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“All you need in life is ignorance and confidence and then success is sure“

Mark Twain

Last week, we discussed the most recent data and commentary driving the Developed Market monetary policy considerations and by extension the dominant macroeconomic sentiment and positioning - concentrated on the European Central Bank and the Federal Reserve ahead of this week’s events.

With lower-than-expected inflation prints for March in the Eurozone, the set up and sentiment into this week's European Central Bank meeting was dovish. However, last week we argued: “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 European Central Bank are biased to cut and that the first of those cuts is likely to be 25bps at the June 6th meeting”.

This week’s meeting delivered largely what was expected by us and by markets. The European Central Bank President outlined the view that “there is a clear disinflationary process in progress” - confidence in which was enhanced by continued assessment of downside risks to growth. However, the message was clear that the majority of the Governing Council still needed further data to be confident that inflation is returning sustainably to target (despite clearly stating that ‘a few’ Governing Council members had achieved sufficient confidence - inferring their willingness to vote for a cut now given the chance). The barometer by which this ‘confidence’ will be assessed is via (i) the updated assessment of the inflation outlook, (ii) the dynamics of underlying inflation and, (iii) the strength of monetary policy transmission, in order to further increase its confidence that inflation is converging to the target in a sustained manner, such that it would be appropriate to reduce the current level of monetary policy restriction.

While Lagarde insisted that the European Central Bank policy trajectory is not determined by the US data or the Federal Reserve, the reality is likely a little more complicated than that. There are a number of US dominant factors that will feed through into the European Central Bank considerations. For instance, a front-loaded European Central Bank easing cycle, ahead of the Fed, could be self-defeating; the likely move lower in EURUSD may engender a negative inflationary feedback loop. That said, in the near term, many commentators are considering the prospect of divergent monetary trajectories in developed markets. Rate cuts in the eurozone are coming - the timing and pace of which are however more moot, from our perspective.

This week the US data and the Fed have also spoken, with the latest CPI print and the minutes of the March FOMC.

Last week we discussed the sentiment from Federal Reserve Chair Powell, highlighting 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”. This week, the US data again disappointed the doves, ourselves included, with yet another bump in the road.

From our perspective, however, we continue to view the disappointments as bumps, on an otherwise disinflationary plane (bumps that will ultimately be squashed and not a ramp to an accelerating or higher baseline inflationary environment). We continue to see the configuration of supply and demand dynamics in the US as ultimately disinflationary.

The focal points of the minutes from the March FOMC meeting were twofold: clarity of the Federal Reserve in relation to the path of balance sheet reduction and breadth of views/debate around the inflation trajectory.

The balance sheet comments were very clear. The Board appears close to a decision to taper the asset purchase run-off, such that balance sheet run-off does not translate directly into falling reserve balances at the Fed. More notable perhaps was the discussion on the economy.

The minutes noted that “almost all” participants judged it would be “appropriate to move policy to a less restrictive stance at some point this year.” but that they did not expect cuts to be appropriate “until they had gained greater confidence that inflation was moving sustainably toward 2 percent” and noted that “the recent data had not increased their confidence” in that regard. Indeed, much of the debate on the inflation progress alternated between the ‘significant progress’ that has been made since the peak in June 2022 (September for the core measure) and the near-term uncertainties or the “somewhat uneven” path.

Increased potential growth as a function of higher immigration and implied productivity gains are significant in relation to the Federal Reserve’s thinking - recent growth upgrades - but should also be important in relation to the market interpretation of the Federal reserve’s reaction function. If inflation remains well behaved (and we understand that this is a bigger ‘if’ in the minds of many following this week’s data), then the bar for the Fed to normalise monetary policy is much lower than the current market pricing, from our perspective. This dovish asymmetric reaction function of the Fed is likely very important - especially given the recent sentiment swing - in relation to the June Federal Reserve meeting.

The Consumer Price Index print is also more of a moot point from our perspective. While the headline and core inflation prints were above expectations, the upside surprises were in categories that are not clearly driven by excess demand (and thus reactive to monetary policy), rather supply driven factors such as car servicing costs, insurance, and medical services. Indeed, on a modest tangent to this argument the Krugman article in the NYP this week pointed out that on a harmonised basis (the basis upon which the European Central Bank looks at its inflation data) US CPI would already be back around 2% - given that it does not include the somewhat controversial OER. Market negotiated rents are falling sharply, and we expect OER to follow suit and as we await this normalisation, the month-on-month oscillation of volatile CPI basket items are having an outsized impact.

In this context and our view of inflation (not the inflationary environment that the market currently assumes) we have one last thought this week. The current consensus assumption is that the US economy will see higher growth, higher inflation and higher rates in the remainder of the year. For me this is a difficult triangle to square (so to speak). Especially if we consider that the recent ‘upside surprises’ to inflation have been supply driven (Oil/Gas prices, Insurance, Medical services) and thus likely constitute a tightening of consumer finances. This is particularly important in the context of recent conclusions by the Fed, that domestic savings in the US are almost exhausted. Something that is not consistent with higher demand growth.

If we add in the fact that we are already starting to see some fragilities in smaller businesses (NFIB small business optimism index fell to its lowest level in more than a decade recently, and hiring intentions fell sharply - not a positive sign if you believe small businesses are the biggest employer in the US). Furthermore, the broad Russell 2000 index has also risen slower and fallen faster over recent weeks. The top 100 or 500 companies in the US (Nasdaq and S&P) are doing fine but the centre of gravity of the US is a little lower.

There is a lot of data and commentary for the markets to digest at the current complicated macroeconomic juncture. Emphasis on the attainment of sufficient confidence throughout global Monetary policy maker rhetoric is very important from our perspective and confidence (especially in uncertain times) may be rapidly altered.

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