Volatility eases but is not forgotten

AIB’s Senior Economist John Fahey and AIB Treasury’s Ed Wilson discuss the latest on interest rates, central bank positions and the waiting game for implications of trades tensions on the global economy. 

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Transcript

You are listening to AIB Market Talk, bringing you financial market insights from AIB's experts. Hello and welcome to AIB Market Talk. I'm Edward Wilson from AIB's London Treasury team and I'm joined today by AIB senior economist John Fahey. For this Market Talk episode, we'll be discussing a variety of market topics in what has proved to be another eventful few weeks. Morning, John. Morning, Ed. So, um, I think what I'd like to start with is maybe a look back and reflection over, you know, what's been happening in the US over the last sort of six weeks or so. So at the beginning of April, we had liberation day and the announcement of, you know, tariffs across the whole of the world for the U S is trading partners. Then we had a rollback, um, some pausing of some of these tariffs. There were some trade deals, notably with China. Uh, the Trump administration was on a Uh, a tour around the Middle East last week, uh, announced a number of significant trade deals. Um, and after weeks of financial market turmoil, things seemed like they were returning to normal. There was a sense of calm. And then on Friday, Moody's announced a one notch downgrade to the U.S. credit rating, stripping it of its coveted AAA rating, a rating it's held since 1917. Now, was this a surprise? And do you think there will be any consequences for the U.S. economy? Yeah, well, in terms of ratings downgrading, the announcement may have been somewhat of a surprise, but they're really only catching up what the other rating agencies have done previously. I think back in early 2010s, they had a ratings downgrade and another one then from the other rating agencies. Really just symbolic from that perspective and whilst there was a bit of initial reaction markets in terms of higher yields since then that's largely evaporated. But as you say, it's just another thing into the mix in relation to uncertainty. And the reason it probably got a bit of attention in the timing of it was interesting was over that, over the weekend when it was announced late Friday, you obviously had some moves in the US Congress around passing new fiscal measures which only make the debt situation worse. The debt cycle in the U.S. is not something that's just under the current administration. It's been there for the last twenty to thirty years. So there's been a number of administrations that haven't really wanted to or had the appetite or been able to get a hold of Uh, that debt situation in the US and it's something we've talked about previously on our podcast, uh, in terms of our longer term view of the dollar and the potential for weakness there because of those, what we've termed the twin deficits around current count. And also the fiscal balance in the US economy. So the timing might have been a bit of a surprise, but really it's largely symbolic that they've already had those rating downgrade from previous rating agencies over the last ten years plus. Getting back to your original point, a reflection is one way of looking on it. I suppose if you'd gone away at the start of April and come back, you might have worried, wondered what all the fuss is about because markets have, you know, largely settled back down. The S&P is now, uh, You know, up, ah, you know, three to four percent since the beginning of April, so it's recovered the ground it had lost. Where we're still seeing the impact, though, is on currencies, and I know we'll talk about that. Uh, in a little while, but we are still seeing that more softer tone to the dollar on that side. And, and, and what about like us yields? I know kind of. Long-term U.S. yields, they're up sort of pushing, like the 30-year pushing for, you know, 5%, which is, you know, levels we haven't seen for a long, long time. Yeah. Is that a concern? Uh, you know, is, is it going to cause a problem for, you know, Trump's, you know, tax spending and kind of cut plans? Yeah. And we, we already saw in terms of you, you mentioned earlier in terms of that ninety day pause of what was the driver of that? Well, it wasn't the equity market sell off or the weakness in the dollar. Those were happening, but it was when it started to impact bond markets and yields move higher. The White House was quick then to adapt to that situation and introduce that ninety day pause. So higher yields are also helpful if you have a debt situation where you need to finance your current spending. Uh, on international markets. And you know, if you look since the start of April, that thirty year yield is up fifty base points, ten year yields in the U S are up forty Now they're generally up across the board, but obviously. You've seen it much more. So that is problematic if it continued on that upward trend going forward. Yes, any economy or any sovereign That needs to raise significant sums on a regular basis on debt markets. Higher yields are pause for thought there. And we did see the impact that that had when we got that sharp, volatile move in yields Uh, we got the ninety day pause in terms of those reciprocal tariffs on the back of that. So, you know, it is something that is, uh, you know, there. And as we've talked in previous podcasts, It is acting to some extent as a guardrail against how much the US administration can ramp up trade tensions. Whilst we've seen some other central banks cut, uh, official rates recently, the Fed opted not to, uh, last time round and there's a, you know, it appears there's a little bit of friction between, you know, the Trump administration, Uh, and the fed chairman and, you know, again, it's just that all, all these little cracks kind of creeping in. Um, so, you know, You've had a very resilient US economy, but you know, is, is there a degree of fragility kind of creeping in and, you know, We're seeing these kind of longer term sort of yields kind of creep up. Is that going to spill over into, say, equity markets and, ah, you know, the dollar and, and, you know, arguably the dollar's been overvalued for a long time. Could we be, you know, be beginning to sort of see a, a change in sentiment and maybe a weaker dollar going forward? A little bit of friction is probably the politest way you could have put it. Yeah, and that did impact. So you talked there about the dollar when we saw the trade tensions were one aspect of that dollar weakness as the market starts to reassess the outlook for the US economy. But we saw that The move up to 115 in euro dollar on that key pair happened when, you know, Trump, you know, you know, had that disagreement with the Fed and the market got worried about the Fed's independence on that side. It's actually interesting when you take a step back, if you think of, you know, where all this is centered from has been the US administration, yet the Fed has been of the three main central banks that we look at, the only one that hasn't cut rates this year. We've had a number of cuts from the ECB and similarly, as you mentioned there, the Bank of England earlier this month cut rates too. The Fed's position at the moment is that they're Continue to emphasize that they're quite comfortable, that where monetary policy is positioned at the moment, that they did already cut rates last year. And I suppose the Bank of England is only catching up with the degree of rate cuts we saw from the Fed. The Fed message has been that they're quite content with That, uh, policy is, is, is at the required level that it needs to be at the moment while they get clarity, uh, on the outlook for trade arrangements going forward, the impact that will have. And really that's the key thing. Cause you mentioned there. That the data has been holding up pretty well in all the main economies. Hard data yet hasn't started to see the impact it's been in sentiment surveys and sentiment indicators. And really the Fed is saying that they'll wait to see what impact it has and the key metric they'll be looking at or key metrics will be in relation to the labour market. So if you look at what's happened in markets, There's been a lot, from an interest rate pricing perspective, there's been a lot of volatility because when the dislocation in financial markets generally peaked after Liberation Day in, you know, the first half of April, What we saw was a significant softening in rate expectation. In other words, the market started to price in more rate cuts from the Fed and to a lesser extent from the Bank of England and the ECB. But since then, as those trade tensions have eased and as some of those, uh, you know, agreements or frameworks at least, uh, have been put in place or pause. Then the market has firmed a little bit in its rate expectations outlook. So at the moment in terms of what's priced in for the Fed, the market's got about fifty basis points of cuts priced in between now And the end of the year. And really at the moment, the market's not fully pricing in a rate cut from the Fed till September. So, you know, in terms of the Fed outlook, the Fed seems to be quite comfortable. Where rates are at the moment because of the cuts it implemented last year. And it's not looking to preempt anything or preemptive rate cuts. It's going to wait for the date. And that's been the consistent message from the Fed. Uh, it's a weight and clarity in terms of what impact all this trade uncertainty and new trade deals and trade dislocations will have on the economy and specifically around, I think over the summer, the key thing to watch out for. His US labour market and that monthly payroll figure on the first Friday of each month is removed through the summer to see is there any softness coming there. And so I guess we've kind of got sort of two things at play here. We've got a lot of noise from, um, you know, Tariffs and kind of immediate market reaction, which I think we see through, you know, playing through the equity markets. But then you've got the Fed looking at the, you know, the core kind of hard economic sort of data. Which takes a little bit more time to sort of feed through so um, I guess that all adds to the friction between kinda, you know, the two sides and kinda Yeah, and I suppose it doesn't make central bank's jobs any easier in the current environment that, you know, uncertainty is so elevated and just that uncertain outlook in relation to trade policy and the potential at any given time for there to be another flare up in that. Uh, means that, you know, those competing things. Now the Fed also, obviously different to the Bank of England and the ECB has a dual mandate around price stability and the labor market. So, you know, it, it, and that's why we think those labor market numbers over the next couple of months will be important. And they will decide the degree to which and timing that we get records from the Fed this year. So that's, that's the ones we look for, the numbers, the employment numbers in the coming months. Okay, um, moving closer to my home and the UK, um, we had Q1 GDP reported last week at a better expected 0.7, which showed the UK economy growing at a faster rate than the US and the Eurozone. Earlier this week we had the UK and the EU announcing closer trading ties with some, you know, concessions around kind of fisheries and defence and sort of food standards. Yeah, this comes on the back of, you know, a couple of kind of smallest trade deals that the US has also negotiated. Um, so, one might argue things are looking up. And then we've had the UK inflation data which showed a big increase from March to April 3.5% printed this morning I think slightly higher than expectations uh, March figure was I think 2.6 so Again, two things at play here. We've got kind of things pointing towards better prospects for the UK, but still this underlying kind of core inflation problem and the impact that's going to have for Bank of England and policy. Yeah, so, well, generally speaking, if you look at the UK over the last, you know, two years has shown more resilience than would have been expected. It's performed better than expectations. At the same time, in absolute terms, growth has been, you know, subdued or non-existent in some quarters, but it has been better than had been expected because the outlook and consensus forecasts were probably over, it would have been proved to be overly negative in the UK economy. We're always mindful of quarterly numbers because they can be quite volatile and obviously the first quarter what we're likely to see is strong numbers across a lot of regions because it's likely that activity was brought forward ahead of the pending US tariff announcements. So that pace of growth of plus 0.7% is, is unlikely to be maintained or matched in Q2. We may see a bit of a pullback as some of this, uh, activity that was, uh, You know, pull forward ahead of those tariffs doesn't occur again. And if you look at the year and year rate, just above 1%, you know, it's, Forecasts this year for the UK economy have obviously been downgraded like they have across the board since the beginning of the year. But in terms of where we are at the moment that year in year, entering 1.3, 1.5 would be an improvement on where we were last year. But obviously the quarterly numbers May jump around a fair bit on that side. And you can just see in terms of business investment was quite strong in the first quarter. And that's it. It was completely at odds with a lot of the survey data. So that's likely down to the fact that a lot of businesses maybe did some activity in Q1. That they might not have been doing otherwise or more gradually over the course of the year, but they brought it forward. So the data may be a bit distorted in the first half of the year because of those pending tariff announcements around that. And as you say, in terms of the inflation numbers were higher than expected. So that's not helpful from a Bank of England perspective. The general view was always over the next couple of months that inflation numbers would move higher on the back of inflation. Uh, utility inflation that, that was, uh, in terms of energy price increases that were, that were coming on stream. But what was interesting about the latest numbers for April, uh, was the core number was also higher than expected. So obviously headline inflation. It is skewed by energy prices, food prices, and this number was very much driven by energy. You know, overall, the bulk of the increase was due to a 10% year-on-year increase in utility inflation. But when you strip through that and look at the core numbers, they were also stronger than expected. So it's back to this. If you look at UK inflation, core inflation, Compared to the eurozone and the US, there is, all three have a level of stickiness, but the core rate in the UK is higher than, than those other two economies, so. It is a challenge for the Bank of England, which is why you had such a split over the last while. Anytime the Bank of England has decided to do anything that you haven't had unanimity. Yeah, you've had some members voting for twenty-five some for fifty and then you've had two members at the most recent meeting Voting for no rate cuts. So, you know, it's those competing assessments of, you know, is growth slowing? Is inflation sticky? Are interest rates further cuts? Warranted or justified at the moment. So that's something that the Bank of England is going to be battling with internally and debating over the next couple of months. If you look at what the market's priced in for the Bank of England, Uh, you know, there is, uh, compared to where we were at the start of the year, the market now is rates getting below 4%. Now we've had the view for quite some time that we figured that the UK, UK, uh, economic outlook was, was going to be more subdued. So that we always had a view that it would likely go below 4%, 3.75. Now that's what's priced into markets at the moment, 3.75. It's not that long ago around the middle of April, the market had it even getting towards 3.5% because at that point in time, Financial markets, volatility had peaked on the back of all that tariff and trade tensions and uncertainty. Where the market is now is probably a fairly reasonable expectation in terms of timing the next rate cut. Uh, isn't fully priced in, uh, till September. So the next inflation report or is now called the monetary policy report we get from the Bank of England, uh, in early August. So that would be a useful meaning for the bank to be able to set markets up for a rate cut the following month. But again, given that the vote was so close the last time round, you know, there's always that layer of uncertainty in terms of what the Bank of England may do. Uh, so, you know, that's where we are at the moment, but the market roughly has, uh, around fifty basis points priced in between now and the end of the year in terms of further rate cuts. Okay. And I mean, that's a good assessment and I think the Bank of England chief economist was at a briefing earlier this week and I mean, I think his mindset Was that, was cautious and gradual. Yeah. Careful and gradual. These words are what we're hearing the whole time from a raft of BOE speakers. Yeah. I mean, depending what sort of happens with those rate expectations, could there be an impact on kind of the euro sterling rate? If, you know, if the rate expectations of the cut kind of drop, if the curve affirms, might that kind of just give sterling a bit of a boost? Yeah, well, if you look at the last kind of six to eight weeks, it's been interesting and we've talked with this previously too. Since Brexit, sterling has kind of tended to exhibit a bit more of a cyclical nature to it. So what I mean with that is when we've seen a lot of turmoil in financial markets, We've seen Sterling become more vulnerable in the short term but then recover ground as tensions or as concerns eased in financial markets. So we saw that in, you know, in April where the euro sterling rate, euro gain ground against sterling, sterling weakened against the euro at that peak of sell off on markets in terms of volatility. And risk off environment. Since then, Sterling has recovered ground. But if you look at the levels we've traded at in the last couple of weeks, just like we're coming closer to the end of May, you know, it's been in a basically an eighty-four to eighty-five P trading range. Tested briefly above the 84p level and it was at the start of the month slightly above 85p but really been eighty-four 85p. And for the last year, year and a half, there hasn't been a lot of movement in Eurostirling. It's been in a fairly narrow trading range because there hasn't been a lot to differentiate. In terms of economic performance, both the Eurozone and the UK have been fairly sluggish, subdued growth. Obviously, the ECB has been more proactive in the level of rate cuts. That hasn't seemed to have been a huge game changer for the pair in terms of those trading ranges. But the sterling has recovered that ground as market, general sentiment has improved and as I said we've gone from a bit above 85p back closer to 284p on that side. So, where that could play out from an interest rate differential perspective which is a key driver of currency markets is You know, to the extent what you get rate cuts, we think that the ECB is probably closer to the end of its cutting cycle than potentially the Bank of England. Uh, so on the back of that and not a huge amount to differentiate, there's hard to see a strong bias either direction for euro sterling. And we still have a kind of in an eighty-four eighty-five P. As two key levels over the remainder of the year, notwithstanding that there can be volatility within that. And as I said, we've seen if there's a lot of dislocation financial markets, uh, sterling can weaken, but you know, into Q4, Of a midpoint of a trading range, we still think eighty-four 85p is a reasonable expectation to have. Good levels, good levels. Okay, and moving on to the Eurozone, we've got an ECB meeting beginning of June. I think the market is... Nigh on guaranteed rate cut. Yeah. Not, not fully priced in, but close to it in terms of there's around twenty-three base points priced in at the moment. So that's what the market's expecting. As I said, the market has the bank or the ECB rates, the deposit rate getting down to a low in around 1.75%. Uh, by the end of the year, our view would be, and we've, uh, you know, since the start of the year is we think 2% is a, is a, is a, is a level that they'd like to get to. For it to go below 2% would mean that they just see a bit more weakness in the economic outlook and feel they need to do more to provide some stimulus from a monetary policy perspective. So our view would be that at least One more cut to get you to 2%, the depot rate at the moment is at two and a quarter. Whether it goes below 2% will very much depend on, you know, is there some underlying softness in the data as we move into the end of the year that would justify another rate cut? So that's why we're saying even though the market is now below 2%, we think 2% is a fairly rational expectation for that rate, but not ruling out the fact that it could go to 1.75 if softness in data starts to justify that. Yeah, and softness in data, there is so much going on across the globe. Um, there's, there's tension between, you know, in, in the South China Sea, obviously in Europe, there's threats of tariffs, um, Yeah, geopolitical tension just everywhere. I mean, volatility is, looks like it's going to continue and is, I guess this is all going to play into kind of central bank decision making and how that kind of impacts kind of The underlying kind of cool data that they'll be looking at. Yeah, I think probably the most used word at the moment is uncertainty and after that it's, you know, probably volatility when you look at market discourse and that. And that's likely to continue because even though we've had some easing in trade tensions and a pause, there still is a lot of uncertainty in relation to where things go from here. So against that backdrop, And obviously throwing the mixed geopolitical uncertainty means that you're likely to see that level of volatility still remain. Now, it may not see this huge trading range that we've seen over the last couple of weeks from a dollar pair related perspective. Uh, but you still see volatility, but maybe within more narrow trading ranges. Uh, but even at any point in time, investor sentiment is obviously On a day-to-day basis, very reactive to news flow. So over the last couple of weeks, the news flow has turned more positive. So we've seen the recovery in equity markets. But again, we still have a lot of uncertainty in relation to trade. And from the White House in terms of its negotiations. So against that backdrop, yeah, I think volatility will still remain a feature between now and the end of the year. Brilliant. Okay, watch this spice. Well, thanks John for your valuable insights and thanks to everybody for taking the time to listen. You can stay close and access all of our latest podcasts by pressing the subscribe button to ARB's Market Talk and we look forward to welcoming you back next time. Thanks for listening to the latest edition of AIB Market Talk. Allied Irish Banks PLC is regulated by the Central Bank of Ireland. AIB NI is a trademark used under licence by AIB Group UK PLC. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Allied Irish Bank GB and Allied Irish Bank GB Savings Direct are trademarks used under licence by AIB Group UK PLC. 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