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“... so close to you right now. It’s a forcefield“

Calvin Harris, Close to you

Last week, we took a look into the week ahead focussing on three key events: (i) the UK Budget and by extension the fiscal trajectory, (ii) the European inflation update and by extension the inference for the ECB and the European monetary trajectory and (iii) the plethora of jobs data prints from the US, alongside testimony from Fed Chair Powell and by extension an inference on the all-important growth trajectory of the US.

The UK Budget was largely as we and the broad commentariat had anticipated (essentially a function of well leaked proposals from number 11). The Chancellor delivered the expected changes to non-dom status, fuel duty freeze as well as some additional tinkering in the form of changes to pension investment rules, a ‘British ISA’ allowance and an additional six billion pounds for the electronification of the NHS records system (and some AI productivity enhancement targets). However, the intended headline grabber was the 2ppt cut to National Insurance (and the aspiration of eventual eradication of the NI tax). From our perspective, the main aim of the Budget was one of fiscal conservatism, without the moniker of ‘Austerity’. In this regard, the gilt market received the budget well, and the compliance with the fiscal rule.

Last week, we discussed the potential ‘election sweeteners’ in the Budget. While the tax cuts were modest (and some would argue offset by the freezing of income tax bands) their impact peaks this fiscal year at around thirteen billion pounds. In reality though, it is likely that the fortunes of the current government (as bleak as they may look in the current polls) are less likely to be determined by the cut in National Insurance, and much more dependent on the path of inflation and prospective monetary policy easing ahead of an election. In that regard the relatively dull Budget may have been just what the Chancellor may have wanted.

Into the close of last week, the flash estimate for eurozone inflation came in above forecasts (2.6% y/y headline and 3.1% y/y core - vs expectations of 2.5% and 3.1%), tightening expectations of a sharp reduction in the ECB staff projections for inflation throughout the forecast horizon. In the event, this week’s ECB meeting announced new projections with slightly bigger downward revisions to the inflation path (at least relative to updated expectations) for core inflation.

In conjunction with the downward revision to the projected inflation path from the ECB, the narrative on growth was also weaker - at least in the near term - as the forecast for 2024 was revised down to just 2.6%. That said, the forecast for 2026 was revised a touch higher to 1.6% and the rhetoric from Bundesbank head Nagel following the ECB suggested that the Governing Council see the economy in upswing in the second half of this year. Perhaps the most interesting part of the discussion on growth from the ECB President was that they consider the dominant factor in growth and inflation weakness as external, and that domestic inflation is “not declining” – a likely reference to the fact that tight labour markets and positive real wage growth continue to support domestic demand growth and inflation.

However, despite the dovish trajectory of the growth and inflation projections, the monetary narrative remained unchanged. Lagarde was clear that the Governing Council is not yet sufficiently confident on inflation (“what we are seeing is not yet strong, durable enough”). And in a clear nod to the start of the ECB rate cutting cycle in June, the ECB President stated that in terms of the data to satisfy this insufficiency, “we will know a little more in April, and a lot more in June

This week also brought a huge amount of US data, and monetary policy guidance from the semi-annual testimony of Chair Powell to Congress. While the message from the ECB was “not there yet”, the narrative from Powell (and backed up by recent rhetoric from wider Fedspeakers) was “not far”: the Fed are not far from the level of conviction needed to begin dialling back the level of restrictiveness of monetary policy.

With both central banks turning their policy focus clearly in the direction of the evolution of the data, this week has been significant in the US - both in terms of the amount of data, and the directional inference. Last week, we suggested that while going into the January data, Fed speakers were clearly pushing back against rate hike expectations (which had been increasing extrapolating rate cuts). We also suggested that going into the February data, that the Fed rhetoric appears more biased to warning against extrapolating the recent upside surprises (narrowing of rate cut expectations).

From our perspective, the data releases this week have validated that interpretation of the Fedspeaker guidance. Namely, we saw weakness in factory orders (Jan), ISM services (Feb) - especially in relation to prices and employment - activity moderation, and even the February employment report into the close of this week (where despite the higher than expected headline jobs gain, we saw significant revisions to the January print and a jump in the unemployment rate, indicating further weakness in the household survey relative to the establishment survey). More importantly, they have also validated our interpretation of the macro backdrop, whereby we continue see disinflation and growth moderation as the dominant macro trajectory in the US, and by extension, given the current Fed policy settings deep into restrictive territory, we see an asymmetric dovish reaction function from the Fed if this macro trajectory continues.

Last week, we discussed that the upside surprises we have witnessed so far in 2024 are one-off or distorted by seasonal factors. This week’s data was a reasonable start in the validation of this theory. Next will be equally so. The US inflation and retail sales data thus keep a bid in front end vols and market interest piqued. To paraphrase Calvin Harris, the turning point in DM monetary policy ‘feels so close… right now’

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