| Rafi Gozlan, Chief Economist at IBI Investment House
| The bond market is exposed to positive news in the growth sector
The last week was characterized by high volatility against the background of the “Ionian” interpretation that the markets attributed to the US and Europe, and this compared to better than expected macro data, which reflect a certain improvement in global growth, which somewhat undermined the expectations of a recession inherent in the US bond market.
Good news in the growth sector, and in particular the rapid correction in the services index in the US back into the territory of expansion alongside strong employment data, created confusion in the markets, in particular in the bond market whose pricing reflected a growing probability of the end of the cycle of interest rate increases and a quick turn to lower interest rates later this year.
The interest rate decision in the US drew a positive reaction from the markets even though the message that emerged from the announcement and from Powell’s press conference was in the direction of further interest rate hikes that are currently aimed at the level recorded in the DOTS of last December, i.e. of 5.25%-5%.
Of course, the Fed sounded encouraged by the decrease in the last few months, and this was also reflected in the announcement, but the emphasis was on the decrease in commodity inflation, and at the press conference Powell estimated that this effect is expected to gradually fade.
The price components from the ISM reinforced this assessment. Although the price component of the industrial index is still below 50, it rose in January and reflects a more moderate rate of price decline. On the other hand, the price component of the services index moderated slightly in January, but remained at a high level of around 68.
This assessment by Powell reflects an expectation of a certain increase in the inflation environment later this year (in relation to the low index environment recorded in recent months), especially when the rapid improvement in financial conditions recorded in recent months is taken into account.
Powell, however, refrained from referring to this explicitly, and noted in general that the last year saw a tightening of financial conditions. This statement led to a positive reaction in the markets (an increase in stocks and a decrease in yields on the bond market), meaning a further improvement in financial conditions, a development that reduces the probability of inflation returning to the target.
In terms of macro data, the ISM index for activity recorded a decrease in January as well and is below 50 for the third month in a row, meaning that it indicates an expected contraction in industrial activity. This development is not surprising considering the normalization of consumption and a renewed shift towards service industries at the expense of commodity consumption.
In contrast, however, the services index quickly corrected the surprising decline recorded in December and returned to a level of around 55, meaning that it indicates an expansion in activity. Following the surprising decline in the services index in December to 49.2, the bond market reacted by lowering yields out of a growing assessment of a slide into recession. Because, in the past, the consolidation of the industrial and service indices together below 50 was an effective indicator of sliding into recession.
Despite this, the decrease in the previous month seemed a little puzzling to us, and in response we estimated that it is better to wait for the following months’ data before drawing conclusions. In this review, we presented the mismatch between the services index and the employment data and the unusual gap between the new orders component and the activity index. Indeed, these two indices quickly corrected the decline in December, including a sharp increase in the new orders component.
| The US labor market continues to show strength
The employment data for the month of January considerably surprised the early estimates and indicated a lot of more than half a million jobs (517 thousand), significantly higher than the increase registered in the last few months, so that the average for the last 3 and 6 months hovers around 350 thousand. dropped to a low of 3.4%, with a slight increase in the participation rate.
Despite the unusual upward surprise in the employment data, the examination of the main indicators of the employment situation is quite consistent with the message that emerged from the latest figure. Thus, data for the month of December indicated a renewed increase to 11 million jobs, and the data of new job seekers fell in recent weeks to low levels of under 200 thousand.
The figures did indicate a moderation in the annual rate, to 4.4%, but the previous months’ figures were revised upwards closer to 5%. Also the labor cost data, which are a better indication for examining wage pressures, hovered around 5% in the last quarter of 2022, a rate that corresponds at the time to a higher inflation environment of 4-5%, and certainly higher than the target.
| The macro picture is more positive outside the US as well
The more optimistic message from the macro data in the US also characterized the data from Europe and China. The growth data for the last quarter of the year was better than expected (quarterly growth of 0.1% compared to expectations for a decline of the same rate) despite a slowdown in the annual growth rate from 2.3% to 1.9% , when in addition there was an improvement in the aggregate index which returned to levels of over 50 points led by the service industries. A return to expansion also characterized the purchasing managers’ indices in China following the opening of the Chinese economy, with an emphasis on the service industries.
Against the background of the relative improvement in the macro picture in the Eurozone, which was supported by a drop in prices, ECB Governor Lagarde stated that the risks to the Eurozone are more balanced, although the risk of inflation is still upward. Therefore, beyond the 50 basis points to 2.5%, the ECB announced an expectation of another increase at the same rate to 3% in the next decision in March.
Beyond that, the decisions depend on the data, but considering the environment of high basic inflation, which remained at 5.2% in January, the probability of continued interest rate increases in the second quarter is quite high. Similar to the reaction of the markets to the interest rate decision in the US, this decision was also received positively and with a rapid drop in yields in the bond market, which apparently feared a more hawkish tone.
In any case, in the summary of the last week, the interest path embodied in the USA reflects an expectation of another interest rate increase of 25 basis points in March and a partial probability of another increase in May. In the Eurozone, the market is pricing in an incremental increase of around 3.5%-3.25%. In our estimation, the apparent recovery in Europe and China, and the strength demonstrated by the labor market in the US,
Against the background of the improvement in financial conditions, the markets are expected to re-price the probability of sliding into a recession, at least at a later date, and at the same time to price a higher inflation environment. Since the bond market in the US continues to price a significant deterioration in activity that will lead to an interest rate reduction in the last third of the year, we attribute a high probability to an upward pricing of the interest rate path and an increase in yields in the coming period.
In the local aspect, the local market erased during the last week a significant part of the increase in the risk premium registered a week before. It is possible that the local market estimates that, against the background of the warnings that continue to come from the world regarding the negative consequences of the measures to weaken the judicial system and harm the separation of powers, the chance of the plan passing in its current form is quite low.
Despite this, we estimate that more significant pressure will be required from the markets, in order to lead to a halt or a significant change of the plan. Examining the pricing in the local market reveals that it is far from embodying a high risk premium, and we expect a step up in the perceived risk premium of the local economy while devaluation and underperformance of the local bond and stock markets in the coming period.
In terms of the bond market, the current pricing continues to support a defensive position towards the local market, in terms of the portfolio’s price, both against the background of the risk on the political and security level and against the background of the risk of a higher interest rate increase arising from the risk of “sticky” inflation in the coming year.
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