In 1995, Oasis and Blur released their latest single (in days when people still bought music in the old-fashioned way) simultaneously, creating a chart battle or battle of the bands. 2023, may have some similar attributes as markets look to the latest economic releases from the US and Europe and the all important release of economic projections from the European Central Bank (ECB) and Federal Open Market Committee (FOMC) in March, and decide which one they wish to 'buy' most.
Last week we discussed the significance of this week's events on the global macroeconomic outlook and for financial markets. Given the significance of the events it is only fair that we review the subsequent evolution of monetary policy against a complex macroeconomic backdrop and how this affects our views on the progression of financial market themes.
“And it looks like we might have made it“
Blur, To The End
First up, and likely most important for global markets, was the FOMC.
Going into the meeting, there was a broad consensus around a further moderation in the active policy increment to 25bps and an acute focus on the retention of the phrase' ongoing increases' in the policy statement - "The Committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time" - as a gauge of the proximity of Fed policy to the terminal rate, or the end of the tightening cycle.
The fact that there were no updated forecasts (we have to wait until the March meeting for those) meant markets would have to rely on its scrutiny of any changes (no matter how subtle) to the statement and an interpretation of the Q&A responses from Chair of the Fed at the Press Conference. We have some thoughts.
As the statement was released, the collective eyes of the market would have immediately scanned to the second paragraph and the 'ongoing increases' reference, only to find no change. However, while in itself, this could be viewed as hawkish relative to market expectations, there were some subtle changes that infer a shift towards a Fed that sees more balanced risks between inflation and growth on the path of monetary policy.
In reference to prospective future hikes, the term 'pace' (of hikes) was replaced with 'extent' - likely referencing both the proximity of the terminal rate and the active policy increment (back to standard 25bps increments). With specific reference to inflation, the statement replaced "remains elevated" with "has eased somewhat" - a further sign of a rebalancing of the growth/inflation risks and, thus, a move back to a more data-dependent Fed.
In the Press Conference, the Chair of the Fed was even more balanced, and the biggest reaction in the market came from the specific question about the Fed's position on the tightening of financial conditions. In recent days there has been significant propagation of analysis that suggested that Financial Conditions are now looser than they were before the start of the Fed hiking cycle. This is obviously not true on any level other than perhaps a stylised, relative incremental basis. On any absolute basis, it is clear that equities are significantly lower, interest rates are significantly higher and with the help of recently declining inflation, real rates are significantly positive across the curve (tighter financial conditions).
The Fed's Chair, was clear that the full effects of the rapid tightening are yet to be felt", that "financial conditions have certainly tightened" and that the difference between market pricing of terminal rates and the Fed' dots' is a difference of opinion on the pace at which inflation will decline. A clear lack of desire to 'push back' against the easing of financial conditions (as was implored by some in the market) and a clear intimation that if the data shows inflation coming down faster than the Fed expects, then the policy path can 'downshift' towards the market (and of course, vice versa). Data dependent.
In December, we began to discuss the prospect that the Fed will be 'one and done' in 2023. We still see that as the central scenario. The two inflation and payroll prints (and a whole host of other data) between now and the March FOMC will give greater clarity.
“You gotta Roll with it … … Don't let anybody get in your way“
Oasis, Roll With It
Ahead of the ECB, economic data releases had been relatively balanced. Resilient activity metrics (buoyed by lower energy prices due to a mild winter and the China reopening story) argued for a more persistent ECB response - consistent with the December narrative. However, domestic demand and bank lending surveys suggested that the cumulative impact of past rate hikes (and hawkish ECB rhetoric) have already induced clear signs of weakness.
In short, this was reflected in the ECB narrative. While the Governing Council sanctioned the second consecutive 50bps rate hike (and indeed outlined the intent to raise a further 50bps in March), there was an acknowledgement of the "material" growth slowdown, with particular reference to bank lending (firms and mortgage demand) as money growth slows.
However, from our perspective, on an absolute and relative basis, the ECB remains hawkish. The President of the ECB was clear - despite the reference to a re-evaluation of the policy path beyond March - that "We know we are not done" and that while there are signs that the risks to inflation are becoming more balanced, being so far away from the inflation target with concerns over rising wage pressures, excess fiscal support (non- temporary, targeted or tailored), as well as resurgent energy price concerns mean that it is "completely legitimate" for the ECB to give an intention (50bps in March) in a very strong way. "In all reasonable scenarios, significant hikes are needed".
In contrast to the Fed, markets likely wanted the ECB to be dovish (at least as a function that participants have been slow to react / believe the EUR rally (and likely remain significantly underweight), thus hoping for a pullback to provide an easier entry point.
“... paying the price of living life at the limit“
Blur, Country House
The Bank of England is more complicated on many levels.
Last week we stated our view that current rates are likely already 'sufficiently restrictive' and that further rate hikes will likely have an asymmetric or non-linear impact on consumption relative to (still largely transient) inflation - which is likely already falling due to supply side factors. Stating my view that I felt rates were already "sufficiently restrictive" in the UK.
This week, two members agreed (or more correctly continued to agree), dissented in favour of unchanged policy arguing that the "Increasingly restrictive policy would bring forward the timing of rate cuts" due to the "sizeable impacts yet to be felt from previous rate rises".
The majority of the MPC (the remaining seven members) voted for a rate hike of 50bps. However, they also implied (albeit guardedly) that they may have reached the terminal rate at the first meeting in 2023 - unless the very significant upside 'risks' that they see to inflation (from resurgent higher energy prices and unanchored inflation expectations driving higher wage gains) materialise. Indeed, the central projection of the Bank's inflation forecast sees headline inflation at just 0.37% in the first quarter of 2026 - so far below the target that in any other circumstances, it would elicit rate cuts, not hikes.
The reason for this divergence (or central bank headache) is the extraordinary uncertainty around energy and wages. The BoE emphasised the level of uncertainty and the upside risks to inflation (highest ever as implied by BoE models). However, Governor of the BoE was also clear that while they "need to see more evidence" the Bank have changed the language deliberately to reflect this - the removal of the guidance it will "act forcefully" if needed in relation to future policy and emphasised in the Press conference that "if the economy evolves as per our central case, then we will have to evolve… our message to markets is to watch this carefully".
If we are right, and non-linear downside risks to the consumer generate a faster realignment of supply and demand in the UK economy, the BoE could well be cutting rates.
Ultimately, the BoE, like the Fed and even the ECB have become data dependent. If upside risks to UK inflation fail to materialise, the BoE will face increasing pressure to cut rates (especially if we are right and non-linear downside risks to the consumer generate a faster realignment of supply and demand in the UK economy). Indeed, it is not inconceivable that by May, the UK and the ECB could be pointing (if not acting) in opposite directions.
From our perspective, the USD is in the early stages of a multiyear cyclical decline, and there are many structural reasons why the EUR will continue to be supported. However, market participants will have to decide - Is the EUR an Oasis amid troubled global macroeconomic dynamics, or is it simply a Blur?
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Sources
Federal Reserve Minutes, February 2023: https://www.federalreserve.gov/monetarypolicy/fomcpresconf20230201.htm
ECB Minutes, February 2023: https://www.ecb.europa.eu/press/pressconf/2023/html/ecb.is230202~4313651089.en.html
Bank of England, February 2023: https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/february-2023
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