The Long-waited breather

Financial markets take a breather after an impressive sprint
Macro data in the US pushes rate cut expectations further
Euro zone appears to stay on the original rate cut path, for now
Flare up of tensions in the Middle East

The start of the year for the financial markets had been an extraordinary one, indeed, with equities gaining year’s worth of advances in one quarter, while bonds were languishing in the background. No wonder many market participants have been taken aback by the sheer optimism taking hold of the markets and the name of the game for the recent months has been the guesswork, just how long this optimism could hang on before giving way to the more of a roller coaster mode that financial markets usually are. The guessing time has come to an end in April as financial markets took a long-overdue breather while investors were assessing the ever-changing circumstances. In the wake of these changes developed markets’ equities (measured by MSCI World index) have dropped 3.85%, while emerging markets’ equities (measured by MSCI Emerging Market index) rose 0.26%. The bonds took a hit, too, with 10-year US Treasury bond yields rising to 4.68% from 4.2% a month ago, and German 10-year Treasury bond yields rising to 2.59% from 2.29% a month ago.

The emerging cross-Atlantic interest rate gap

Long gone are the days of the late-2023, when the substantial share of investors were expecting to see the central bank rate cuts rolling in already in 2024 March with the US Federal Reserve (FED) most probably taking the lead. That story is largely off-the-track by now, as inflation in the US has appeared to be slightly higher than previously expected in recent months. With the relatively strong economic growth, still humming labor market and inflation getting lower only at a measured pace, some investors are having second thoughts whether FED rate cuts are needed at all this year, with the previously-off-the-table bets on rate increases coming back to the discussion, as well. That puts the US situation in a stark contrast with the European economic perspectives and the stance European Central Bank (ECB) has been insisting on. On the back of subdued economic activity and slower inflation, ECB appears likely to cut the interest rates for the first time in this cycle in June, should there be no unforeseen market developments.

EUR/USD takes a dive

As a result of the above-described divergence in central bank paths, financial markets may need to get adjusted to the widening interest rate gaps in between the two major currencies. The classic outcome of that could be the depreciation of euro versus US dollar, as investor flows tend to favor the higher-yielding currency, with preference increasing as the interest rate gap widens. As some investors have already started assessing such probability, one could witness the EUR/USD exchange rate taking the lower path during the first months of this year (see chart). Further path for the exchange rate will no doubt depend on the macroeconomic data, central banks’ stance and other variable factors. However, should the rate-divergence scenario materialize, the investors could witness further US dollar strength in the foreseeable future.

EUR/USD exchange rate

Source: investing.com

Flare up of the Middle East tensions

The financial markets have been showing great resilience towards lately increased risks, when it comes to recent months performance in the face of geopolitical standoff in Ukraine, as well as renewed tensions in the Middle East since last autumn. This markets’ utmost immunity to the flow of geopolitical tensions got tested again in April, with Iran launching waves of attacks on the Israel territory using missiles and drones. As this sort of direct confrontation in between Iran and Israel is unprecedented, market participants had feared the tensions may spill over and affect the oil transportation flows via Strait of Hormuz in the Persian Gulf, thus naturally causing the oil price to spike. At least during the month of April these fears have turned out to be unfounded, as the Brent crude oil price trades in the 85-90 USD/bbl range – slightly higher than the previously traded price lows in the 70s USD/bbl, but substantially below the peaks of over 120 USD/bbl in the 2022 Q2.

Market view

The financial markets appear to be getting used to the idea that interest rates are going to be cut much more slowly than previously thought. That in turn gets reflected in the asset prices across the board, as we finally see some long-overdue consolidation in the equity prices and sluggish performance in the fixed income this year. In case there are no unforeseen shifts in the macroeconomic and geopolitical developments, recent market trends have a chance to continue into the foreseeable future.

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