““If I go, there will be trouble. And if I stay it will be double“
The Clash, Should I Stay or Should I Go
Last week, we discussed the recent, better-than-expected, US data and the dominant market inference that evolved as a result: higher growth equals stronger demand, stickier inflation and thus higher and / or more sustained (restrictive) policy rates - an inference we continue to disagree with. Furthermore, we also discussed our view of the likely distortions to the US data at the start of the year as a function of weather, tax policy, strikes and seasonal adjustments - all of which have likely provided (anomalous?) credibility to the current surge in growth optimism and sharp repricing of US rates. In doing so, we also reiterated our view that the disinflationary forces that have been in place since the peak of US headline inflation (in July 2022) and core inflation (in September 2022) will continue and indeed, even potentially accelerate in 2022, with goods price deflation and the base effects of oil and gas price declines likely the dominant protagonists
“In essence, we are of the view that US rates have repriced too much relative to the Fed December inflation projections, relative to the reliability of the seasonal adjustments (given the acute disruptions of the pandemic lockdowns at the end of 2022 and 2023, and relative to the non-linear risks to US aggregate demand at the current levels of nominal prices and the price of money. For those reasons, we are less inclined to believe that there are material upside risks to the terminal rate - given that we are already in restrictive territory.”
This week, we have heard from other global central banks: the Reserve Bank of New Zealand (RBNZ) inferred they are in restrictive territory, following a slowing of the active policy increment to 50bps, projecting a peak rate of 5.50 in q4 this year (which by definition implies a slowdown in policy increment and frequency of tightening). The Bank of Korea left policy unchanged at 3.50%, inferring a pause while keeping options open, as they assess the level of restrictiveness against lower inflation and growth forecasts. The Reserve Bank of Australia (RBA), who have recently found renewed hawkishness, as inflation has bounced, highlighted increased concern over the prospective weakness in the labour market. After consecutive weak jobs reports around the turn of the year, it is likely that the March release (of the February data) will play a big part in the terminal rate for the RBA.
In all cases, the Central Bank’s are concerned about the ‘long and variable lags of monetary policy on the prospects for future demand’. Ultimately, this relates to a point we have made many times over recent weeks. Falling inflation raises real rates, even without further hikes. Combined with the non-linear downside growth risks that we have highlighted, this likely means that terminal rates are closer than markets anticipate - especially after recent (unreliable?) data and a significant rate repricing.
Most significantly for the current, dominant financial market debate was the release of the Minutes from the February 1st policy decision meeting.
On the hawkish side - the side the current market sentiment wanted to hear - the minutes noted that “almost all” participants agreed that a 25bp hike was appropriate in February, while “a few” participants preferred a 50bp hike (while ‘a few’ generally means more than two, we also know that St. Louis Fed President and Cleveland Fed President are in this contingent - both non-voters this year and both advocates of getting to terminal rates quicker, not a higher terminal rate. St. Louis Fed President reiterated his terminal rate projection of 5.375% - below current market pricing, and he is deemed to be at the hawkish end of the Fed spectrum). ‘All participants’ continued to anticipate that “ongoing” rate increases would be appropriate going forward, categorising inflation as “unacceptably high”. Given the absolute level of inflation and the amount of data between Fed meetings, this implicit tightening bias is not a surprise.
On the dovish side - participants "agreed that cumulative policy firming to date had reduced demand in the most interest-rate-sensitive sectors of the economy, particularly housing." Indeed, while markets have repriced rate curves significantly, based on jobs and retail sales data (that we feel are overstated), this weeks’ existing home sales were the weakest since the fallout from the GFC in 2010/11, and Redfin data that suggests US housing market value dropped by 4.9% or $2.3 trillion in H2’22 (the biggest drop since 2008 GFC). Furthermore, some participants "
Noted that the probability of the economy entering a recession in 2023 remained elevated." And the overall Fed assessment of the balance of risks to growth remained to the downside.. Real consumer spending declined in November and December alongside indications of cost-induced substitution, as higher interest burden spreads.
Commentators may argue that the data in January suggests a rebound in labour market and consumer activity. However, from our perspective, this does not fit with the ongoing announced job cuts, small business sentiment at near decade lows, clearer housing market stress, rising arrears, both at the consumer and notably in commercial property levels. Our ongoing opinion is that the tightness in the labour market is at the low end of the income scale, and thus does not have linear positive implications for aggregate demand growth. While the high nominal prices, low fiscal support, eroded pandemic savings, high cost of money and falling asset prices pose non-linear downside risks to aggregate demand.
In short, we remain of the view that the deflationary forces will continue to bring prices lower through 2023. In doing so, real rates in the US become tighter, even without further action from the Fed. At the same time, there are downside risks to consumption and (as the Fed warn) growth. While we are not suggesting an imminent or deep recession in the US, markets are likely too optimistic on the prospective rate path of the Fed. Furthermore, markets are now expecting upward revisions to the ‘dots’ at the March meeting. In our view, this is less likely when viewed in the context that the inflation path is lower than that expected by the FOMC in both September and December projections. Thus, even if we are wrong in our view of the distortions of the January data, the prospect of significantly higher implied terminal rates from the Fed dots is not an obvious assumption.
In a speech last week, ECB Chief Economist theorised the monetary policy adjustment since December 2021 as having two elements: (i) an exit from the accommodative stance, which can be viewed as essentially permanent (in the absence of a new disinflationary shock). Importantly, the ECB Chief Economist utilises the forward curve pricing - where rates settle around 2%, reflecting the re-anchoring of long-term policy expectations at the 2% target (thus the tightening of real rates is less than the tightening of nominal rates) and (ii) there is an adjustment component that reflects the ECB monetary response to the current (transient?) high inflation. The ECB Chief Economist thus denotes the transient (or non-permanent) component of the monetary adjustment as “restrictive and further adds to the tightening of financial conditions, even if it is less persistent than the normalisation component of our policy adjustment.”
The last couple of weeks have seen substantial repricing of global rate curves, driven by the US. However, the RBNZ, RBA, BoK, and even the ECB have highlighted either the proximity of rates to their peak or a clearer notion that rates are already in restrictive territory (with falling inflation likely increasing the restrictiveness over coming months). After the recent high-profile data (we would argue that the broad data gives a far less positive bias), there is a rising consensus for the Fed to go further. You could argue that the market is currently of the view that “If [the Fed] go, there will be trouble. And if [they] stay it will be double”. In our view, the risks of action and inaction are far more balanced - A Clash of opinion? - if inflation falls as we expect, real rates will continue to rise even without action. Thus ‘sufficiently restrictive’ is not just a function of the nominal rate path, but the inflation path too.
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Fed meeting minutes: https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20230201.pdf
ECB Chief economist speech, 16 Feb 2023: https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230216_1~f8cf2cd689.en.html
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