“I'm still here trying to figure it out“
Royal Blood, Figure It Out
In our last piece, we discussed the recent central bank actions and rhetoric from the ECB, BoE and Federal Reserve, arguing that the shift towards data dependence was a significant watershed for DM monetary policy and the global rate cycle - even if notable differentiation (or lags) in respective cycles remain.
On the DM side, there have been notable developments this week
In Europe, the rhetoric is consistent across the Governing Council, that the hiking cycle has further to go, as core inflation shows little sign so far of reversing. Some members chose to emphasise the likely proximity to the end of the hiking cycle relative to the beginning, but there is remarkably muted pushback against further rate hikes from the ECB - even as some signs of further growth moderation (in manufacturing) appear.
In the UK, the picture is more mixed. It is increasingly clear that the MPC are ‘hoping’ that they will not have to raise rates further, but as a good friend of mine once said, ‘hope is not an investment strategy’. However, if we look at the Bank of England forecasts relative to market pricing, the prospect of further ‘inflation persistence’ (the yardstick by which the MPC have promised further rate hikes) has a relatively high bar through the rest of this year. MPR forecasts for inflation through Q2, Q3 and Q4 are significantly higher than the market implied expectations for the period, and thus the ‘trigger’ for further Bank rate hikes is relatively high. If we add in the big drop in employment in April (136,000 - undoing almost the entire Q1 gain of 182k), the second consecutive uptick in the unemployment rate and clearer signs of workers (especially young workers) returning to the labour force, there are clearer prospects of easing wage pressures as supply and demand continue to rebalance. All of these factors lead us to be increasingly of the view that the Bank of England has reached its terminal rate for the cycle - an important prospect considering markets are currently pricing an additional 47bps of hikes.
In the US, there have been a raft of Fed speakers. The message has been clearly more mixed on the inflation trajectory / policy expectation front. Arch-hawk James Bullard stated that the prospect for disinflation was now good, though “not guaranteed”, and many FOMC members have emphasised the fact that the full effects of the rapid pace of Fed hiking are likely ahead (or words to that effect). New York Fed Williams stated that the US is starting to see demand and supply coming back into balance, as the economy is starting to get back to more normal patterns. To sum the sentiment of the FOMC up, I would suggest that the FOMC are now happy with the current policy settings, and thus a pause (for at least a few meetings) is likely - even if, in the meantime, the Fed ‘talk’ likely errs on the hawkish side so as to keep market expectations from loosening policy pre-emptively.
The divergence of opinion about what happens next is interesting. There are essentially two schools of thought on the macro backdrop, those that think there will be a soft landing, and by extension that demand and therefore inflation will be stronger or more persistent, and those who expect a recession and thus lower growth and lower rates. Our view is somewhere between the two, where we think that the rate path will be led by declining inflation and not collapsing growth. As the supply and demand in the economy normalises, so too will prices. If, as we expect, inflation continues to decline significantly through the remainder of 2023, real rates become excessively, not sufficiently restrictive, thus enabling lower rates to support moderating (but not collapsing) growth. The macro backdrop under this scenario would be supportive of stronger equities and bonds and a weaker USD (the trough of the dollar smile).
Further, we still view the experience of the recent small bank ‘credit viability scare’ (for want of as better descriptive narrative for recent events) as having a significant impact on the supply and demand for credit against the current, complex macro backdrop. Small businesses are the most dependent sector on small banks, but they are also the most likely to downsize as a function of financial challenges and are more reliant on debt (and therefore more sensitive to changes in the price and availability of that debt). Furthermore, as small businesses have accounted for somewhere in the region of 70% of labour demand growth, the recent chain of events is likely to encourage an acceleration of the rebalancing of supply/demand in the labour market - easing wage pressures and underlying inflation.
The current debt ceiling debate adds to the current market confusion. Depending on which of the dominant market ‘camps’ participants favour, there is likely a differing implication of the recent sell off in US front end bonds (higher yields). The recession camp likely seeing this as a US default risk premia and the soft-landing camp seeing this as stronger data and thus lower prospect of rate cuts in H2 23 and beyond. In this regard we are more inclined to see the front end sell off as debt ceiling risk premia - with implications (transitory in our view) for the USD - ultimately, we view the current situation as exacerbating our viewpoint, not contradicting it. The absolute levels of debt and the CBO projections are also very concerning and offer a debt trajectory that likely undermines the USD, perhaps for many years to come.
Interestingly, Fed Mester also said this week that “Current trends point to slow long run growth”. From our perspective, this is a further validation of the long duration view. Long end rates should be indicative of long-term growth rates (under the premise that inflation also normalises over the long run). The Mester comment thus offers no validation that US long rates should trade persistently above the equilibrium rate - around 2.50% in the FOMC projections. The recent China slowdown is likely a further advocating factor for long global duration.
However, the process of the debt ceiling is resolved (and even how close it comes to a potential default, the likely outcome is a compromise that results in a fiscal contraction (the reversal of planned further spending from the Biden administration). As a factor in the inflation debate, we expect this to ultimately weigh on prices - and by extrapolation rates.
Ultimately, the back up in yields that we have seen this week are notable. However, we remain of the view that long duration (short yields) makes more sense against the current global macroeconomic configuration the debt ceiling and inflation shock get ‘figured out’.
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Bloomberg, Huw Pill, April 2023 - https://www.bloomberg.com/news/articles/2023-04-25/boe-economist-says-uk-people-need-to-accept-they-re-worse-off
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