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“Life is the art of drawing sufficient conclusions from insufficient premises“

Samuel Butler

Last week, we discussed what in our view is an evolving Fed reaction function - New Rules. In focussing on the three key components of inflation (Core goods inflation, Housing services inflation and inflation in non-housing services) and outlining their individual normalisation paths Powell returned to the inference of the ‘transitory’ language that has been long since banished. Furthermore, as the Fed projections show all three components of inflation heading back to target over time, there are two other aspects of the backdrop that should be seen as less hawkish (if not dovish, relative to current market expectations), the first is the continued reference to the ‘long and variable’ lags associated with the past cumulative tightening in the quest for “sufficiently restrictive”. The second is the clear slowing of growth, and its implications for future growth as the full effects of even current tightening are yet to be felt. This situation is exacerbated when you consider the prospect of a non-linear demand slowdown as we outlined last week. The policy outlook may well have moved over recent weeks, but we think that significant room for the Fed to underdeliver on market expectations in 2023, is emerging.

So, what does this mean for the rest of 2022 and beyond?

In many respects this week has seen something of a holding formation ahead of next week. Indeed, if you look at the EURUSD vol surface it likely sums market sentiment up. Very elevated vols around next week, followed by a swift decline back to a more modest baseline by Christmas and into New Year. With such a vol. premium being priced in, it is worth taking a closer look at the events of next week.

  • ECB (Thursday 15th December - Markets are pricing ~55bps). After an incredibly spring loaded exit from negative rate policy in Europe over recent months, the ECB are poised to slow the pace of rate hikes to 50bps in December. However, recent activity data has remained resilient, despite increasing signs of a global slowdown and the composition of inflation in the eurozone is likely more concerning for the ECB than it may be for the Fed (not to mention the single vs. dual mandate considerations). While the Fed attempt to land the US economy softly in the narrow gap between trend growth and mass layoffs, the ECB have the less enviable job of trying to slow a largely externally driven inflation from driving more persistent second round effects, whilst being mindful of the financial stability risks that higher rates could expose - especially in the more heavily indebted periphery - as growth clearly slows.
    The growth and inflation projections of the ECB will likely be the key focus as well as the emphasis that the ECB projections place on growth risks relative to inflation risks will shape market expectations about the likely ECB terminal rate. Interestingly, despite the fact that the ECB have a singular policy mandate - price stability - and the components of inflation appear more persistent in the near term, there is a widening range of analyst forecasts for the ECB terminal rate (2.50% - 3.75%). December projections will be key in this regard.
  • Bank of England (Thursday 15th December - Markets are pricing ~55bps). The situation in the UK remains extremely uncertain as the UK has the negative energy shock of the eurozone as well as the stimulus demand shock of the US, and the Labour supply shock of Brexit. Indeed, after the spread of voting at the last BoE meeting {25bps, 50bps and the Governors proposal of 75bps}, it is possible that the December meeting has an even wider distribution (to include unchanged). Some MPC members have sounded hawkish (Mann, Ramsden, Haskell) some worried about growth (Tenreyro, Dhingra). Markets are now pricing a rate peak around 4.5% - significantly below the level that prompted the Bank to warn markets of excessive pricing (aided by a sharp, fiscally corrective Autumn Statement). Even 4.5% seems high given the price and fiscal squeezes facing the UK consumer into 2023. The MPC language about risks to growth are likely key.
    However, the most significant and consequential events of next week likely occur in the US where the debate over the implications of the transition from inflation to growth as the dominant driver of monetary policy reaction function, is most acute. Not least because the Fed, unlike many other central banks, has a dual mandate: Price stability and full employment.
  • The US CPI print (Tuesday 13th) is undoubtedly the most important data release remaining in 2022. Markets are expecting a further decline in the headline index to somewhere around 7.3% and closer to 6.0% in the core. Further deceleration will reinvigorate the argument that inflation, and thus rates, have peaked, giving renewed energy to the rebound in risk and the sell off in the USD. A more stubborn print will derail this thesis and see higher risk premium and a higher USD resurface.
  • FOMC (Wednesday 14th December - Markets are pricing ~52bps). There is a clear consensus expectation that the FOMC will step down its active policy increment to 50bps in December as Powell and a number of Fed speakers have suggested over recent weeks. Indeed, as suggested in the Statement and Minutes from the November meeting as the Fed try to balance the effects of the ‘long and variable lags’ of previous cumulative rate hikes (the fastest spell of rate hikes in modern history) at the same time that inflation pressures are already showing signs of turning lower (helpfully split out by Powell at the Brookings conference at the end of November: Goods price inflation, Housing services inflation and non-housing services inflation - all three of which with a path back to target, albeit at different speeds), both of which suggest rising real rates even with unchanged policy rates.

Against this backdrop, and our expectations as outlined last week that we see the potential for non-linear demand decline to change the balance of risks for monetary policy more swiftly than expected in 2023, we are increasingly of the view that rather than the Fed playing catch up to market rate expectations we are likely at a peak where Fed expectations can start to look a little rich over coming months.

In this regard the December updated ‘dots’ and SEP projections are very significant. The November Minutes discussed the prospects that ‘rates will have to rise higher than previously anticipated (the September forecasts - which showed a peak of 4.50% - 4.75%). Market interpretation of this is that the new dots will show a peak Fed Funds Rate of 50bps higher than the September projections at 5.00% - 5.25%.

Given the pace of decline in activity in the rate sensitive sectors of the US economy, most notably but certainly not exclusively housing, and given the falling inflation / rising real rates dynamic at the current juncture, this is beginning to feel a little rich. Of course the second line of hawkish defense from the Fed is the duration over which they expect to hold rates in restrictive territory. Again we think that this has a very different level of commitment from the Fed at one end of the ‘inflation concern’ spectrum to the other.

Overall, as we look at it markets are beginning to price an increasingly close end to the hiking cycle across DM - we would err slightly closer than the markets - especially in the US and UK, but higher than usual uncertainty means this is far from a no brainer.

As growth cools, it becomes much more complicated for Central Banks to gauge what the Fed describe as “sufficiently restrictive” especially given that as growth slows, it potentially does so in a non-linear manner as we discussed last week, while at the same time, the long and varied lags of monetary policy lead to further tightening even with policy unchanged. The prospect of Fed overtightening will, from our perspective become an increasing concern of the FOMC as we move into 2023.

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