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Falling inflation brightens US outlook

market snapshot

Insight
12 May 2023 |
Active ESGMacro
US inflation came in slightly weaker than forecast in April, supporting hopes that the Federal Reserve’s aggressive monetary tightening is finally bringing price rises under control.
  • In the UK, the Bank of England raised rates for the 12th consecutive time in the face of stubbornly high double-digit inflation.
  • In Turkey, President Tayyip Erdogan faces the biggest political challenge of his two-decade reign as polls show him trailing the main opposition candidate, Kemal Kilicdaroglu, who has vowed to restore policy orthodoxy and repair frayed relations with the West.

Equity and bond markets exhaled a collective sigh of relief this week as headline inflation dipped below the US Federal Funds rate, providing respite to the beleaguered financial sector.

US inflation came in slightly weaker than forecast in April, supporting hopes that the US Federal Reserve’s aggressive monetary tightening is finally bringing price rises under control.

US consumer price inflation has fallen to an annual rate of 4.9% in April, its lowest level in two years. The Fed, meanwhile, hiked its benchmark rate by 25bps early May to the 5.00-5.25% range1.

“While this development doesn’t necessarily herald imminent rate cuts, it does imply a potential pause in monetary tightening,” says Geir Lode, Head of Global Equities at Federated Hermes Limited. “Should inflation continue to decline and prove less persistent, rate cuts may follow suit, paving the way for lower inflation and more affordable debt. This improved macroeconomic landscape is expected to bolster equities, with growth factors gaining prominence as conditions unwind.”

Should inflation continue to decline and prove less persistent, rate cuts may follow suit

UK’s thorny dilemma

In the UK, the Bank of England raised rates by 25bps on Thursday – the 12th consecutive raise – bringing the benchmark rate to 4.5%2. The annual rate of inflation in the UK remained in double digits in March.

“With retail and wage inflation proving much stickier than expected, the Bank of England faces a thorny dilemma,” says Silvia Dall’Angelo, Senior Economist at Federated Hermes Limited. “In the short-term, the BoE will likely hike rates further – to 4.75% most likely – and it will maintain a tightening bias. Yet, amid economic challenges and the financial stability risks, the risk of overdoing it is high.”

European stocks inched higher on Thursday, following a rally on Wall Street. Europe’s region-wide Stoxx 50 rose 0.07%, while France’s CAC 40 ended up 0.28%. The UK blue-chip FTSE 100 closed down 0.14%. On Wednesday, the Nasdaq rose 1% to close at its highest level since June, while the S&P 500 finished up 0.5%3 .

Turkey at a crossroads

As a key emerging market economy with a gross domestic product (GDP) of $905.5bn in 20224, the outcome of Turkey’s presidential and parliamentary elections on Sunday 14 May could have far-reaching implications. President Tayyip Erdogan of the ruling AK Party faces the biggest political challenge of his two-decade reign as polls show him trailing the main opposition candidate, Kemal Kilicdaroglu, who has vowed to restore policy orthodoxy and repair frayed relations with the West. Erdogan’s support has fallen in the last few years as a series of currency crashes and a worsening cost-of-living crisis have been brought on by his policy of slashing interest rates in the face of soaring inflation.

Figure 1: Turkish inflation vs. interest rates

“The Turkish economy has toiled under an unorthodox economic policy, with the Turkish lira having witnessed around a 30% depreciation versus the US dollar in 2022 and a 44% decline during the year prior. At the same time, the country saw inflation peak at 85% in November 2022 following a 500bps run of rate easing by the central bank,” says Mohammed Elmi, Senior EMD Portfolio Manager at Federated Hermes.

“Despite these glaring problems, Erdogan set about pump-priming the economy ahead of the election, including raising the minimum wage by 55% and encouraging Turkish banks to extend credit. As one could expect, such expansionary policies have impaired the one key strength of the Turkish economy: its fiscal position.”

Figure 2: Turkey 10-year government bond yield

Despite a requirement that banks hold bonds against loans, Turkish government bond yields have risen. The benchmark 10-year bond yield has spiked almost 300bps this week5.

For further insights on the global macroeconomic outlook, please see the latest Ahead of the Curve.

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