“Is this our last embrace, or will the walls start caving in?“
Last week, we discussed the latest round of central bank meetings from the Federal Reserve, ECB, and Bank of Japan - ultimately suggesting the significance of all three in terms of the monetary policy cycle peak (trough, perhaps, in terms of the BoJ).
For the Federal Reserve, we highlighted that the statement (and ultimately the press conference) was a clear step back from the hawkishness surrounding the higher dots at the June meeting, with a clear emphasis on the extent of previous cumulative tightening and the lag with which that would be fully felt on the economy (and inflation) and the need to continue to assess additional information on both sides of the dual mandate … as “tighter credit likely weighs on activity” going forward.
For the ECB, we highlighted the significance of the acknowledgment that the near-term economic outlook had deteriorated, but that it will be supported over time by incomes from both labour market strength and moderating inflation - not to mention the still very generous national fiscal support schemes and the huge stimulus of Next Generation EU funds being disbursed over the next few quarters.
For the BoJ, we highlighted what we saw as a clever monetary policy tweak that removed the ‘line in the sand’ and market stability risks that come with such a policy in creating a staging post between the perceived need for monetary accommodation through the yield curve and freely tradeable rates.
This week, it was the turn of the Bank of England. From our perspective, they did not disappoint the DM theme of announcing a tentative proximate end to the respective tightening cycles.
The Bank hiked rates 25bps to 5.25% as broadly expected, with a vote split three ways (Dhingra dissenting, as expected, in favour of unchanged rates, six members voting in line with the governor’s proposition and Mann and Haskell voting for a 50bp hike). The three-way split highlights the complexity of the UK’s growth/inflation trade-off, but the accompanying narrative was in our view clearly more dovish than reflected in market pricing of the forward path of implied interest rates. Most significant was the amply repeated statement that the current policy settings are in restrictive territory - “Given the significant cumulative rate increases, the stance is now restrictive… there is clear evidence that the rate is having an impact” – this is a significant new evolution.
The statement kept the guidance that rates may rise if inflation pressures prove more persistent. However, the press conference saw Bailey and Broadbent introducing the concept of time as well as magnitude into the policy debate. Governor of the Bank of England and Broadbent essentially suggested that there are “different paths to achieve the same end” - inferring that the prospects of rates being held in restrictive territory for a significant period would likely have the same impact as the market path of rates that implies further hikes, then cuts. This is new thinking, and significant from our perspective - rates will need to be ‘sufficiently’ restrictive and be so for ‘sufficiently’ long. A switch from hiking to holding?
There was clear acceptance that there had been more mixed data from an economic perspective and that future policy activism would be ‘evidence driven’ (not a million miles from the ECB’s ‘data dependence’). Growth forecasts continue to show no recession, but the press conference added emphasis to the ‘significant’ risks around this assumption. While economic activity has been unexpectedly resilient, the significantly higher Bank rate will increasingly weigh on activity over time. Further, the narrative around the all-important labour market, acknowledged recent signs of rebalancing, and as the Bank sees more clear evidence of the balance of supply and demand shifting, forecasts show increasing economic slack next year.
Inflation forecasts nudged up from the May forecast round, but likely only catching up from the upside inflation beats since the last report. Importantly, conditioned on market rates, the MPR forecasts still see inflation below target at the forecast horizon – implying rate cuts may even be necessary if upside inflation risks don’t play out or downside growth risks do. Indeed, the topside distribution skew in the forecasts for inflation has been halved, suggesting that a significant proportion of those risks are now ‘in the price’.
Lastly, Governor of the BoE discussed the contribution of energy, and the complicated passthrough of the energy price shock not only on households due to the energy price cap (where the Governor of the Bank of England pointed out differences in energy treatment as an explanatory variable in headline inflation differences between the UK and Europe), but also to energy intensive production processes such as food, and even to services (noting, as we have previously, the implications of businesses falling outside the energy price cap but liable to ‘sticky’ annual price agreements with providers) with an implied dovish bias.
Ultimately, we continue to see progress towards a clear affirmation of the peak in the DM monetary cycle. While it is likely from our viewpoint that the Fed take the lead, the ECB and BoE are likely not far behind. With growth continuing to hold in better than expected, supported by already negative output gaps and strong labour markets, we continue to see the peak in the rate cycle as positive for risk assets and bonds, and negative for the USD.
This week has seen a lot of noise and complexity, especially in the treasury market, after the US rating downgrade by Fitch and the Treasury refunding schedule (higher issuance). While these arguments (and even some more complicated debates about whether equilibrium rates, and thus long yields, have moved structurally higher) have notably increased the debate around long end Treasury yield targets (higher), we maintain the view that the cyclical dynamics will dominate, and that long duration (long bonds) will ultimately prove the path of least resistance.
To paraphrase Muse, from our perspective, DM central banks are in their ‘last embrace’ of policy tightening, else “will the walls start caving in?”. As growth and inflation come into better balance, policy rates in restrictive territory likely increasingly require upside price pressures to justify their nominal levels - and we remain more sanguine on inflation.
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Fed Minutes July, 2023 - https://www.federalreserve.gov/monetarypolicy/files/monetary20230726a1.pdf
Monetary Policy Decisions, July 2023 - https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.mp230727~da80cfcf24.en.html#
Bank of Japan Minutes, July 2023 - https://www.boj.or.jp/en/mopo/outlook/gor2307a.pdf
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