reflecting increased risk of defaults and possibly tighter liquidity conditions. Commodity markets may also have been sniffing out a global slowdown, as most industrial metals were down for the week although energy prices were up, perhaps reflecting a cold snap in severely supply constrained Europe.

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