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“Take the time to make some sense of what you want to say“

Oasis, The Masterplan

In our last piece, before the Easter holiday period, we discussed the recent monetary evolution of a range of DM central banks and the critical nature of the Fed narrative against the noise and uncertainty about the interpolation or extrapolation of US growth and inflation trends.

We discussed the complex monetary policy reaction function in Australia, as immigration continues to boost idiosyncratic domestic demand in specific areas (notably in housing and services), despite particularly weak household consumption and productivity. The Swiss National bank was the big surprise in the DM space, with a 25bp cut to 1.50%, as inflation (after a moderate surge by global standards) continues to decline below target, and conditional inflation projections from the SNB show further substantial downward revisions. Indeed, the SNB stated that the fight against inflation had been successful - a very clear statement about the likely trajectory of monetary policy.

The Bank of England, while leaving policy unchanged, saw a notable change in the voting, as the hawks (Mann and Haskel) dropped their dissent, skewing the vote to keep rates on hold clearly more dovish. This is a clearer move towards our thinking on the UK economy, where we have held the view for many months now that the underlying growth in the UK is weaker than the headline data suggests, and thus disinflation and growth moderation will remain dominant and drive a more dovish response from the BoE, possibly even one which accelerates in the second half of 2024.

Then lastly, but most consequentially, we discussed the Fed. While the FOMC left rates unchanged, the focus was on the economic projections and of course, the ‘dots’. Notably, the Fed raised growth projections throughout the forecast horizon and the near term inflation path, while maintaining the ‘median dot’ for 3 rate cuts in 2024. Some commentators suggested that this is a Fed that is comfortable running inflation above target and by extrapolation they see a steeper yield curve and a positive risk asset trajectory. For us, however, this is likely a further reaffirmation of the asymmetric dovish reaction function of the Fed against an increasingly high bar for the data.

In many respects, the past week has been relatively quiet, but there have been a couple of developments that in conjunction with next week's data are likely to prove important milestones or barometers of the DM central bank policy path. Indeed, markets will be hoping that the data goes some way to deciphering the noise and uncertainty about the interpolation or extrapolation of US growth and inflation trends.

In Europe this week, we have had the release of the euro area March CPI data. While the data missed expectations to the downside, there are a number of reasons to caution against an accelerated monetary response from the ECB. Firstly, the downside miss on the core measure was very marginal 2.945% (rounding down to 2.9% - against an expectation of 3.0%) and secondly, the momentum of services inflation continues to pick up, supported by still rising unit labour costs. In addition to the more mixed inflation breakdown, the narrative on inflation from the minutes of the March 7th ECB meeting was also a little more balanced, with Governing Council members choosing to highlight the likely “bumpy” profile of inflation beyond the summer.

However, while there are some reasons not to get carried away with the downside inflation trajectory - and indeed, on the growth front there are a number of more positive progressions in the periphery that, at least in part, offset some of the more publicly debated problems in the core - it remains clear that the ECB are biased to cut and that the first of those cuts is likely to be 25bps at the June 6th meeting. Technically, this would mean the ECB cutting ahead of the Fed, although we still expect the Fed to match the move just six days later.

Next week, we expect the ECB narrative to remain consistent with a rate cut in June, but not necessarily to make a firm commitment. The big focus from a rates market perspective will be whether or not the statement and press conference are consistent with rate cuts at a frequency above once per quarter (markets are currently priced above that frequency at just above 90bps this year). The other reason that we expect the ECB may offer a slightly more cautious tone is the recent significant rise in the oil price. The minutes of the March meeting released this week emphasised the fact that, at the time of the March meeting, the ECB expected oil prices to decline. This divergence may be a cause of concern - though at this stage not likely to derail the modest ECB easing cycle through the second half of 2024.

Perhaps the most interesting progress of the week however, has been in the US, starting on the bank holiday Monday, with the Manufacturing ISM. While at the headline level the index rose above the 50 expansion line and the prices index rose more than expected, from our perspective, the rally in yields was more a function of the bank holiday liquidity than rational extrapolation. Manufacturing accounts for less than 20% of the US economy, and the employment subindex remained in contraction. Furthermore, the more important services index (almost 80% of the economy) fell more than expected, with prices paid falling to a three-year low and employment remaining in contraction for a third consecutive month.

Testimony from Fed Chair Powell this week also contributed to the market’s interpretation and extrapolation of monetary policy expectations in the US. While price action into the event suggested concern (or hope) that Powell would convey a more hawkish message, the reality was more balanced and consistent with the March FOMC. Powell highlighted that the “risks continue to move into better balance” and that it is too soon to say if the data at the start of the year were more than a bump in the road. More clearly, he stated that “the data has not materially changed the overall outlook”.

Ultimately, we remain of the view that the Powell statement that he doesn’t expect cuts until the Fed has more confidence on inflation remains consistent with rate cuts starting in June - essentially as a function of our continued view of disinflation and growth moderation. Indeed, the ‘noise’ that has disconcerted the market is not apparent in the Core PCE data (the Fed’s preferred inflation measure), which continues its smooth path towards target - despite the noise.

Finally, we find it very interesting that the sell side consensus continues to suggest growth and thus policy divergence between the US and Europe, with logical FX consequences. However, we see the potential for convergence, not divergence. Manufacturing PMI data has clearly shown a turn and a return to global correlation and the ECB noted in the March minutes that the data in January to March confirm the bottoming out of the economy. In the US, markets expect strong US growth to continue unquestioningly; we are more skeptical. From our viewpoint, peak divergence has passed.

To paraphrase Oasis, while some are becoming skeptical that the Fed can deliver on their promised ‘dots’, we believe that taking some time to make some sense of what central banks are saying remains consistent with disinflation and monetary normalisation - and not just acquiesce on a ship of hope!

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