“Gotta get it together to see what’s happening”
Beastie Boys, Get it Together - Ill Communication
Last week, we discussed the Bank of England and their extraordinary forecasts for UK economic growth over coming years, and the likelihood that much of their prophecy of economic doom may come into question over coming months - at the very minimum, on the basis that the incoming Prime Minister (whichever of the two contenders it may be) has pledged to enact various measures to combat the real income squeeze through fiscal easing, something which is not a part of the BoE forecasts. The other point that we made last week was that much of the BoE’s negative growth forecasts may well have been intentionally uncorrected, such that they provide an element of self-restraint on consumption (and even labour market expansion) through the policy communication channel.
However, it is not the UK that dominates the debate this week, but the US. And for the Federal Reserve System (Fed), the issue of communication remains at the fore.
We have argued over recent weeks, months even, that Fed communication is essentially the most important driver of sentiment and positioning. In June, following the accelerated pace of tightening to 75bps, we wrote about the importance of the Fed communication in regaining control of the inflation narrative; indeed, following the acceleration to 75bps (and despite a further increase in the underlying inflation rate) medium and long term real yields trended lower. At the time, we argued that this ‘regaining of control of the inflation narrative’ should narrow the distribution of potential Fed Funds rate paths and thus stabilise both US yields and the rate differentials to the USD - ultimately suggesting that the USD may be nearing the end of its (albeit very impressive) run.
There has been much debate over the past couple of weeks about Fed policy, and at the centre of the debate was a criticism of Fed’s Chair communication, and what some had referred to as a dovish pivot. We disagree.
In short, the point we are trying to make is that the July, Chair of the Federal Reserve, narrative was completely in keeping with the June SEP’s and the June dots, and was in no way suggestive that the Fed will not live up to its clear forward guidance contained therein (i.e. most specifically, the 3.25-3.50% median dot, for end ’22, but also the 3.75-4.00% median dot for end ‘23). However, until this point, the 2nd derivative of Fed policy had been positive (i.e. the iterative policy path became increasingly hawkish - taper, faster taper, 25bp hike, 50bp hike plus (passive) QT, 75bp hike); the July meeting validated the June projections of the terminal rate, and thus the change in the second derivative - from positive to negative, as the hike increment slows.
Indeed, much of the problem likely stemmed from the fact that much of the market had become convinced that there was a self-fulfilling doom loop of financial conditions, whereby if the Fed communication or action led to a loosening in financial conditions, then the resultant boost to demand and thus inflation would lead to the Fed having to tighten financial conditions further. Built around this thesis was the view that any rally in equities must be sold, as a function of the desire of the Fed to engineer demand destruction.
We see things slightly differently. For some time now, the Fed has been operating in the forward space. By this, we mean that the tightening of financial conditions came through ‘talking tough’ on inflation, and thus tightening financial conditions through rate hike expectations - directly through the rate space, but also through rate sensitive and risk assets. Therefore, it does not follow that the Fed’s more balanced narrative in July should be taken by markets as a reference to anything but guidance beyond the previous forward guidance.
In this context, easing pressure in inflation is a significant development. Obviously ‘one swallow does not a Summer make’, but we are inclined to view the easing of inflation this week (especially with core NOT rising as expected) as a significant event, with some more concrete signs that inflation may be topping out.
Furthermore, this likely validates the view that the Fed are past the peak ‘pace’ of tightening, or that the 2nd derivative has changed direction, as policy moves into restrictive territory. While the Fed have pushed back against issuing renewed forward guidance, I think it comes back to the Fed’s Chair insistence at the July meeting that the June SEP’s are the best estimate of the future. The recent data validates the June SEP’s, and thus the path to 3.25-3.50% (which is essentially fully priced). Thus, on a forward basis, the tightening cycle looks pretty well done.
By extension, this likely does two things: (i) at the margin, it likely reduces the Fed’s desire to communicate further tightening beyond the forward guidance; for now, it is perhaps reasonable to suggest that the baseline forward guidance is the June SEP’s or dots (3.25%-3.50% rates by the end of 2022 and 3.75% -4.00% by the end of 2023). Anything beyond this could be referred to as the inflation risk premium, the narrative over which is largely controlled by the Fed and medium term inflation expectations. (ii) on the other side of the argument is the market pricing of rate cuts in 2023. The lower inflation print for July, while tapering expectations for higher than ‘guided’ rates, effectively reduces the ‘growth risk premium’ in the market. The combination of the reduction in growth and inflation risk premia, respectively, further narrows the likely path of US interest rates, and thus suggests more stability, if not support for the US Treasury market.
Thus, we see the reduction in inflation as a watershed moment. If our inclinations are correct and the evolution of prices slows, while the prospects of a soft landing rise, then US bonds are indeed stabilised. By extension, the narrowing of the path of potential rate paths in the US also likely adds clarity to the bond carry that is on offer in different parts of the world (Latam is a clear and obvious example, with significantly higher yields and likely distinct beneficiaries of a more stable, soft landing US). Furthermore, this rate differential argument is also likely to be particularly relevant to the USD. We have argued for a little while now that we have distinct sympathy with the theory that the USD is carving out a top. From our perspective, the events of this week have progressed the timeline of this more negative USD evolution. EMFX carry, amid a likely low volume summer, with low participation and a latent USD long position across markets, may well seem increasingly attractive.
Ultimately, we also think this general narrative is directly supportive for Equities. Indeed, not only does the turn in second derivative for inflation and rate rises imply a greater probability of soft landing, but by default of the reduction of the growth risk premia it implies higher expected growth rates. If we add in the amount of negativity that is baked into the equity markets, the level of short positioning / underweight, then we could potentially have a significant further move up in equities, disappointing those continued subscribers to the doom loop thesis of inflation and financial conditions.
As price dynamics and the Fed narrative evolves, we continue to view the world with a more ‘glass half full’ bias, and as far as inflation is concerned, it is not even beyond the realms of probability that the term ‘transitory’ returns to the Fed lexicon by the end of the year. While markets have flip flopped between growth and inflation concerns, we are more aligned with the Beastie Boys in that you must [focus on their evolution] “together, to see what’s happening”. Either way, central bank communication (ill or not) remains key.
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Fed Minutes January 2022 - https://www.federalreserve.gov/monetarypolicy/files/monetary20220615a1.pdf
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