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“Some people are on the pitch, they think it’s all over … It is now!“

Kenneth Wolstenholme: 1966 FIFA World Cup Final Commentary

In December, following the Federal Open Market Committee (FOMC) decision to hike rates 50bps to 4.25% - 4.50%, we outlined our view that the prospect of the Fed hiking only once in 2023 (Feb 1st) was a more realistic prospect than markets were contemplating - as a function of the pace at which rates had risen, the nominal level of interest rates and the lagged effects of previous cumulative hikes began to weigh on demand. Subsequently, commentators continued to argue for an ever increasing terminal rate, driven by an ever increasing, or an ever stubborn inflation rate - despite the fact that there was (in our view at least) a distinct lack of convincing rationale to suggest a persistent positive demand shock, or indeed further negative supply shocks (evidence continues to point to supply chain normalisation) to maintain that inflation.

Inflation hawks would likely argue that ‘sticky’ inflation will be maintained as a function of a tight labour market, but we continued to doubt that the labour market ‘tightness’ is equally distributed across income levels (outside of some isolated skills shortages). For this reason, we find it hard to see how tightness at the low end of the pay scale (and an increasingly demonstrable weakness at the higher end, as highlighted by Meta’s second firing round of approximately 10-13% of staff in a couple of months, this week) translates into a linear, positive demand impulse - particularly set against a period of high nominal prices, high nominal rates and falling asset prices (most notably housing).

Furthermore, we have continuously argued that the risks to demand are in fact to the downside and non-linear, due to the negative wealth effects in the middle income distribution (as described above) the erosion of the pandemic excess savings (especially at the low end of the income scale, offsetting the labour market tightness) and even now, as we have seen in recent days, a likely increase in lending standards that threaten to tighten financial conditions and reduce lending capacity in the real economy.

Through January and February, we continued to expand on this view, adding to the discussion that the ‘sufficiently restrictive’ level of real rates, that the Fed has sought, is as much a function of inflation as nominal interest rates. Thus, as inflation falls, real rates rise for the same level of nominal rates - nominal rates become more restrictive. We also argued that there was likely very significant distortions to the January US data suite, that likely gave a much rosier snapshot of the consumer than what is consistent with our views (or the broader high frequency data - especially sentiment driven data - which was significantly weaker).

Indeed, last week, we discussed the evolution of the monetary policy debate in Australia, Canada, and Poland and how we believed that the themes generating far more caution from the RBA, BoC and NBP were likely also applicable to the Fed. We stated, “For us, therefore, the bigger question is likely how quickly US rates will need to return to equilibrium (now likely around 300bps lower than current terminal rate pricing in the US), and not on whether the Fed will hike 25 or 50bps in March.”

The events of this week have clearly surprised markets, and us, especially in terms of the historic and unprecedented moves in rates markets. However, the root cause of the issues are familiar to our writing. At the heart of the problem is the cumulative impact of monetary tightening and the resultant high nominal level of interest rates (not the relative fiscal and monetary variations that many commentators chose to focus their attention on) and the long and variable lags of this monetary action. It is also worth noting that there is not any other period in recent history where the Fed have hiked rates by as much in as short a period as today.

There is also growing evidence of slowing demand, not directly in through the January suite of high-profile US data (that we have continued to question) but through the greater utilisation of cash deposits by businesses to fund day to day activities - as was apparent at SVB, in retrospect at least.

In conjunction with the greater business demand for cash, the speed of the rise in rates also likely meant that interest rate hedging (or lack thereof) meant that deposit rates were kept much lower than they otherwise would have been - and customer withdrawals from cash deposits in favour of much higher yielding money market funds drove a further (and ultimately self-fulfilling) run on deposits that led to the instability and eventually demise of SVB.

So what now? It is clear that markets have unwound the recent rate repricing in the US curve, and more. It is also clear that there is a strong case for the Fed to pause its hiking cycle - one which is already comfortably in restrictive territory - to assess the impact of the SVB failure on the stability of the market, and any potential contagion. And perhaps most significantly, the implications of this episode on the availability and cost of bank lending to the real economy. In our view, a pause in March makes a lot of sense. Ultimately, we have been asking whether US monetary policy is ‘sufficiently restrictive’ yet. We are increasingly convinced that it is.

This week, following some high-profile concerns of a Swiss bank and the subsequent emergency lending from the SNB, it was the turn of the ECB.

In the aftermath of the acute (and perceived potential) banking stresses, expectations had diminished that the ECB would deliver on their promised 50bp rate hike this week, as fears that financial stability risks would trump price stability risks propagated.

The ECB ultimately delivered on their promise of 50bps, however, in doing so, they removed their ongoing tightening bias in favour or a ‘data dependent outlook’ with three main criteria for assessing the monetary policy response: (i) The ECB assessment of inflation (as a function of the incoming economic and financial data), (ii) The ECB assessment of the dynamic of underlying inflation trends and (iii) The ECB assessment of the strength of monetary policy transmission.

Furthermore, President of the European Central Bank spoke of the impact in the credit segment of the economy from the previous, cumulative rate hikes – although not yet clearly in demand channels and that there are some signs of improvement in core inflation, while at the same time the risks to growth are tilted to the downside.

Lastly, President of the ECB was clear to point out that the ECB staff economic projections were generated using data that was collected (and references the period) before the recent financial stresses emerged. Thus, they can only be viewed through a lens contingent on no further, or persistent financial stress.

This is also relevant to the Fed, where the dots/SEP’s must be based on some probabilistic or contingent version of the future in relation to financial conditions – and thus do not fulfil their main purpose, forward guidance. With a longer lead time to consider the implications, we do not think it a zero-probability event that the SEP’s are postponed at the March meeting (as they run the risk of being dismissed, upon further financial developments, or being so notably caveated that their function is undermined).

If we bring all of this together, we are increasingly of the view that the downside risks for demand that we have been concerned about for some time have been made more acute by recent events (and the resultant tightening of credit conditions through bank funding and lending channels - at both business and consumer levels). The resultant impact of a further slowing of aggregate demand is likely to be a faster decline in inflation and thus (as we have discussed) higher real rates or tighter policy.
We are now increasingly of the view that the ECB, Fed, BoE, BoC, RBA and SNB have reached the end of their respective policy hiking cycles.

In the infamous Kenneth Wolstenholme commentary from the 1966 World Cup Final, he commented “some people are on the pitch, they think it’s all over”, at which point Geoff Hurst scored England’s fourth goal (his third). His riposte - “it is now!”. To paraphrase Mr Wolstenholme, we were of the view that monetary policy had got ahead of itself and was likely already too tight. After the recent events in the banking sector, we are more inclined to believe ‘it is now’.

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