US inflation preview and why China’s latest move is unlikely to boost sentiment

We have experienced a volatile week for asset markets as stock markets had some of their strongest rallies of the year earlier this week, yet futures markets point to a mixed performance on Thursday. The market focus is shifting from positive news about Omicron and vaccine effectiveness, to the other threat to risk sentiment: what the Fed will do next. While next week’s Federal Reserve meeting is the main event before the end of the year, in the run up to this meeting Friday’s US inflation report is going to be watched closely as it could give us an important steer on what to expect from next Wednesday’s Fed meeting.

PBOC crackdown won’t benefit broader markets

Overnight Asian stocks were mixed, the Nikkei fell 0.5%, however Chinese stocks were sharply higher. The Shanghai Composite index rose more than 1% on Thursday after the Wall Street Journal reported that China’s corruption agency had visited the PBOC. Of all the financial institutions that are being scrutinised by Beijing, the PBOC is the most influential. The report said that corruption inspectors had made it clear that Beijing has little tolerance for an independent central bank. This suggests that the PBOC was put under pressure earlier this week to lower the Reserve Requirement Ratio (RRR) for Chinese banks, in order to boost the economy and protect Beijing’s economic reputation. China’s growth has slowed sharply, and the Evergrande insolvency crisis is putting the administration under pressure due to the sheer size of the real estate sector in China and Evergrande’s huge debt pile. Interestingly, China’s stock markets surged on this news, however that did not translate into positive performances for other Asian markets or markets in Australia and New Zealand. Chinese markets rallied on the hope that monetary policy will be loosened further now that Beijing has ordered the PBOC to tow its line. However, in the long run, a lack of central bank independence should be bad news for Chinese investments and for foreign investment in China in particular, look what has happened in Turkey. However, the Chinese government’s nationalistic pivot this year seems to be driven by a desire to look inward and attracting foreign investment does not seem a priority. Due to this, future policy moves by the PBOC may not have an impact on global markets now that we know for sure that the PBOC is controlled by China’s Communist party.

US CPI report crucial ahead of Fed meeting

Elsewhere, risk sentiment improved dramatically earlier this week, however markets could be fairly quiet as we lead up to the important inflation report that is due out on Friday. While US CPI is not the Fed’s preferred measure of inflation, it is extremely important to the US consumer and is thus closely watched by Washington. Last month the CPI rate rose to its highest level for 30 years, however, November’s CPI report is expected to show that the annual rate of CPI has risen further to a whopping 6.8%. If analyst estimates are correct, then this would be the highest level of inflation in the US for nearly 40 years and the era of low inflation would most definitely be over. Many believe that October’s 6.2% CPI rate was the impetus behind the Fed Chair Jerome Powell’s hawkish pivot during his testimony to Congress last week. He also chose to drop the word “transitory” when referring to inflation. If CPI does have another large increase for November, then this would justify the Fed’s hawkish shift.

Drivers of inflation set to broaden

It will be important to dig into the US CPI to see the drivers of inflation. Up until now the main drivers of a higher inflation rate have been limited to used cars and energy prices, the latter account for 30% of the surge in prices. However, US oil prices have fallen from a high above $84 per barrel in early November to a low around $65 at the end of November, thus energy prices could have a dampening effect on inflation last month. You may be wondering why investors are expecting such a large increase in CPI if energy prices fell last month? That is because analysts expect there to be a broader range of items that are starting to see price increases. This is a big fear for the Fed: that inflation becomes more broad-based. Thus, if this report signals that inflation is becoming embedded in the US economy then it would support hawkish action from the Fed next week, including speeding up their tapering programme and starting to discuss the timing of interest rate increases.

FX: why EUR/USD is in the firing line if US inflation surges

Overall, we think that stock markets will be fairly reflective as we lead up to next week’s FOMC meeting. There could be some profit-taking as we move to the end of the week and stocks may trade sideways, especially as US indices have nearly returned to their record high levels. However, the CPI report could have a big impact on the FX market. Notably, EUR/USD and GBP/USD. After big declines this year for EUR/USD, this FX pair has mostly been trading sideways in the past week between $1.12-$1.14. If we see US CPI at 6.8% or above for November, then this will widen the interest rate differential between the US and Europe, which is likely to be bearish for the euro. We could see a break below $1.12, which opens the way to $1.1120 in the short term, the low from June 2020, and then back to the psychologically important $1.10 level. Alternatively, if inflation is not as high as expected, then we could see some relief for the euro and a break back above $1.14.

GBP and the UK’s new Covid restrictions

The pound is also in focus, after GBP/USD fell to its lowest level of the year. As the focus has been on Fed tightening, the pound has trended lower against the dollar, and last night’s announcements of further restrictions for the UK economy weighed heavily on sterling, which is trading fairly flat at the $1.32 handle at the time of writing. The risk is that Omicron could delay the BOE from hiking interest rates yet again, which is negative for GBP. Overall, we think that the restrictions announced on Wednesday may not have such a large economic impact on the UK for two reasons: 1, there were signs that a slowdown in the hospitality sector was already brewing before the WFH guidance was announced. 2, The data so far on the severity of Omicron is fairly optimistic, thus it may not be necessary to implement more onerous lockdowns. However, the lack of government support for these sectors, for example no new furlough scheme, could dent employment growth and cause unemployment to move higher in the future. If this happens then estimates for growth to be around 5% or higher for 2022 could be revised down substantially towards the 2-3% level, which is why the pound is coming under downward pressure. However, if the data on Omicron does not lead to greater hospitalisations in the next month, then we could see restrictions lifted, which may also benefit the pound. In the short term, a stronger CPI report from the US on Friday, could trigger another leg lower for GBP/USD in the short term, with $1.30, the low from November 2020, now in sight.