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“You say it best, when you say nothing at all“

Ronan Keating (Overstreet / Schlitz)

Last week, we discussed the partial reversal (or pull back) in some of the dominant trends of November and December (dominated by higher rate cut pricing and duration outperformance). We argued that the pull-back was driven by three main factors (i) the rise in geopolitical tensions - in particular the tensions in the Middle East and the potential implications for energy and shipping costs in general (and thus inflation, as goods are diverted away from the Red Sea passage); (ii) the aggressive pricing of rate cuts in the front end of US and European curves had started to price larger than 25bp increments for some 2024 Fed meetings and (iii) better than expected economic data in both the US and Europe - thus reducing the likelihood that bigger than 25bp increments in the rate cutting cycle will be needed, for now. We also noted some Fed and ECB commentary (WEF and otherwise) that pushed back against both timing and magnitude of the policy response.

Ultimately however, we noted that our core macro views remain. Stating that while the rising geopolitical uncertainties (and even the prospect of significant US economic outperformance) cloud the prospects for USD weakness a little, we remain resolute in our views. Notably, that continued disinflation (and not the ‘tough last mile’ view that appears consensus) will prevail alongside growth moderation (but not - for now at least - negative growth). Conditions that should be positive for both duration and risk assets.

Last week, we also discussed the January ECB, where there was notable pushback against the market pricing of imminent rate cuts, with the reference ‘discussions around rate cuts by the Governing Council as ‘premature’’. There was, however, explicit acknowledgement that the risks to growth were to the downside and that the inflation trajectory was dependent on some elements of global growth, real wages and significantly given its importance in the tightening cycle, that nominal wage growth was already declining.

The inference was that the ECB will remain data dependent and will assess the data under three main criteria: (i) their assessment of the inflation outlook in light of the incoming economic and financial data, (ii) the dynamics of underlying inflation and, (iii) the strength of policy transmission. Calibrating the current prospect for rate cuts with the “need to be further along in the disinflation process before we can be sure inflation will reach target, in a sustainable way, within a sufficient period of time”. Effectively, the ECB pushback to near term market rate cut pricing retains the caveat or ‘optionality’ of data dependence (the March updated staff economic projections will be key in this regard).
This week, it was the turn of the Fed.

Following the ECB, the Fed statement and subsequent press conference outlined a more cautious narrative on the progression of monetary policy. In both cases, there was an explicit and formal end to the rate hiking cycle - in the case of the Fed with the omittance of the reference in the statement to “additional policy firming that may be appropriate”, and Powell’s statement that “Almost all [FOMC members] believe it will be appropriate to reduce rates.

Perhaps the defining sentence in the statement was “The committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards target” (my emphasis). Powell damped the inference of this sentence a little in the press conference - “We are already confident.. and increasingly so… that inflation is returning to target… what we are looking for is more good data, not better data … is the signal correct… It is likely we achieve that goal, but we have not yet”!. However, his response in the Q&A that at the moment he ‘doesn’t think it likely that the Fed will cut rates in March’ was significant from a market perspective. Going into the meeting, market pricing for the March meeting was 19bps. Post meeting, it settled around 9.5bps

Indeed, the vast majority of the statement and press conference were dovish in composition or bias (excluding disappointing market expectations of a March cut). Powell was clear that “the Policy rate is well into restrictive territory” (and at its peak) and that we are “getting more growth because of supply chain healing”.

This week also saw the Monetary Policy Report from the BoE, where rates were left unchanged at 5.25% and despite a three-way split in the vote (1-6-2 - 2 dissents in favour of a 25bp hike and 1 dissent in favour of a 25bp cut), the Bank also gave an implicit signal that the rate hike cycle is over and that the next move will be lower. I say implicit, as in typical Bailey/Broadbent style, the bias was expressed via the description of monetary policy being categorised as bookended by inflation projections, conditioned under market and constant rate assumptions - the former seeing inflation at 1.9% at the forecast horizon and the latter a bigger downside miss. A technical way of saying the next move will be lower, without saying the next rate move will be lower!

The Bank forecasts also see UK inflation at target by the spring, but as the drag from energy price base effects is withdrawn, they are inclined to wait for more data - gain greater confidence - that inflation will return ‘sustainably to target’. This is essentially the message from the Fed and the ECB as well. Provided growth (which Powell admitted had been an upside surprise to the Fed) remains non-recessionary, policy makers are likely to seek further ‘confidence’ in inflation sustainability (at target), as base effects of pandemic (and energy shock) distortions roll off. Particularly, as again highlighted by the BoE, that the impact on wages, and by extension services inflation, is asymmetric (slower to decline than it was to rise).

Last week, we referenced the Post Malone lyric “the more things change the more they stay the same” in relation to the ECB. The term is equally relevant to the similarity of the approach of the ECB, BoE and FOMC despite their very different experiences with shocks, growth and inflation. The central narrative for all was summed up in the opening remarks from Governor Bailey, “Good news, but we are not there yet.” Close, but no cigar. The data does not have to outperform central bank forecasts to warrant rate cuts, more of the same will suffice.

We still hold the view that developed markets will see a hard landing for inflation and a soft landing for growth. Recent headline data in the US has corroborated this theory. However, there have been notable weaker data across manufacturing and broader labour market metrics. Furthermore, while the headlines were dominated by the debate over a March rate cut in the US, in its entirety, the January FOMC was, in our view, dovish. We see no reason why the dominant themes of November and December (also our core views) should not reassert themselves - most notably long duration.

‘Passive tightening and the cost of inactivity’ may sound like the least interesting Harry Potter book but it is fundamental to the current underlying macro dynamic and market positioning. The Fed may well be hesitant to act, as they remain unconvinced that the past six months of at target (on a 6m annualised basis) inflation is indicative of sustainable trajectory. However, the decision to hold rates in restrictive territory (inactivity) also has a cost. If, as we expect, the disinflation trend continues (irrespective of the energy price base effects), then real rates become more restrictive - passive tightening. With high (and potentially rising) real rates and inflows into money market funds (further encouraged by extended hold on rates), small banks are likely to face higher funding risks - not just consumers and businesses. Indeed, the well publicised stresses of NY regional bank this week highlights the exact issue - Just as the reference to bank stability was omitted from the Fed statement.

Finally, it was not just the reference to the prospect of additional policy firming, or that to the soundness and resilience of the banking sector that were omitted from the Fed statement. The reference to tighter financial and credit conditions weighing on economic activity, hiring and inflation was also omitted. We are less convinced that the least risky option for the Fed is to remain inactive for longer. Indeed, as far as the statement is concerned, we see the omissions as key - or maybe they say it best, when they say nothing at all… As far as actions are concerned it may be quite the opposite!

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    Fed Minutes, 31st October - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20231101.htm

    Image: Bank, GI, by tostphoto from Getty Images


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