“The Universe is asymmetric and I am persuaded that life… is a direct result of the asymmetry of the universe or of its indirect consequences“
Louis Pasteur
Last week, we discussed the concept of confidence, confidence that inflation is returning to target in the context of the restrictiveness of current monetary policy settings. In terms of confidence, we argued that this was, by default, an asymmetric relationship, and that by extension, the Fed has a default dovish, asymmetric reaction function with interest rates “deep into restrictive territory”. Some had recently questioned how restrictive monetary policy in the US is, given that current settings have not imparted the expected slowdown in growth. We highlighted four points in this regard:
Recap on Current Restrictiveness
(i) we are not convinced by the arguments that there has been any significant upward shift in the equilibrium rate of interest, or r*, (ii) in any case, the debate should be framed by the level of real rates, in that real rates have only been positive for a relatively short period of time. Thus, the argument that the growth momentum has some immunity to the current level of nominal rates is likely premature (iii) it is important to consider the level of growth in relation to ‘potential growth’, in the context of policy restrictiveness. Productivity gains and significant supply side normalisation have likely pushed up the equilibrium growth rate, and thus recent growth data that has come in above expectations is less likely to be inflationary. We argued that from our perspective, the current growth backdrop (even after this week’s GDP figure) is not sufficient to prevent further disinflation and thus ultimately policy normalisation - rate cuts.
Lastly, (iv) we argued that the Fed mandate is to maintain price stability, the preferred barometer of which is PCE. However, if the Fed chose to look at inflation on a harmonised measure (HICP excluding housing and OER) such as the methodology used by the ECB, then core inflation in the US is currently 1.9%. The current level of divergence pricing between the US and European rate paths is not obviously consistent with the fact that on a harmonised basis US inflation is significantly below that of the eurozone. Indeed, even on the Fed’s preferred measure, the decline in inflation has been much smoother and more consistent (less bumpy) than the CPI.
US Exceptionalism?
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This week, we attempt to expand upon this discussion, particularly in relation to the relative trajectories of Europe and the US - what markets have recently termed the divergence trade, or US Exceptionalism.
Over recent weeks (perhaps months) we have argued that the underlying strength of the US economy is, in our view, not as strong as the recent headline macroeconomic data (notably CPI and labour data) has suggested - highlighting a string of alternative economic indicators that show protracted weakness on an absolute basis (small business sentiment, Russell 2000 underperformance, housing transactions, …). At the very least, we argued that the extrapolated projections of US economic outperformance underestimated the level of restrictiveness of overall policy settings - even against the backdrop of significant, procyclical fiscal expansion (and not forgetting the fact that the recent enormous congressional aid for Ukraine, circa $60B, is also likely a huge positive domestic investment in replacing the ‘gifted’ ammunition.)
European Underperformance?
At the same time, we have argued that the underlying strength of the eurozone economy is not as weak as recent market sentiment and extrapolation of recent data trends had suggested. Indeed, we continue to push back against the consensus view of a sharp decline in EURUSD on this basis. Amid this week’s global PMI data were two interesting developments (1) consistent with the brighter global picture, India maintained its momentum alongside (to a lesser degree) the UK, Japan and Australia. However, the US activity slowed sharply (we now keenly await the ISM for confirmation - or otherwise). (2) The European, and notably German data also showed a further recovery. Indeed, the German data is likely consistent with a bottoming out of the German economy, which is an important development for Germany, Europe and the Global economy, as well as an important contradiction to the consensus view of growth divergence - European Underperformance and US Exceptionalism.
ECB rhetoric has also notably calmed this week with Bundesbank’s Nagel suggesting that he is “not yet fully convinced that inflation is returning to target” and that a June rate move will not necessarily constitute the start of “a series of cuts”. Muller, also a Governing Council member, added that he was “not comfortable starting with back-to-back cuts” - as has been largely priced by the market and predicted by numerous commentators.
Volatile Earnings
Geopolitical and macroeconomic uncertainties have also been set against the volatile backdrop of Q1 earnings season this week - so volatile, in fact, we have seen post-earnings moves in 2 of the biggest stocks in the US (Meta and Tesla) moving more than 15% (one in each direction), as markets digest the earnings and guidance, and significant volatility following earnings beats from Microsoft and Alphabet. Going forward, we expect the higher baseline volatility across asset classes will have material implications for the long carry (and ultimately long risk) trades that have dominated the macro landscape over the start of 2024.
The Long and Short of it
Ultimately, we believe that we are approaching an important juncture for financial markets, as the data starts to question popular narratives and volatility starts to question popular positions. Furthermore, we remain of the view that the reaction function of inflation to slowing growth is asymmetric (i.e that the level of inflation in the system is currently greater than the level that would historically be generated by the level of costs. Thus, any weakening in demand could see sharp price cutting). We also see the policy reaction function of the Fed as asymmetrically dovish, given the fact that we are likely deep into restrictive territory. And the risks to market positioning in terms of this reaction function are also likely skewed asymmetrically towards reversing the long carry, long risk consensus trades (and long USD in the DM space). In that regard, it is possible that all it would take is a trigger. To paraphrase Louis Pasteur “The macro universe is asymmetric… and this likely has indirect consequences for markets”
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Sources
https://www.bloomberg.com/news/articles/2024-04-24/ecb-s-first-rate-cut-doesn-t-have-to-kick-off-series-nagel-says?embedded-checkout=true
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