“I’ll see you when you get there… if you ever get there“
Coolio, C U When U Get There
Last week - as the European Central Bank (ECB) outlined significant progress on policy normalisation and inferred a slowing of the active policy increment - we discussed the prospect that global monetary tightening might be easing - essentially the process by which Central Banks, having reached somewhere in the vicinity (+/-) of neutral over a (historically very) short period of time, downshift the incremental size of rate hikes as policy shifts towards (or in some cases into) restrictive territory. This process is validated and exacerbated by the fact that monetary tightening acts with long and variable lags through the various economic channels and thus, as the Bank of Canada Governor put it, a slower pace signifies the Central Bank “trying to balance the risks of over- and under- tightening”.
Indeed, this week we had already seen the RBA maintain its slower pace of tightening, even in the face of some higher-than-expected inflation indicators since their respective downshift, noting that 'the board recognises that ... the full effect of interest rates is yet to be felt in mortgage payments'. However, Governor of the Reserve Bank of Australia stressed that the RBA retain the optionality of a pause, more 25bp hikes or indeed faster increments if needed going forward.
The synchronous monetary tightening is slowing - as the global economy slows. The big question now is what happens to inflation?
In the UK, this week the BoE were an outlier in respect of the fact that they were expected to accelerate their hiking pace, not indicate a deceleration. The reality, however, was that the BoE hiked rates 75bps (albeit with two dissenters - one, external member of the Monetary Policy Committee, preferring just 25bps!) but continued to push back against the aggressive market pricing of BoE tightening still to come. Indeed, in what could be described as a dovish hike (if that is possible with the largest increment in at least 30 years). Even without the inclusion of the, likely significant, fiscal tightening at the Autumn statement, the inflation forecasts conditioned on constant rates (3.00%) saw inflation at just 0.8% at the forecast horizon - admittedly with an unusually asymmetric upside skew. This projection falls to 0.0% under the market implied BoE rate path - a projection that would ordinarily induce policy easing, not tightening. The Bank’s central message was that markets continue to price too much from Threadneedle Street.
The dominant focus of the markets this week, however, was on the Fed.
Markets had extrapolated the sentiment from the RBA, BoC and the ECB - in addition to the now assumed Fed ‘guidance’ from the column inches of WSJ’s Nick Timiraos - that the Fed would deliver on market expectations of 75bps in November and confirm the slowing incremental pace of rate hikes at the December meeting. Essentially, that is what they got, but as is often the case with financial markets, it turned out to be not quite as simple as that!
The side-by-side comparison of the FOMC statement (Sep 21st vs. Nov 2nd) highlights one change - the addition of the following text: “[The committee anticipates that ongoing increases in the target range will be appropriate] in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”.
The introduction of the term ‘sufficiently restrictive’ is an important inclusion in terms of the Fed communication going forward. It is important insofar as it likely aims to define a policy setting that is not directly described by a level of rates (terminal rate), rather an implied ‘restrictiveness’ as a function of underlying growth and inflation via real rates. Sufficiently restrictive could therefore imply a range of levels depending on forward inflation expectations and wider financial conditions in the context of growth and thus gives the Fed some flexibility to extend or curtail the hiking cycle dependent on the data.
The reference to the impact of ‘cumulative tightening’ and the ‘lags with which monetary policy affects economic activity and inflation’ are a more dovish iteration, the emphasis on tighter financial conditions going forward at the current monetary policy settings, implies caution and in itself warrants the suggested incremental slowdown that the market was looking for. Reference to economic and financial conditions I would take as a direct reference to incoming data. In short, the statement implies a slowing of the incremental policy trajectory and more data dependence in relation to the Fed’s judgements on a ‘sufficiently restrictive’ posture.
So far pretty much as the markets expected. And then came the press conference… This came in two parts.
The first part of the press conference was orderly. Chair of the Fed outlined a framework for the three phases of decision making in this inflation episode: 1. How Fast: The Fed have clearly moved ‘expeditiously’ in this respect with four consecutive 75bp rate hikes - appropriate maybe, but now likely achieved; 2. How High: The Fed’s Chair was clear that this is the new focus - the debate is now about how high do rates have to go in order to become ‘sufficiently restrictive’. This clearly depends on the economic and financial developments; 3. How long to hold rates in restrictive territory after attaining 2.
Again, from my perspective, the framework, and the progression within the framework were largely consistent with market expectations going into the meeting that the Fed are not only slowing the incremental pace, but also becoming more data-dependent as rates trade in the vicinity of neutral.
Subsequently, there was a change in the tone of the press conference following one (intentionally misleading?) question. The Chair of the Fed was asked if he was comfortable with the higher bond and equity markets that had occurred as a function of the statement and press conference thus far. At the point the question was asked, equity and bond markets were actually lower than before the rate announcement itself. Whether The Fed’s Chair was explicitly over-sensitive to the prospect of markets inferring a dovish pivot in the manner that they did in June (and likely for which the Chair of the Fed took significant criticism) or not, his rhetoric immediately erred more hawkish. Indeed, his response to this one question was key to the market interpretation of the entire November FOMC.
There were four explicit references that the Fed’s Chair made when he appeared to try and ‘correct’ this (likely intentionally) misleading characterisation of the market response to Powells words. The Chair of Fed stated that it was his job to ensure the Fed message is clear, that: (i) the Fed has “a ways to go”, and “some ground to cover” before we get to the level of rates that is “sufficiently restrictive”; (ii) That incoming data suggests that the level of (terminal/sufficiently restrictive) rates will be higher than they were estimated to be in September; (iii) that it is premature to discuss pausing; (iv) that markets should understand the Fed’s commitment to get this done and thus the Fed will not, not do enough, or withdraw policy too soon. All are clearly hawkish relative to the statement and largely relative to market expectations going into the meeting.
Later reaffirming the bias from the September meeting that the Fed continue to see “the risk of doing too little on rates (/inflation) as greater, than the risk of doing too much”, the Fed’s Chair essentially put a contingent base on US rates at 4.75%-5.00% and shifted the risk premium at the front end of the curve higher - even if this may be offset a touch by lower front end rate vol as a function of smaller hike increments.
However, from our perspective, the risks are not clearly weighted to the topside for rates or the USD. Firstly, going into the meeting markets were already pricing a terminal rate in excess of 5%. Secondly and most importantly, ‘sufficiently restrictive’ has a clear meaning while inflation (or more importantly forward inflation expectations) are rising - i.e. steady further Fed hikes (or decreasing magnitude). BUT, the moment inflation in the US starts to fall - and essentially we still view US inflation as largely external, supply-side driven and temporary in nature - then real rates start to rise quickly, restrictiveness rises and the debate about ‘sufficiently’ restrictive becomes much more pressing - especially if the labour market and or the economy continue to show signs of weakness.
In the Fed’s Chair framework, it shifts the Fed from 2 to 3. Indeed, a sharp decline in inflation with rates in restrictive territory opens the prospects for a short 3, or in other words rate cuts.
Initially, markets repriced the risk premia and marked yields and the USD higher and risk lower. However, from my perspective little has changed from pre-Fed. If anything, I would suggest that the Chair of the Fed has increased market pricing of an outcome contingent on persistent inflation or a structural shift in inflation pressure. Thus, we would argue that rates and the USD will likely be asymmetrically vulnerable to inflation (and labour market) misses to the downside. We do not see inflation as structurally higher as a function of the events of the past 2 years and on that basis continue to view the USD, US long rates and risk assets in overshoot territory.
To paraphrase Coolio, markets are looking to see the Fed (and the BoE), when they get there [a much higher terminal rate], however, from my perspective this is still contingent on inflation remaining extraordinarily high, despite the recent signs of moderation in many contributing factors… so for me at least we need to add the caveat IF they ever get there.
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FOMC statement Sep 21st, 2022 - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20220921.htm
FOMC statement November 2nd, 2022 - https://www.federalreserve.gov/newsevents/pressreleases/monetary20221102a.htm
Transcript of Chair Powell’s Press Conference, November 2, 2022 - https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20221102.pdf
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