Rising rates, stronger dollar mark market’s optimism on US’ outlook

RISING US rates, a stronger dollar and higher oil prices combined with a firm US equity market signal markets’ optimism about the US growth outlook.

The US has taken back the cyclical lead, as Europe’s soft patch could extend for a longer period while Italian politics are a reminder of its fragile structure.

At the same time, supplydriven oil prices increases, unresolved trade tensions remains, and EM capital flow reversals are risks to the global outlook, implying potential stagflationary impulses of less growth and more inflation.

Core central banks will likely take note, while continuing to signal confidence.

This week saw very significant market moves.

US 10-year Treasury yields surged to above three per cent, driven by rising real rates, which approached one per cent, levels last reached in 2011.

The US dollar appreciated in parallel, unwinding all depreciation from earlier this year.

This happened in spite of soaring oil prices, with Brent briefly touching US$80/bbl, a price last seen when oil was free-falling in August 2014.

Amid all this, US equity markets remained firm, seemingly sanguine about the combination of rising rates, a stronger dollar, and higher oil prices.

A consistent interpretation could be as follows; a strong and sustainable US growth outlook (which is supported by investment and productivity improve- ments), compatible with a longer Fed hiking cycle and higher real interest rates.

As the US leads the global cycle, offering higher growth and investment returns, this is also consistent with a stronger dollar.

Finally, higher oil prices are no longer a harbinger of doom for the US, as it is now increasingly also an oil producer.

Although higher prices at the pump would likely dampen the consumption boost from tax cuts, higher crude should be a boon for US energy exploration.

How realistic is this interpretation? First, the US’s improved relative position seems clear, in particular vis–a-vis Europe.

While both economies are expected to re-accelerate in the coming quarters, the prospects for the European economy have become more clouded.

Following weaker-than-expected 1Q growth, any indications that activities in the region may rebound in 2Q have been feeble.

Europe’s May PMIs this coming week should provide an important signal in this regard.

In addition, the prospect of an anti-establishment government in Italy is a reminder of the euro area’s underlying structural vulnerabilities.

Similarly, the global outlook faces a number of challenges.

Higher oil prices is one of these challenges.

While the oil recovery since 2016 has largely been driven by stronger demand on the back of better global growth, the recent surge is caused by fears of reduced supply from crisis regions.

We have revised our forecast for Brent up to US$70/bbl on average, which looks manageable.

But a scenario of prolonged higher prices would be a stagflationary impulse, implying lower global growth and higher inflation.