Copy of ECB and BoE: The Shape of the Yield Curve
- September 22, 2023
- By Neil Staines
“Waiting for the one, the day that never comes”
Metallica, Day That Never Comes
Two weeks ago, we discussed the upcoming Bank of England Meeting where we offered our view that the decision on rates at the September meeting would be a very close call. While markets at the time were near fully priced for a 25bp rate hike at the meeting (indeed pricing a further 43bps of hikes by the end of 2023), we argued that there was a credible case for the MPC to explore the implementation of the policy alluded to by Chief Economist and Deputy Governor (Pill and Broadbent), that there are multiple paths to achieving the same outcome on inflation (arguing the economic equivalence of hiking rates and then cutting them over an extended period and holding them steady for an equivalent – or longer – period). We argued that if the proposition from the Governor at the September meeting was unchanged rates, that this could achieve a majority (albeit likely a tight one. We stated that we were increasingly of the view that the BoE may already be done.
This week, the MPC voted 5-4 for unchanged rates. While it is possible that the four dissenting voices on the committee continue to vote for a hike at the November meeting, core inflation is likely to fall significantly further by then (not least due to the base effects of the energy price cap reduction). In addition to this, the downward revision to the growth backdrop (to 0.1% in Q3 from 0.4%, and that growth will be weaker than the 0.25% expected in Q4), mean that the MPC’s statement that rates will “remain sufficiently restrictive for sufficiently long” to return inflation to the 2% target sustainably in the medium term – implies the BoE intend to implement their implied ‘long pause’ (or ponder as we referred to it). The Bank of England rate peak is now in, we believe.
Last week we discussed the implementation and inference of the ECB’s implied pause. Having raised rates by 25bps to 4.00%, the ECB lowered their projections for expected growth throughout the forecast horizon and, in the press conference, the President was clear that the ECB feels the policy rate is set to a ‘sufficiently restrictive level’ and that now the core focus of policy is on the guidance of the ‘duration’ over which rates need to remain restrictive. In short, the ECB rate peak is now in, we believe.
This week it was the turn of the Fed.
Going into the meeting, expectations were for a hawkish pause – in effect a Fed likely to leave rates unchanged but infer a continued vigilance against renewed inflation pressures, especially in relation to the more resilient growth backdrop that has seen recent upside surprises in the high frequency macro data – a narrative that could easily be inferred through the release of the updated Summary of Economic Projections (SEP’s) and the Fed Funds projections, or ‘dots’. This was duly delivered.The updated SEP’s highlighted a clear uplift to the growth expectations for both 2023 and 2024 (though it is noteworthy that this uplift is only relative to the Fed’s previous SEP forecasts in June – the upgrade was largely in line with market expectations for growth over the respective periods). The Core PCE forecast for 2023 was downgraded to 3.7% (from 3.9%), but in many respects this continues to look a little high to us with supply of goods and workers reducing tightness in goods and labour markets (and by extension services). So stronger growth but less inflation pressure in the near term.
However, it was the dots that caught the markets attention. The 2023 dot was unchanged from the June projection implying a further rate hike and the 2024 dot implied two fewer 25bp hikes than the dots implied in June. At least in part this was justified by sharp downgrades in the unemployment rate projections throughout the forecast horizon – essentially inferring an equilibrium of 4.1% through 2025. A bold statement given the 0.2% jump to 3.9% in the August employment report and continued signs of loosening of the labour market (if not yet the clear signs of workers returning to the labour market that we expect, and that we have seen more clearly in the UK).
In our view the SEP’s and dot projections from the FOMC are the new forward guidance. While the dots project a further rate hike this year, the Fed Chairs tone in the press conference was less convincing – instead he emphasised the term ‘carefully’ in terms of future policy moves and stated that the committee would be prepared to raise rates further if necessary (our emphasis). Forward guidance that is essentially an insurance policy against stronger growth – just as the data starts to show increased effects of tighter credit conditions (admittedly this is not clear in all sectors of the economy… yet).
The Fed dots imply a strong pace of growth is set to continue and infers little or no further improvement in supply (goods or labour – something which we expect to continue). Indeed, we have discussed in past pieces that we have been surprised at the singular focus of analysts on the ‘relative’ or sequential tightness in monetary conditions or price levels without considering the impact of absolute levels. In relation to supply and demand, we feel that analysts are placing too much emphasis on absolute levels and not the sequential implications – for example there appears to be an implicit assumption that due to the fact that on some measures labour market tightness appears to have returned to pre covid levels, there is an assumption that that the correction is complete – why can supply continue to improve. Indeed, in the medium term we see little reason for excess demand or insufficient supply to persist, thus no clear reason why we cannot continue to see improving labour and goods markets and thus further disinflationary pressure on prices and wages.
From our perspective, the ‘hawkish pause’ from the fed is essentially a function of uncertainty going forward. At the current juncture with the inflation rate still above target, the messaging from the Fed skews hawkish. However, we see risks in both directions. It is not clear to us that the current backdrop should imply a higher US yield curve. The rest of the world is showing signs of fatigue in the face of tighter monetary policy, we do not see the US as an exception to this rule. This potentially makes the new SEP’s and dots very optimistic and on that basis the balance of risks is now likely in the opposite direction.
Ultimately, similar to the ECB and the BoE, the Fed peak is now in, we believe. The proof will be in the data – but the bar to satisfy the Fed projections and thus the dots, is now much higher. In fact, to paraphrase Metallica, it may be the data that never comes.
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