“When you think you’ve got hold of it all. You haven’t got a hold at all“
Depeche Mode, Get the Balance Right
Last week, we discussed the recent market reaction to the stronger-than-expected payroll and inflation data for January - questioning the correlation of the data to several other high frequency data releases that paint a far less rosy picture of US economic momentum and consumer activity. We also discussed the details of the minutes from the Jan 31st/Feb 1st FOMC policy meeting and highlighted the fact that there was a clear discussion of the interaction of the two factors - inflation and growth. Indeed, on growth the FOMC minutes were clear that "...cumulative policy firming to date had reduced demand in the most interest-rate-sensitive sectors of the economy, particularly housing”. 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.
This week, there have been a number of data prints that have added to the debate between the dominant dynamic- growth or inflation - and the implications for the monetary policy evolution as the year progresses. Indeed, commentary from Cleveland Federal Reserve President , that while the current cost of undershooting on rates outweigh the costs of doing too much, as inflation falls she expects the balance of risks to shift.
From our perspective this is important, as we remain of the view that the data suggesting a renewed acceleration in consumer activity are anomalous and thus that the current trajectory, and indeed the balance of risks remain skewed to the downside for growth. Thus, our view is that the ‘true picture’ warrants Cleveland Feds President ‘shift’.
This week, there have been some new developments that have contributed to the debate. US consumer confidence fell sharply, data on national house prices showed that prices fell by an annualised 5.4% in the last six months of 2022 and, Chicago Fed and Richmond Fed activity indices both showed further declines into historically very weak territory. Broad leading indicators continue to show underlying economic weakness.
At the same time that the broad data paint a less than convincing picture of underlying US growth, the rate repricing continues. Tightening of financial conditions continues. Indeed, while last week we discussed the concept that the markets had been encouraged to price higher terminal rates by the better-than-expected data, inference from Fed speakers over recent weeks is that forecasts are unlikely to rise beyond (or even equivalent) current market curve pricing. (Bullard indicated his forecast of around 5.375% and Bostic 5.125% - against a current market implied Fed Funds terminal rate of 5.45%).
From a USD perspective the argument is even more complex. Higher than expected inflation prints in Spain, France and Germany this week have driven renewed hawkishness in European curves with markets pricing an ECB terminal rate above 4.00%. Indeed, markets are pricing a further 148bps of ECB tightening by the Autumn relative to 86bps in the US. This divergence is keeping yields differentials (at the 2 year and 10 year yield levels) narrowing in favour of the EUR. Furthermore, as long as European rate expectations continue to be supported by sufficient growth expectations the USD can remain in the trough of the USD smile. Our structural views on the capital flow, valuation and cyclical drivers of a higher EURUSD remain.
Technically, the USD has found some significant resistance levels at 1.05 (EURUSD), 7.00 (USDCNY), 138.00 (USDJPY), and even 18.50 (USDZAR) over recent sessions. Next week’s data on US employment (ADP, JOLTS and Payrolls) is likely very significant in this regard. We remain of the view that next week’s data is vulnerable to an unwinding of the seasonal adjustment, weather, and strike distortions of the January data. If we are correct - so is the recent sharp repricing of US rates and strengthening of the USD. Data next week (and the CPI print the subsequent week) are critical to the near-term evolution of the Fed reaction function (to the balance of known risks) and thus will be a huge focus for financial markets.
Ahead of the US employment data and the Fed response, the RBA has some complicated decisions of their own. Coming into 2023, market expectations were forming a consensus that the RBA was at, or at least very near, the terminal rate in the current hiking cycle. However, in the runup to the February meeting there was an unexpected spike in inflation that caused analysts and the RBA to respond with a further 25bp hike and more hawkish projections. Furthermore, following the rate hike the RBA acknowledged two consecutively weak employment reports and that further signs of labour market weakness (to remove year end / seasonal adjustment doubt) would have more dovish monetary connotations. This week the most recent Australian CPI print fell sharply. The RBA this week - ahead of an updated labour market report - thus face a complicated balance. I would expect a slightly more cautious narrative to emerge - a narrative, and a data path that may also hold lessons for other global central banks at the current juncture.
Ultimately, we continue to believe that the balance of risks is more skewed towards disinflation than inflation and growth weakness than excess demand in 2023. While the likely distortions over the year end (and as a function of covid disruptions to the historic comparisons) make the policymakers job more complex, to paraphrase Depeche Mode the Fed and other global central banks increasingly need to “get the balance right” - especially as growth and inflation slow.
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