“The more things change, the more they stay the same“
Post Malone, Circles
A belated Happy New Year.
The Bank of England were clearly the most hawkish of the three, with a higher projected inflation path and three members of the nine strong Monetary Policy Committee voting for a rate hike - despite increasing signs of fragility in a number of sectors of the economy.
The ECB were also focussed on the upside risks to inflation, even as the market’s concerns had drifted toward downside risks to growth. Though Lagarde acknowledged that inflation had fallen considerably (more than expected and below the ECB forecasts in some instances) and that the Governing Council expect inflation to rise in December on base effects and to fall at a slower pace through 2024 (due to further base effects), emphasis was placed on the resilience of the European labour market. Indeed, the inference was clear, that upside risks come from bigger than expected increases in real wage growth and higher than expected foreign demand (read China recovery?). She also said that the data we have now does not show wages declining. Collective bargaining and price increases in the new year will be key.
The Fed also left policy unchanged, and we argued that the subtle changes that were made to the statement were iterations that emphasised the proximity to the peak of the cycle and the further disinflation and growth moderation - both nods to the attainment of peak policy restrictiveness. However, we also argued that the real focus was on the forward guidance, or the updated Summary of Economic Projections (SEP’s) and the dots (or projected forward rate path of the Members). The projections showed that the ‘median’ dot indicated 75bps of rate cuts in 2024, facilitated by lower growth and inflation projections - more than the 50bps that was implied by market pricing going into the meeting. Powell also made clearer reference to the pandemic distortions to the inflation trajectory, not simply a period of natural excess demand.
For a long while now, we have had a strong view that we will see continued disinflation in the US, with growth moderation, but still growth (‘a hard landing for inflation, but a soft landing for growth’). The December FOMC was the first time the Fed had so clearly inferred this direction in their broad thinking. Importantly Powell continued to emphasise that the Fed would “want to reduce restrictiveness well before 2.0%”.
So, with a much more dovish than expected Fed, markets were quick to price in extrapolated rate cuts, not just from the Fed, but also the Bank of England and the ECB.
What has changed in 2024? In short, for us, relatively little.
January has seen a moderation in the pricing of rate cuts in 2024 and a pullback in yields more generally. In our view, the driver of the pullback is the combination of three factors: (i) the rise in geopolitical tensions - in particular the tensions in the middle east and the potential implications for energy and shipping costs in general (and thus inflation) as goods are diverted away from the Red Sea passage; (ii) the pricing of rate cuts in the US and Europe that in some parts of the front end of the curve exceeded the 25bp increment for rate cuts and (iii) better than expected economic data in both the US and Europe - thus reducing the likelihood that bigger than 25bp increments in the rate cutting cycle will be needed, for now.
In addition to this, commentary from policymakers (ECB and Federal Reserve) at the WEF meetings appeared more moderate than market expectations in terms of the urgency of rate cuts (especially across Europe, but also in the US).
For us, our core macro views remain. While the rising geopolitical uncertainties cloud the prospects for USD weakness a little, we remain resolute in our views that continued disinflation (and not the ‘tough last mile’ view that appears consensus) will prevail alongside growth moderation (but not - for now at least - negative growth). These are conditions that should be positive for both duration and risk assets - Nasdaq being our favoured expression.
From a policy perspective, this week we got an update from the ECB.
Going into the meeting, the emphasis was on the Governing Council’s assessment of the inflation outlook, and by inference, the assessment of the timing and size of rate cuts in 2024. On the face of it, Lagarde continued to push back; she stood by her comments from the recent WEF meetings, where she implied that rate cuts may start in the summer: she reiterated that the ECB GC did NOT discuss cutting rates (they saw this discussion as premature) there was explicit acknowledgement that the risks to growth were to the downside and that the inflation trajectory was dependent on some elements of global growth, real wages and accepted that wage growth was already declining.
The ECB will remain data dependent and will assess the data under three main criteria: (i) their assessment of the inflation outlook in light of the incoming economic and financial data, (ii) the dynamics of underlying inflation and, (iii) the strength of policy transmission. Ultimately stating that they “need to be further along in the disinflation process before we can be sure inflation will reach target in a sustainable way within a sufficient period of time”
Effectively, the ECB pushback to near term market rate cut pricing retains the caveat or ‘optionality’ of data dependence and the March updated staff economic projections will be key in this regard. Any uncertainty at the Governing Council could result in the use of the publication of national accounts (not available by the April meeting) in order to delay the commencement of the easing cycle, but as per the market response, April is now very much a ‘live meeting’ from a policy perspective.
Next week, it will be the turn of the Fed (and indeed, more importantly from our perspective the January labour market data) and with a very high correlation between DM rates, the market interpretation of the Fed reaction function will also have a significant impact on European rate curves. The more things change, the more they stay the same!
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Fed Minutes, 31st October - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20231101.htm
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