In our last piece, we discussed two main topics: (i) the most recent inflation print in the US and (ii) the (co-ordinated) change in emphasis of the Federal Reserve Board members to a more dovish posture - suggesting that the rising term yields in the US were a likely substitute (equivalent tightening of financial conditions) for the additional rate hike for 2023 implied by the September dots. We argued that overall, the CPI report, in conjunction with the US employment report for September, reflected continued progress towards the rebalancing of the labour market and prices, and thus attainment of Fed objectives.

Indeed, two weeks ago, we discussed the recent divergence in DM central bank rhetoric and the implications of this divergence in currency markets. We argued that while the rhetoric and inference of the ECB and Fed guidance are, on the face of it, increasingly divergent, the expected growth path for 24 and 25 are very similar.

From a currency perspective, this divergence is crucial - divergence in yield differentials, fiscal differentials but also, importantly, the monetary policy bias differentials - particularly in terms of current FX market sentiment.

However, as we see it, yield differentials are currently consistent with historical ranges that have existed in EURUSD. Fiscal differentials are wide in 2023, but the fiscal impulse next year, or the change in fiscal stimulus relative to this year, likely swings back in favour of the eurozone. While the incredible (unsustainable) US procyclical stimulus will remain high, it will be largely flat; while in the EU, stimulus picks up, as NextGenEU spending plans start to be implemented (and holdbacks resolved).

If we consider the fact that all of the move in long end yields was driven by real yields, with breakevens unchanged, you could make the argument that the rise in long yields is not about an embedded higher growth and inflation equilibrium but a more hawkish (and credible) Fed reaction function. If this is the case, then it could be argued that it would require a more modest growth slowdown to remove the Fed’s hawkish policy bias (reduced of late but still clear), return them to truly neutral and thus undermine the repricing of the curve. Thus, from our perspective, next year also likely sees a narrowing of the monetary divergence that we argue above is currently a ‘policy stance’, or ‘implied reaction function’ - a hawkish bias from the Fed.

Furthermore, globally there is increasing evidence that the rising US term yields and resultant tightening of financial conditions are impacting the global economy (i.e. other countries are feeling the effects of higher US yields on their growth). In the very near term, the inference that many have drawn from this - at least while the implied US growth momentum remains ‘exceptional’ - is likely for further USD strength. However, this must also be true on the flip side. Easing US term yields (as a function of moderating growth or else) would be supportive for global growth and thus not just USD negative, but also alternate currency positive.

However, you look at it, the rise in long dated US yields is currently the most influential and consequential factor driving financial markets. The dominant reason behind the rise in term premium is debatable and unclear, but the path of US yields is critical to the global macro backdrop and dominant in all asset classes at the current juncture.

This week, the market highlight was commentary from The Chair of the Fed in prepared remarks from the Economic Club of New York.

The Fed’s Chair was clear that the recent data had shown “ongoing progress” towards the Fed’s dual mandate goals of maximum employment and price stability. While acknowledging that the path down for inflation is likely to be bumpy and even take time, The Chair of the Fed was clear that there “may be meaningful tightening in the pipeline from past hikes” and that there are “very many signs that the labour market is getting back into balance” - ongoing progress. Ultimately, The Fed’s Chair was clear on the growth front (however surprising it has been to the Fed) - “we certainly have a very resilient economy on our hands”.

Furthermore, The Chair of the Fed highlighted that there is no precision in the Fed’s understanding of how long the lags over which monetary policy acts are, and that it may be simply that rates have not yet been high enough for long enough. In any case he stated that “the evidence is that policy is not ‘too tight’ right now”.

With the long end of the US yield curve the dominant driver of market sentiment, however, it was commentary about the yield curve that drew the most market reaction.

The Chair of the Fed was clear that the long-term bond yield is an important factor in policy tightening, but at the same time, listed a number of factors that ‘could’ be driving the long end. Initially The Fed’s Chair started with factors that he suggested were not driving higher term yields: not rising inflation expectations, not near-term policy expectations, and not principally near-term funding. The list of possible factors {markets extrapolating the current resilience of the economy into the longer term, concern over fiscal deficits, QT, the changing correlation between risk assets (stocks and bonds) were however still not helpful.

Essentially, The Chair of the Fed made the point that there are many factors that could be driving term premium in the US, however, that the Fed would change their policy (both actual and effective) based upon persistent changes in financial conditions. Further, when asked if the recent higher long rates were driving tighter financial conditions The Chair of the Fed implied this was demonstrably the case.

“We will have to let this play out and watch, but this is clearly a tightening of financial conditions”.

So where does this leave us and the markets? In the near term, it is likely that uncertainty prevails. However, we remain of the view that the moderation of US growth in Q4, the continued disinflation (that we expect, counter to the prevalent view of a more persistent inflation path from the market) and further normalisation of labour markets will bring the Fed policy bias back to neutral over the course of Q4. This may seem subtle but may well prove sufficient to undermine the momentum in US yields, the USD and to keep risk assets supported.