Fra BNP Paribas:
The financial markets have improved over the last two-to-three weeks. The S&P 500 is up from 1829 on 11 February to about 1980 on Wednesday; EURUSD has retraced about four cents to around 1.09 and the UST 10y yield is up 16bp, from 1.66% on 11 February. A number of factors help to explain this better tone:
Economic data surprises were more positive in February. For example, in the US, retail sales, household spending and income, ISM, the unemployment rate, and durable goods were better than expected, and only partly offset by weaker-than-expected housing and employment data. The market has priced out Fed hikes for this year. According to Bloomberg, the market is pricing in an 8% chance of a March hike; two months ago the odds were over 50%.
The odds of a June hike are now priced in at 35%; two months ago this was almost 75%. The flow of bad news has calmed down: the earnings season is out of the way, Chinese currency policy is more stable, at least for now, and oil prices are up. What will the Fed and other central banks make of this?
Our assessment is that the Fed likely will see the market turbulence as having been out of kilter with US fundamentals, especially the labour market, and so will be inclined to revise its medium-term view very little. However, it will likely be unsure of the effects of the turbulence on economic activity. We believe uncertainty has increased, and the risks will have been revised to the downside on balance.
Thus, we see the Fed as unlikely to move in March – it should await more data. We will write a preview of the statement next week. In terms of longer-term Fed strategy, payrolls are key – we are above consensus in expecting 215,000 on Friday, 4 March. Equally if not more important to the Fed’s tactical outlook view are equities. It seems clear that whatever the Fed says, the market sees it as sensitive to stock prices, so the S&P 500 leads the 1y1y (Chart 1).
Roughly speaking, the market sees a second Fed hike as “On” with the S&P 500 at 2100 and ‘Off” at 1850. Thus, if equities continue to rally, we should expect bond prices to suffer, especially if a Fed statement shows a bias to hike earlier than the market expects. Since we see the reasons for market turbulence as rather deep-seated (see The great global monetary mess, The Great Monetary Tightening and The next US recession), if interest rate hike expectations build, market turbulence may well return, hence our view that the Fed will not hike in June either. Short-term, the data may challenge our view. In terms of data, while remaining in contractionary territory, the US ISM came in a bit stronger than the market had expected.
The more forward-looking orders component also picked up. However, China disappointed on the headline PMI, though orders did strengthen. While there was some good news in the US and China, Japan and Europe PMIs have softened (maybe the differences reflect FX moves) so that globally manufacturing still looks weak
