Posted on

Inflation will be the key driver of bond and equity markets for 2023

Annual US inflation fell in December to its lowest level in more than a year, in a further sign that price pressures have peaked amid the Federal Reserve’s historic campaign to tighten monetary policy. The consumer price index, released January 12th declined for a sixth consecutive month, registering an annual increase of 6.5 per cent. While still near a multi-decade high, this was the lowest level since October 2021, and represents a notable decline from the 9.1 per cent reached in June.

US Federal Reserve officials are monitoring the latest inflation data closely as they decide how much more to squeeze the US economy. Having already stepped down to a half-point rate rise last month — following four consecutive 0.75 percentage point increases — the central bank is now considering whether it can revert to a more typical quarter-point speed at its next policy meeting at the end of January.

This belief that inflation is finally cooling, and interest rates may not rise too much from here, is driving equity markets higher. Global stocks have risen some 20% from the lowest point of October to mid-December despite the lack of meaningful brightening in growth or easing of geopolitical tensions. This may limit the upside potential for equities in 2023.

Most Fed officials expect the key Fed Funds interest rate to peak between 5 per cent and 5.25 per cent later this year, up from the current Fed Funds target range of 4.25% – 4.50%.

10-year US Government Bond yields are also more optimistic about the 2023 interest rate outlook yielding circa 3.6% Yield-to-Maturity well down from the 2022 circa 4.25% highs.

The US Dollar as measured by the DXY Index has weakened also on the back of softer/more ‘dovish’ expectations around US interest rates. Its range over the past 12 months has been 94 (weakest) to 114 (strongest October 2022) and is now trading mid-range at 103.

Returning to stocks – whereas many equity markets are trading something like mid-range looking at the last 12-month highs and lows, London’s FTSE 100 share index is trading close to an all-time high for 2 reasons

  1. UK markets lagged behind the big US rally in 2020 and 2021, which was led by high-flying growth stocks like Apple, Alphabet and Tesla so is ‘catching-up’ to a degree
  2. The FTSE 100 dodged the carnage in global stocks last year because it is filled with the type of companies that prospered in an environment where interest rates and energy prices were rising e.g. Shell, the Angle-Dutch oil major, that is the second biggest company on the London Stock Exchange, gained 43% last year. HSBC, the banking heavyweight, gained 15% as higher interest rates boosted profits.    

Let’s follow the 2023 inflation story!