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“Let down and hanging around“

Radiohead, Let Down

In our last piece, we discussed our views of the impact of credit concerns in the (small) banking sector and how they appeared to differ from central market expectations - essentially we were/are of the opinion that the recent issues {lower deposits, lower profitability, lower share prices and likely increased scrutiny and regulation ahead} would all bring about a more conservative lending strategy from the ‘small’ banks and restrict the supply of credit, in addition to the price of credit.

We also argued that the small business sector is likely to be the most acutely affected by this shift - a view that this week’s NFIB index of US Small Business Optimism may attest to, falling to its lowest level in at least a decade. Furthermore, it was stated last week that small businesses account for somewhere in the region of 70% of labour demand growth, and thus the current chain of events is likely to encourage an acceleration of the rebalancing of supply/demand in the labour market.
Since we last wrote, there has been another chapter in the DM central bank policy evolution.

Firstly the Fed. Previously, wrote: “While we have clear reservations against further rate hikes in the US, markets are convinced (perhaps rightly as a function of Fed speaker guidance over recent weeks) that the FOMC will vote to hike rates by a further 25bps on 3rd May. Given the current Fed’s desire to avoid decision-day market volatility, it seems likely that the Fed will deliver on expectations.” While the 25bps was delivered, the Chair of the Fed gave his clearest indication yet that the peak in Fed Funds may well be in place - ‘sufficiently restrictive’ may have been found.

The FOMC removed the sentence in the statement that referred to additional policy firming being appropriate, while in the press conference, the Fed’s Chair emphasised the ‘meaningful change’ to the Fed stance and maintained his baseline view that there will be a soft landing in the US (and no recession). We are more aligned to the Chair of the Fed viewpoint on the path of the US with a negative output gap, investment from CHIPS and IRA acts, and labour market strength (whereby demand and supply of labour rebalancing can remove the inflationary and thus hawkish labour market dynamic) can support underlying growth.

The ECB was more balanced in its outlook but remained resolute in the view that “the inflation outlook still has significant upside risks” and that “it is very clear that the ECB is not pausing”. Rather, the ECB stressed that it would be “future decisions that would make rates sufficiently restrictive”. However, the ECB also decided to end reinvestments of the APP (Asset Purchase Programme), which implies that the QT increment will step up to around EUR 25B per month as of July (from the currency EUR 15B).

Interestingly, President of the ECB implied that rate hikes had already had an important impact on financing conditions but not yet on real economic activity. For us this is a key factor. One which ESLJ have written about in more detailed analysis making the comparison between the r* and r** and their different values generating differentiated impacts (at the very least relative to time) between different sectors of the economy.

From our perspective, this is very significant when it comes to the UK.

While markets price a similar amount of further rate hikes in the UK relative to the eurozone, this week’s statement from the BoE was more akin to that of the Fed - the Bank implied that they would like to pause - conditional on the absence evidence of further inflation persistence.

The press conference was full of many questions about the impact (and delayed or lagged impact) of higher interest rates on businesses and consumers. And while the Governor of the BoE maintained the supremacy of the inflation mandate, he was clear that the Bank are sensitive to the economic fragilities at the business and consumer level associated with higher interest rates - especially at a time where nominal tax rates and nominal prices are also very high.

The good news from the BoE Monetary Policy Report (MPR) was undoubtedly the upward revisions to the growth forecasts, in total adding 2.25% to the February forecasts and leaving the new modal forecast in positive territory on a quarterly and annual basis for all of 2023 and 2024. The growth upgrade was largely a function of the energy price decline, which in itself counteracts some of the inflationary impact of an upwardly revised growth path. Ultimately, despite the upward revisions to growth (to a very modest positive), we remain in the Tenreyro, Dhingra camp - that the current level of interest rates is already likely beyond the level that is required to restrain demand and bring inflation back to target. Indeed, the Banks own model has inflation at around 1% at the forecast horizon - a level that would, in any other circumstances, warrant rate cuts, not hikes.

Ultimately, we see the last couple of weeks as an important watershed in the global rate cycle. In the US, we continue to see a significant decline in inflation through the rest of the year as supply chain improvements are matched with demand moderation (fuelled by credit constraints at the small business level) bringing inflation levels back towards target. Market pricing of interest rate declines through the curve therefore seem sensible to us, given the backdrop. In the UK, there is a clearly defined inflation risk premium at the front of the rate curve, with rate hikes over the next six months matched by rate cuts in the subsequent six. We are more inclined to see rates as high enough, but again market pricing seems sensible to us given the likelihood that further rate hikes (if warranted by further inflation persistence) likely have a material further negative impact on growth and thus induce rate cuts further out.

Europe is at the other end of the spectrum, with core inflation showing few signs of falling and a Governing Council that remain committed to their price stability mandate. Indeed, to paraphrase Radiohead, US rates now have an opportunity to be “let down”, eurozone rates are more likely to be “hanging around” - UK rates are somewhere in between!

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