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“Holding too tightly, afraid to lose control?“

Linkin Park, Numb

Last week, we posed the question, “what has changed?” to the US growth and inflation trajectory. Ultimately we argued that, continued disinflation and growth moderation were likely to remain the dominant themes - despite the recent upside surprises in US data.

Again despite the data, we argued that on the inflation front, the minutes portrayed notably more optimism. The clear statement that upside risks had diminished was emphasised by the clear curtailment of right tail risk in the statement that the “policy rate is likely at the peak of the cycle”. At the same time, likely ‘twice shy’ from the ‘bite’ of the “transient inflation” narratives of 2022, the Fed is now consciously proceeding carefully. In practice, this likely means erring on the side of tighter policy settings to ensure the anchoring of inflation expectations, as the Fed remains “highly attentive to inflation risks”. However, we continue to see a backdrop where the Fed policy reaction function is asymmetric in that with rates “well into restrictive territory” lower than expected growth and inflation prints (as we continue to expect) throughout the year will bring faster than expected action from the FOMC - potentially even including bigger than 25bp increments - whereas higher than expected recent prints have merely delayed, but not deterred rate cut expectations from the Fed.

On the growth side, we pointed out that the Fed emphasised the two-sided considerations in highlighting the risks of cutting too quickly. However, some members noted the “downside risks associated with maintaining an overly restrictive stance for too long”. Moreover, there was an explicit reference to the signs of financial stress for low and moderate-income households {increasing usage of credit cards or revolving balances, increased usage of buy-now-pay-later offers from retailers and increasing delinquencies}. The Fed still expects GDP to be below potential in 2024 and 2025, with the risks skewed to the downside - exacerbated by any extended period of higher than expected inflation. Another factor that facilitates an asymmetric dovish Fed reaction function!

This week has been very quiet (outside of the volatility spike in crypto), but next week, as data and events are much more abundant we expect volatility and activity to pick up anew.

The UK Budget will be a significant event as the government lays out the fiscal trajectory and targeted measures to boost growth in the medium term (and their domestic popularity in the near term). Commentators are expecting cuts to the basic rate of income tax, further fuel duty freezes and even (going by headlines this week) changes to the non-dom tax status rules. However, from a market perspective, the emphasis will be on two factors: (i) how the ‘election sweeteners’ affect the medium-term fiscal outlook for the UK - predominantly through the revised OBR debt forecasts and whether that has material implications for the gilt market and (ii) what is the likely impact (again via OBR projections) on growth, and by extension inflation expectations, of any tax changes.

While in the UK market focus is on the fiscal trajectory, in Europe it is all about the monetary trajectory. At the start of the year March was seen as a distinct possibility for the start of the rate cutting cycle in both the US and Europe. Since then upside surprises in the US (though not indicative of a higher trajectory in our view) and some significantly less dovish ECB rhetoric (helped by some signs of improvement in the growth backdrop - particularly in the periphery) has led markets to price an almost zero chance of a rate cut from the ECB. Indeed, it is likely that the statement that the eurozone has not gone far enough “along in the disinflation process” [Lagarde at the January meeting] is likely to be maintained next week.

However, as we close this week with the flash estimates for the February CPI print in the eurozone it is the updated staff economic projections that will be most keenly anticipated. The ECB December projections saw inflation at 2.7% in 2024 - a rate likely already surpassed that (to the downside) in February - implying perhaps significant downward revisions to the staff inflation projections. This, in itself is likely to be a dovish iteration for eurozone rates and the EUR, but it is not clear that the projections will outdove market expectations with positioning in the rate and FX space already clearly biased to the downside. Core inflation will be key and wage pressures are likely still the battleground under which core prices evolve through 2024 - resilient so far at least. Without doubt the ECB meeting will be a big focus for next week.

Lastly, and most importantly, the focus of next week will be on the US and on growth. A plethora of jobs data, culminating in the non farm payroll release of Friday, will be the key driver of market sentiment. Over recent commentaries we have noted our view that the upside surprises we have witnessed so far in 2024 are one-off or distorted by seasonal factors and that we continue to see disinflation and growth moderation as dominant. In this regard, the nfp data will be intensely scrutinised - at least in terms of the headline momentum and the correction (or otherwise) of the jump in Average Hourly Earnings (AHE) from January.

To put the data into policy perspective we also hear from Fed Chair Powell at the semi-annual testimony to congress. While going into the January data Fedspeakers were clearly pushing back against rate hike expectations, it feels more balanced to me going into the February data. Indeed, if anything the Fed rhetoric appears more biased to warning against extrapolating the recent upside surprises.

Lastly, our focus next week will also be on the market indicators themselves. The most significant progression in market pricing this year is likely the rapid rise in short term inflation expectations (having risen almost 80bps to around 2.80% this year). While much of this may have come as a function of position unwinding in front end nominal and inflation bonds, it is starting to look very stretched - especially if, as we expect, the disinflation trend continues over coming months. Long US duration still feels like the dominant macro story. Indeed, to paraphrase Linkin Park, we see the Fed as holding policy too tightly… afraid to lose control?

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