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“Some will win, some will lose… some were born to sing the blues“

Journey, Don’t stop believin’

Last week, we discussed the broader similarities and evolutions of DM central bank policy narratives. We argued that, while the vast majority of the most recent DM central bank communications were dovish, the reaction function to continued disinflation remains one of caution. It is likely that they view the cost of failing to bring inflation down as higher than the cost of bringing inflation a little below target (as the worst outcome would be unanchored inflation expectations). Thus, current uncertainties, anomalies, or extended distortions in the data likely induce a hawkish (less dovish) bias- a hesitation bias - even as “the policy rate is well into restrictive territory”.

We also argued that the wider macroeconomic and monetary policy debate among market participants had centred around two key points: (i) Is the current data giving a true gauge of the underlying strength of the economy in the US (especially given further evidence this week of faltering DM and global demand) and, (ii) if the growth outperformance relative to expectations is correct, and persistent, is it a function of blockages in US monetary transmission or is the equilibrium rate of interest, or r*, higher (either temporarily or permanently).

We also made the point that recent headlines had highlighted the problems in relation to the Commercial Real Estate (CRE) market in the US (specifically office buildings and low post-pandemic occupancy / valuations) - not just in relation to the regional US banks (NYCB) but also in relation to notable exposures across Europe and Japan. And, on a related note, that the most recent Fed Senior Loan Officers Opinion Survey (SLOOS) had highlighted a larger tightening of conditions in consumer credit (notably autos and credit cards). Indeed, there are increasing signs that the cushion of excess savings has been fully depleted, as delinquency rates in these two sectors begin to rise rapidly above pre-covid levels.

Ultimately we argued that, as far as the data is concerned, we were unconvinced that such a significant tightening of financial conditions could leave little or no impact on domestic demand and or business investment in the US (though in the near term we are still biased towards a soft landing for growth and a hard landing for inflation) - especially in such contrast to the rest of DM. Rather, we were more inclined to see the recent data as dominated by distortion in the seasonal adjustments or one-off outliers to the recent disinflation and supply/demand rebalancing trend - one that gave the January payroll data a misleadingly strong impression of the labour market (one not mirrored by other indicators).
This week, it was the turn of inflation in the US.

- January core CPI rose 0.39% from December, taking the year-on-year comparison to 3.9% (unchanged from December, but above the average or consensus estimate, which was around 3.8%). There was a similar upside surprise on the headline inflation rate. However, while the commentary following the release struck a hawkish tone, we are much more inclined to view the January print as a ‘one-off’. Indeed, we see a number of reasons to suggest that the January print is misleading and thus does not warrant the extrapolation we saw in US rate markets following the release.

First, it was clear that there were some one-off annual price increases in the data, not an ongoing adjustment (and likely reflecting the lagged impact of wage increases in 2023, which we now see declining; this was notable in insurance, care and medical services components. Importantly, in our view, the more rigorous wage measures continue to decline).

Secondly, there were revised seasonal adjustments in the data series that likely depressed December and boosted January. Lastly, there were adjustments to the component weightings that increased those with higher readings (such as rents and OER - Owner Equivalent Rents). Our calculations suggest that this boosted the OER contribution to the monthly print significantly (in our calculation, just the reweighting of shelter and services upward in the CPI basket in December likely added an additional 0.1ppt to headline CPI in January). We see other, perhaps more reliable measures of rent trajectory continuing to decline.

In short, we view the CPI print as distorted by a ‘January Effect’, a potentially anomalous seasonal adjustment change and a weighting adjustment that leads us to view the CPI, and indeed the January payroll number for similar reasons, as inferring excessive strength in US demand, and or economic activity momentum. We expect the disinflationary trend that was prevalent through Q4 2023 to reassert itself in 2024.

The market focus has been to rush to reprice the exact date of the first rate cut in the US and by extension the quantum of rate cuts in 2024/5. This is significant, as we understand that the expression of the ‘dovish Fed’ view was most concentrated (in terms of market positioning) at the front end. The recent data has driven a sharp correction higher in front end yields, as positions have been unwound. However, from our perspective, nothing has changed from a macro perspective, and we view this as missing the broader point. The trajectory of US rates remains lower.

We are disinclined to see the recent data strength as indicative of a higher r* or a permanent blockage to the Fed’s transmission mechanism. Indeed, we see no compelling evidence, via inflation expectations or growth trends, that suggest higher equilibrium inflation or growth to support the notion. Thus, now that the position adjustment has been made at the front end of the curve (dragging the long end with it), we are more comfortable with a long duration bias in the belly and long end of the US. Indeed, the volatility in the January data that has driven markets to price out a March rate cut increases the risk that rates are higher for too long and further damping already moderating demand. Additionally, long duration optionality now more clearly includes the left tail risk (or a sharper decline in economic activity). The right tail - a persistent acceleration of US growth and/or inflation from here - seems significantly less likely to us.

Furthermore, macro risks remain. Regional banking problems continue (most notably in relation to CRE concerns) and the Bank Term Funding Program is set to expire in early March. Thus, while the March meeting may no longer deliver a cut, it could very well deliver an announcement of the tapering of QT and a continuation of liquidity withdrawal.

In reality, it is not just about my or indeed our interpretation of the data. The most important viewpoint remains that of the Fed. In that regard, the comments from Chicago Fed President Goolsbee in the considered aftermath of the CPI print are significant. Comments from Goolsbee this week stated that “inflation can be a bit higher and still on track to 2%” - playing down the January CPI implication; that he does not “support waiting until inflation is at 2% for rate cut” - a point that we have referenced in Powell commentary and specifically relevant with 6m annualised inflation remaining around 1.9%; that the “Fed’s current policy stance is ‘quite restrictive’” - suggesting a downside policy bias as supply normalises. He emphasised that the Fed’s inflation goal is based on PCE and not CPI”. PCE (as suggested above, has a significantly lower trajectory). And finally, he noted that he “does not believe the last mile of the inflation fight is the hardest” - another point we have made, countering the analyst consensus that inflation will land featherlike, perfectly at target after declining from above 9%! Overall, these comments are consistent with our thoughts and with a continued disinflation and of the Fed normalisation policy.

Finally, this week we also saw the release of a disappointing UK GDP print for December and for Q4, a print that essentially triggered the ‘technical recession’ moniker for the UK economy. Regular readers will be aware that we have been in the Tenreyro/Dhingra camp for many months now and are essentially still of the view that the official data is overstating the economic activity in the UK. Going forward, we see this, in conjunction with the downside CPI miss earlier in the week, as removing the hawkish dissents from the MPC and thus enabling a more explicit dovish bias from the governor - even if retail sales was (likely temporarily) more positive.

Ultimately, and perhaps as the weak retail sales number in the US may allude to, we expect this phenomenon to reveal itself in the US over coming months; perhaps not explicit or technical recession dynamics but a clearer, disinflationary, growth moderation. While markets appear overly focussed on the debate over the date of the first cut, from our perspective the direction of travel is significantly more important. Indeed, you could say that the market is overly focussed on the Journey, rather than the Destination.

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