Months since the last major bank fallout have passed leading to a risk-on climate as July and August are nearing. All new data points in the Q2 of 2023 have proved that inflation is coming down and the economy seems to be resilient. The banking system in the US and Eurozone is resilient and stable as new rate hikes are built into the economy. The simplest way of looking at the nervousness in the market is VIX. VIX hit levels (under 14) last seen before the Corona Crisis.
The rhetoric of the two major central banks (European Central Bank and Federal Reserve) is still hawkish as expected. They have done a major job in the past year and this year to curb inflation and bring it back to their target. The fastest tightening cycle in decades did not break the financial system yet and the fallout of the SVB and Credit Suisse has been quickly contained. GDP growth did not crumble and inflation is falling – exactly what central banks want. To prevent upside risk to inflation, the hawkish rhetoric is still in place, however major increases in central bank rates should not be expected. Central banks announcing new hikes no longer impact the bond yields as every participant in the financial market is aware of the insignificance of a 25bps hike to the economy. Central banks have done more than 95% of their job until now and minor tweaks to the policy won’t change the expectation of rate cuts in 2024. Only the major blows to the economy can do enough to avert risk-on sentiment. The state of the economy is the only major impact that can influence markets enough. All of the mentioned above imply that the summer will be positive for risk-on assets in case of continuation of the ongoing risk-on sentiment. However, black swan events cannot be predicted and may change everything. Autumn may prove as a turning point for both risky assets and bonds as the central banks may officially end the tightening cycle. Afterward, incoming economic data is the only data that influence the market and directs it toward the higher for longer policy or toward rate cuts.
On the contrary, the UK is the most fragile market with a dark short-term and long-term outlook compared to the other major economies. The strongest signal for the pessimism of the market toward their long-term growth outlook is a minor inversion of the yield curve in comparison with the German yield curve and US Treasury yield curve. The terminal rate at 6.25% is still 125bps far away and the tightening cycle is far away from being over. Volatility in the financial system may probably be concentrated there over the summer as the pressure on the financial system and the economy keeps being higher as the days pass.
To conclude, the financial markets in the US and Eurozone are expected to experience a relatively calm and stable summer, with a risk-on sentiment prevailing. The resilient banking systems, declining inflation, and hawkish rhetoric from the major central banks have instilled confidence in investors. While minor adjustments to monetary policy are still anticipated, significant interest rate hikes are not expected, and the focus remains on maintaining economic growth. However, the UK market stands out with a more pessimistic outlook due to its fragile economy, persistent inflationary pressures, and a greater level of volatility. As the summer progresses, the performance of these economies will continue to shape market sentiments and set the stage for potential shifts in the autumn. Investors should closely monitor the evolving economic conditions and potential black swan events, as they have the potential to disrupt the prevailing risk-on sentiment and impact market dynamics.