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“Some will win, some will lose… some were born to sing the blues”

Journey, Don’t Stop Believin’

Last week, we discussed the European Central Bank (ECB) policy meeting (as well as the Reserve Bank of New Zealand (RBNZ) and Bank of Canada’s respective 50bp hikes), suggesting that our perspective on the ECB narrative was more hawkish than that of the market - at least with reference to the subsequent price action. However, as we pointed out at the time, the long weekend (and the array of geopolitical uncertainties within) likely led to a more cautious approach to positioning.

Over the past couple of days, however, there has been a more concerted change in the ECB narrative. In many respects, while hawkish, the ECB’s presidents narrative in the ECB press conference was consistent with a normalisation process that was in train, but one that would be pulled along by the data, and still consistent with the base case portrayed by ECB Chief economist Philip Lane, that inflation will moderate to below target at the forecast horizon. The narrative this week, however, has been more consistent with the view that normalisation is in train and will be slowed by the failure of the data to warrant its extrapolation.

This may sound very subtle and indeed it is, but it is also important. This week, we have heard from the Latvian, German, Vice President and Belgian members of the ECB Governing Council - GC, all of whom have explicitly referenced the likelihood of a rate hike in July. This seemingly united narrative change pushes back against the Lane ‘wait and see’ perspective, and is made possible by the subtle language change at the December meeting - reinforced in March - that relaxes the sequencing conditionality between APP purchases and the first rate hike.

Essentially, this now brings the focus of the ECB policy path squarely back to the June meeting. If the Governing Council conclude that the APP purchases should end, say at the end of June, then a 25bp rate hike at the July meeting becomes the central scenario - given the recent narrative change. Markets are now pricing in a high probability of this eventuality. What’s more, unless a July rate hike has an ‘expeditious’ effect on reducing inflation in the short term, it is hard to see why the ECB should not deliver rate hikes in September and December as well. A positive deposit rate in 2022; that would have been an unthinkable prospect only a few months ago.

There has also been something of a uniform change in the narrative from the Federal Reserve System (Fed) - away from specific rhetoric about the prospects of 25bps or 50bps (or even 75bps) at respective meetings towards a process of getting rates to ‘neutral’ as ‘expeditiously’ as possible (thought to be around 2.25-2.50%). In this regard, there has been much focus on the long run real rate (10y nominal less 10y breakevens) going into positive territory (or at least to zero). For us, this measure is fraught with difficulty and uncertainty, especially when this consists of a sharply inverted inflation curve. The real problem for the Fed is the deeply negative real yields at the front end of the curve - hence the renewed determination to get rates to neutral (getting front end rates closer to zero) as quickly as possible.

There are two key questions that we consider today: Firstly, does faster necessarily mean higher? Following on from the RBNZ rhetoric last week that the 50bp hike referred to the policy path of least regret (and a ‘stitch in time’), the strategy appeared to be to bring the cash rate closer to neutral sooner, given the inflation challenge; thus, not increasing the terminal rate, but getting there sooner. It is not clear that the new Fed language implies further rate hikes in addition to faster rate hikes.

This week, a member of the Monetary Policy Committee at the Bank of England stated that for the Bank of England, an early rate hike does not mean bigger moves likely. Indeed, moving now may mean less tightening later. The Bank of England is a very interesting case, as Governor of the Bank of England was very clear that the policy rate needs to be marked higher as a function of the structural (post-Brexit) supply changes, weighed against the cost of living squeeze (exacerbated by tax hikes on top of inflation pressure). How well the UK economy holds up in the face of a consumer spending squeeze will potentially hold information about consumer resilience in other parts of the world.

This brings us to the second question: Does a more hawkish or more urgent monetary narrative imply greater risk of recession? There was much discussion about the inference of the (briefly) inverted US yield curve (2s10s) recently. However, we retain a more positive view of the growth backdrop - globally; but, relative to trend, especially in the US. We have noted in the past, our view, that the signalling coming from the yield curve should be looked at in real terms, and it is equally likely that the inversion of the nominal US yield curve is a function of the inversion of the inflation curve, as the two concurrent supply shocks (COVID-related supply bottlenecks and Ukraine war exacerbated commodity price shock) distort the front end of the inflation curve disproportionately.

Furthermore, we also retain our glass (more than) half full for the global economy for a couple of interconnected reasons. Firstly, we continue to believe that the ability of the global economy to absorb the COVID shock means that there is likely still significant reopening momentum in the global economy (as the length of queues in London bars and restaurants during - not so long ago desolate - weekdays may attest). Household balance sheets remain very healthy. The second is perhaps more interesting. As a result of the nature of recent shocks, we believe that there will be a continued global investment surge - a notable segment being investment in EV’s, as the race to reduce dependence on fossil fuels and to gain market dominance among the big players progresses (we note the announcement of multiyear investment from the big automotive players amounts to well into the hundreds of billions). We also note that much of it is originating in the US, providing an investment boost that could absorb the modest fiscal contraction many commentators have noted in their more gloomy, forward looking growth outlooks.

There are many more questions that we will continue to ask going forward. Are we near peak inflation concern? Or, at least, are we near peak Central Bank implied reaction function? How does this change when the second derivative changes - at least in terms of urgency? What are the implications of the chronological order with which inflation concerns hit the global economy? In Asia, the narrative has solely shifted from growth towards inflation as the dominant factor for the policy reaction function, but in Czech Republic and some parts of Latam, the inflation concern is more sanguine and expectations are that further rate hikes may be more cosmetic, than material.

Uncertainty in the global economy remains high, but despite the gloomy commentaries, we disagree that uncertainty implies negativity. Indeed, against a backdrop of high inflation, a huge cash glut, and relatively few suitable investment assets globally, there are some asset classes that we think deserve significantly more attention than they are getting. “Some will [most definitely] win…”

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