US Cuts Ahead and UK Steps Back

Welcome back to SovereignBeat!

In this publication:

• Soft CPI shakes the markets and reprices rate cuts

• Tech Stocks Tumble; Treasury Yields Decline

• Hung parliement in France

• BoE Uncertain on UK Rate Cuts

• IMF pledges to reconsider high charge costs on Argentina, Ukraine and Egypt

Let’s dissect

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Markets Snapshot

Developed Markets

• US: The June US CPI report released on Thursday was highly favorable for markets and the Fed, with core inflation reaching its lowest since April 2021. Monthly core CPI (excluding food and energy) increased by just 0.06%, significantly below the expected 0.2% and equating to a 3.3% annual increase. Overall CPI fell 0.1% in June and increased by 3% year-over-year, compared to initial expectations of 3.1%. Key components of the core CPI showed softer increases in June. Shelter prices rose by 0.2% month-over-month, compared to a 0.4% rise in May. The owners’ equivalent rent increased by 0.3% month-over-month, marking their smallest gains since August 2021. In addition to slower rent increases, prices for services such as airfares, hotel stays, and inpatient hospital care all saw month-over-month declines.

• In testimony before lawmakers the day before the CPI report, Fed Chair Jerome Powell refrained from indicating the timing of potential rate cuts, emphasizing that future policy decisions would be based on incoming data. On Friday, the day after the CPI was released, Chicago Fed President Austan Goolsbee expressed optimism about the central bank's efforts to reduce inflation without sparking a recession. He noted that recent data from the past few months, including this week, had shown a rapid and significant decline in inflation, continuing the positive trend from 2023.

• US 10-year Treasury yields dropped by more than 10 basis points to 4.19%, reaching their lowest point in over three months, as the bond markets have quickly repriced their expectations on reduction in interest rates. Traders now fully priced in rate cuts for September and December. They also increased the odds of a rate cut in November to better than even, a move that would occur right after the presidential election. Prior to Thursday, there was a division among traders and policymakers regarding whether there would be one or two rate cuts this year.

• UK: Three members of the Bank of England's Monetary Policy Committee expressed reluctance to support lower borrowing costs as of now, leading markets to reduce expectations for a rate cut at the central bank’s August 1 meeting. Chief Economist Huw Pill acknowledged significant progress in reducing inflation but highlighted persistent concerns over wage growth and services inflation. Jonathan Haskel and Catherine Mann, known for their hawkish stance, suggested maintaining current rates until a sustained decrease in services inflation is evident.

• France: The legislative election resulted in a deadlock, as no party won an outright majority of 289 seats in the second round. This outcome signals a prolonged period of negotiations to form a coalition government. The left-wing New Popular Front secured 182 seats, President Emmanuel Macron’s Ensemble came in second with 168 seats, and the hard-right National Rally won 143 seats.

Equity Markets

• Following the inflation report, large-cap tech stocks like Nvidia , Microsoft and Apple tumbled as investors rotated into small caps, hoping for a boost from potential Federal Reserve rate cuts. A small-cap benchmark posted a 6.0% total return, reaching its highest level since January 2022. Despite this surge, the Russell 2000 Index lagged behind its large-cap peer index on a year-to-date basis, with returns of 6.8% compared to 17.5%. The Dow rose nearly 2%, outperforming the fractional gains of the S&P 500 and NASDAQ. It approached its record close set two months earlier, when it closed above 40,000 points for the first time, finishing at 40,003.6.

Commodity Markets

• Oil: Brent prices declined by 1.47% week-on-week as investors weighed weaker US consumer sentiment against rising hopes for a Federal Reserve rate cut in September. On Friday, the University of Michigan's Consumer Sentiment Index slipped to its lowest level in eight months in July, falling short of most economists' expectations. Oil prices still find some support from robust US fuel demand. Government data showed gasoline demand at 9.4 million barrels per day (bpd) in the week ended July 5, the highest for that week since 2019. Additionally, jet fuel demand, on a four-week average, reached its strongest level since January 2020. This strong demand led US refiners to increase activity and draw from crude oil stockpiles.

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Global Finance

IMF Considers Lowering Fees for Biggest Borrowers

• Last Monday, the IMF Board met with staff to review the surcharge policy, which involves fees charged to nations borrowing more than their allotted share or taking longer to repay loans under IMF programs. A spokesperson confirmed during an IMF press briefing on Thursday that a comprehensive review of these surcharges is currently underway, as part of the IMF Executive Board's work program for this fiscal year. This review will consider the implications for borrowers and the credit risk management framework. Any policy changes would require approval from 70% of the board's voting power.

• The IMF has long collected these surcharges to discourage its largest borrowers from becoming overly dependent on its crisis lending. The IMF charges an additional 200 basis points (2 percentage points) on outstanding loans exceeding 187.5% of a country's normal access quota. If a loan remains above this threshold for more than three years or 51 months in case of borrowings under the Extended Fund Facility (EFF), the surcharge increases to 300 basis points. These fees are in addition to the IMF’s basic lending rate, which currently totals approximately 500 basis points.

• Higher global interest rates, particularly from the FED and ECB, mean that the total rate on some loans from the IMF is now higher than 8%. The burden is being carried mainly by a handful of countries including Argentina, Egypt and Ukraine. Over the next five years, Argentina is expected to incur $4.6 billion in additional costs due to these surcharges, while Egypt and Ukraine will face extra charges of $370 million and $348 million, respectively. The United States, the IMF’s largest shareholder, has indicated a willingness to reconsider these fees, reflecting growing concerns over their impact on already struggling economies.

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