“It may be quite simple, but now that it's done“
Elton John, Your Song
Last week, we discussed the ECB policy decision and the accompanying Governing Council narrative. We argued that the ECB more clearly defined its peak in the rate cycle. The message was very clear that the ECB are now data dependent - on both the level and duration of policy settings. On the growth front, the commentary was clear that the near-term view of the economy was weak and that credit conditions had weakened further amid a tightening of financial conditions ‘imported’ from the US rate sell off (not reflective of European fundamentals). However, while the Governing Council maintain the balance of risks are to the downside, the core view remains that declining inflation and a still strong labour market generates a more positive forward demand profile for the economy, as real wages turn positive and support consumption - even if the monetary transmission is not yet complete.
Essentially, we argued that from our perspective, the message from the ECB is more balanced than the current market bias - which has turned increasing negative over the Summer.
In the US, we have the opposite bias - that the market has likely got too positive over the Summer (or more specifically, has extrapolated the Q3 data. This is unsustainable in our view). This week there have been some further DM Central Bank policy meetings that have added to our convictions in this regard and also likely formed a significant milestone for financial markets.
This week, the FOMC left rates unchanged at 5.25-5.50% as expected, with a statement that added the term ‘financial’ to the opening statement, such that it now reads “Tighter financial and credit conditions for households and businesses are likely to weigh on economic activity, hiring and inflation”. Essentially, we see this as a further confirmation of our view that the Fed hiking cycle is over, and also a recognition that the sell-off in US duration (whether a function of a higher r*, weaker global treasury demand or credit term premia) is likely to cause a significant tightening of financial conditions that the Fed have become more attentive to - “tighter financial conditions we are seeing from long-term rates and also from other sources like the stronger dollar and lower equity prices could matter for future rate decisions”.
Chair of the Fed was also very clear in the press conference that while the economy has been surprising in its resilience, there are “many forecasters forecasting it will slow” and that “the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy effects economic activity and inflation, and economic and financial developments.” The data is thus key.
On that note, it is important to flag the recent update of the Atlanta Fed GDP Nowcast. The initial estimate of Q4 GDP at 2.3% has been revised to just 1.2% - this is potentially very significant, as the downgrade takes that particular gauge of GDP (a gauge that was very important as an early signal of the surge in underlying growth in Q3) below the level assumed to be potential or equilibrium growth (circa 1.8%) and an outcome the Fed’s Chair and the Fed have pointed to as likely necessary to facilitate a return of inflation to target.
Linking this back to Europe and our thoughts from last week, this slowing in US growth is another factor that validates our thoughts that Q3 likely marks the peak in global growth divergence, whereby a narrowing from here likely has significant connotations for financial markets. More broadly, the clearer signal that the Fed are done - especially if this comes with clearer evidence that the US economy is slowing - has significant implications for US and global duration and the dollar.
In the UK, the BoE was also significant. The Bank left rates unchanged as expected in November with a 6-3 vote (external members Greene, Mann and Haskel voted to raise rates a further 25bps to 5.50%). While this, and indeed the vote split, was widely expected by the market, we think that there were some significant developments from this meeting - important signals for the path of the economy, rates, and financial markets. Firstly, while the Bank pointed out that ‘restrictive’ policy will likely be needed for an extended period and that they will be watching to see if more rate increases are needed, the core message was hidden a little deeper. In the period since the last Monetary Policy Report (MPR), the market pricing of the UK curve had eased somewhat; by extension, it would have been reasonable to expect growth projections to have been raised.
However, growth projections for the period were actually revised lower - highlighting a further deterioration. Secondly, despite the fact that inflation forecasts for the next two years were raised, the central projections for Q4 25 (and more significantly in Q4 26) are below target - suggesting that policy is not only restrictive, but potentially too tight if the balance of risks to growth and inflation are more balanced at the current juncture. Finally, the Bank commented on the ‘long and variable lags’ of monetary policy by stating that they see half of the policy tightening (515bps) as yet to hit the economy. From our perspective, these developments are substantial and further solidify our expectations that the policy cycle has run its course in the UK and that the next move is a cut, albeit not until inflation is markedly lower than its current setting.
Lastly, the Bank of Japan meeting at the start of the week could also be considered a milestone, as the further loosening of the YCC parameters removes the fixed tender operations and as such likely removes the barrier (or at least hurdle) for removing the long held negative interest rate policy (NIRP).
In short, we believe that the change of tune from DM central banks last week highlights a significant turning point in policy trajectory, and as economic divergence normalises from the extremes of Q3, this will have significant implications for financial markets - duration and the dollar especially. To paraphrase Elton John, it may be quite simple, but now that tightening is done, we may expect markets to reflect the different tune.
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Bank of England, November 2023 - https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/november-2023
FOMC, October 31. 2023 - https://www.federalreserve.gov/monetarypolicy/fomcpresconf20231101.htm
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