“Open mind for a different view..."
- Nothing Else Matters, Metallica
Last week we discussed the dollar rally since the Federal Open Market Committee’s (FOMC) hawkish pivot in June and how, from our perspective, the move may be only just beginning. In essence, the June FOMC meeting was seen as a hawkish surprise in that the ‘dots’ brought forward two rate hikes into 2023, and that while ‘substantial further progress’ remained elusive, that there was ‘further’ progress towards the Federal Reserve’s (Fed) full employment goal (and even that further further progress was expected). However, from our perspective’ it was not a surprise relative to the data or underlying growth, rather a surprise relative to the Fed’s previous rhetoric and market expectations of Fed actions (that they would consciously remain behind the curve).
This week witnessed the release of the minutes from the June meeting with relatively little reaction. In essence, the minutes added little new information to the debate. The economic narrative remained upbeat {“payroll growth increases ‘solidly’... average hourly earnings jumped ‘sizeably’... manufacturing output expanded ‘solidly’... financing conditions remained highly accommodative”}, without committing to an expected timeline for tapering. Outside of the acknowledgement that conditions for the removal of accommodation could be met “somewhat earlier”, the minutes only commit to beginning to discuss plans for tapering of QE purchases “in coming meetings”, amid a range of views on labour market progress, taper timing and even asset sequencing.
Call me cynical, but this likely intentional divergence of views on inflation, the labour market and even the sequencing of the QE unwind (assets and duration) provide the greatest amount of policy optionality for the Fed over coming months. My personal view is that we start to see payroll gains topping 1m over coming months and the ‘glass half full’ contingent of the Fed prevail.
There has been another theme that feels as if it has started to filter through global markets over recent days. We have stated the view that the Fed’s more explicit guidance on its reaction function to inflation (as per the more hawkish response of the ‘dots’ to the higher growth and inflation projections) has led to a shift in the market focus away from the reopening growth momentum and timing of relative adjustments in QE purchase pace, towards the sustainable or equilibrium post pandemic growth rates and terminal rate projections.
This week it feels like there has been a further extrapolation of this theme, where the suggestion that the Peoples Bank of China (PBoC) is preparing a cut in the RRR to support the slowing economy has perhaps raised concerns that the US too is past the peak of the growth rebound and that more pedestrian growth awaits globally. In part, this focus on a potential for slower growth prospects in China and the US may be weighing on their respective curves. US 10y yields are now likely the key metric, or most consequential pricing, for financial markets.
Ultimately, we continue to expect higher long rates in the US. However, there may be a few factors at play that are suppressing long rates:
1. There remains a significant cash glut in the US; rates at the very front end are pinned to the lower bound and have been for some time, and it is likely that there has been a wall of cash in the US hunting for yield - even at these depressed levels; US yields are still high globally.
2. The US Treasury market remains the global safe haven ‘yielding’ asset, and with a troubling resurgence of Covid through the delta variant, it is likely that safe haven demand has risen - especially for one with a decent positive yield.
3. It is also possible that the global growth rerating wobble that we describe above had led to a loss of conviction in r* or the terminal US interest rate, as far as the near cycle is concerned at the very least - how much can the Fed raise rates into pedestrian future growth (moreover, what about other global central banks - especially if inflation proves, as we expect, transitory).
We retain a much more bullish view of the US growth backdrop, but in an adverse scenario, is it possible that the hiking cycle amounts to just 4 25bps rate hikes in the US? Of course.
The European Central Bank (ECB) released their long-awaited Monetary Policy Review this week. There were three key takeaways:
1. The ECB will adopt a symmetric 2% inflation target (as opposed to the ‘close to but below 2%’ previous ‘target’)
2. It will (eventually) include housing costs in its inflation measure
3. It will incorporate climate change measures into its economic models and operational framework.
Despite this, the press conference narrative suggested that this was a largely cosmetic change in terms of the target. And while markets viewed this as modestly hawkish (in that the ECB will not seek inflation above target for some time,like the Feds FAIT, rather, it would be more flexible in its actions if inflation independently rose above), the problem that the ECB has remains: inflation is still significantly below target at the forecast horizon - arguing for more accommodative policy going forward!
From an FX perspective, this is important. The market may very well be in the midst of a confidence wobble about the global economic trajectory, but if this is the case then the prospect of the ECB not being able to adjust rates in the entire business cycle must be a possibility (or more concerning that the ECB run out of space to stimulate? - this was indirectly inferred at the policy review press conference where it was stated that the effective lower bound was a constraint for symmetry!). What then, for monetary policy in a subsequent downturn?
Our pushback to the market does not stop there. It is also interesting to note that EMFX has struggled over recent sessions, despite the fact that US yields (real and nominal) have fallen sharply - the exact opposite of the price action that caused EMFX to falter earlier in the year. Similarly, I have heard a number of suggestions that US equities, and tech in particular, should come under pressure given the current backdrop - despite the fact that the consensus view over recent months was that the rally in US rates and curve should hurt ‘long duration (growth) assets’ and thus argued in favour of the growth/value rotation.
From my perspective, it is likely that the recent wobble is, in the most part, driven by position reduction in assets and securities where positioning is stretched, arguments are stale and summer liquidity threatens to raise volatility. (In Developed Markets (DM), JPY is worth watching in this regard).
However, for the global economic recovery, led in DM by the US, we remain of a positive persuasion. US labour market progress through the summer likely leads to a narrowing of the distribution of the Fed views around taper timing and ultimately some stability in the US curve.
This would be exacerbated by good news on the Virus front. From our perspective, the recent market wobble is just that. Composure likely returns, and with it, further gains for the USD. As we stated above, it is very likely that the US Treasury curve is the dominant factor for global markets and (maybe?)... Nothing Else Matters.
Sources
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