“How many roads must a man walk down “
Bob Dylan, Blowin’ In The Wind
In our last piece, we discussed the recent divergence in DM central bank rhetoric and the implications of this divergence in currency markets. We argued that the ECB, having raised rates and lowered their growth projections, implied that the peak is in place, unless data is stronger than expected (the active policy tool is thus the duration over which rates are held in restrictive territory). In the US, however, the emphasis was the opposite; the Fed raised growth projections (and lowered inflation projections) and implied they would continue their hiking cycle (one additional hike this year) and would leave rates at the more restrictive setting for longer unless the data is weaker than expected.
Essentially, the Fed and the ECB positions are very similar - the hiking cycles are likely complete - but with an emphasis on the burden of proof in opposite directions. Despite these alternate emphases, the growth projections of the ECB and the Fed are remarkably similar (Eurozone 1.0% ‘24, 1.6% ‘25: US 1.5% ‘24, 1.8% ‘25 - even if the descriptive narrative of the Fed has shaped the perceived risks to be in the opposite directions for Europe and US growth). We also pointed out the inconsistency that inflation projections are lower in the US – but the implied policy urgency is greater!
The next two inflation and employment report prints are thus critical to the market emphasis on the implied positive growth (and thus rate) divergence in favour of the US – and thus also of US / Europe rate differentials and EURUSD. Market positioning and analyst sentiment continues to think that this is clear. We remain less convinced.
Over the last couple of weeks, there have been a number of events. On the data front, the US employment report for September was a trigger for some significant market volatility. But we have a more sanguine interpretation than the knee jerk market reaction. The headline payroll gain was significantly higher than the consensus forecast (336k vs. 170k) and this drove higher yields and a stronger dollar. However, the household survey gave a much more pedestrian 86k gain on the month - offset by a 90k gain in the labour force, thus returning an unemployment rate that was unchanged at 3.8% (higher than market expectations). There is some suggestion that the establishment survey was exaggerated by additional part time work, which is not captured by the household survey, which was itself in line with the ADP gains for the month. Furthermore, average hourly earnings continued to drift lower.
This week we received the US CPI print for September. While the headline print was unchanged at 3.7% y/y (a marginal disappointment relative to expectations of a one tick reduction), the core measure came in line with expectations and down another 2 tenths to 4.1% (having peaked at 6.6% one year ago). Further, the breakdown of the CPI was benign, with shelter services, and durables all lower - consistent with continued declines in the core - even if there was some disappointment in the shelter component. Indeed, core CPI on a 3-month annualised basis has slowed from 5.1% at the end of Q1, to 4.1% at the end of Q2 and now 3.1% at the end of Q3. CPI ex food, energy, shelter and used cars is already below target and if we strip out shelter (a component that the Fed believe turns negative mid next year) then inflation is far less sticky or elevated than the consensus opinion.
Overall, the reports reflect continued progress towards the rebalancing of the labour market and prices, and thus attainment of Fed objectives.
What is perhaps more significant over recent weeks is the change in the emphasis of Fed speakers. In particular, it is noteworthy that, over the past couple of weeks, we have seen a softening of the Fed’s hawkish narrative.
At least in part, the bias has been altered by the tightening of financial conditions, as a function of the selloff in bond markets that we have seen over recent months (around 100bps in Q3, with a significant duration capitulation over recent weeks). It is not clear that we can reliably state one factor in the bond market sell off, but a combination of rising term premia (as a function of increased deficit concern, put under the microscope by the US rating downgrade at the start of August), and by extension, the higher fiscal deficits which require greater issuance / supply, as well as the surprisingly resilient US growth momentum that has sparked debate about higher equilibria and thus higher term yields.
In many respects, therefore, it comes down to the sustainability of the current growth dynamic in the US, and this is where it seems the FOMC are starting to shift. Just this week, we have heard from Waller - “If current trends continue, inflation will basically be back to target”, Bostic - “There are a lot of signs the economy is starting to slow”. And the minutes from the September policy meeting (released this week) also offered more concern on growth - “many members saw downside risks to growth despite resilience”. Indeed, even the IEA commented that they see “oil demand destruction signs as US gasoline use drops”.
To paraphrase Bob Dylan, how many more data prints does it take, before the effects of the significant monetary tightening are felt in the US data? While the answer may well be blowin’ in the wind, we remain of the view that disinflation continues to evolve, and that the cyclical downturn will drive asset prices into year end.
We are not in the camp that expects US growth to fall off a cliff, but in our view, there are clearer signs that growth momentum is waning as a function of tighter financial conditions, and there is further pipeline pressure on demand yet to be felt. Furthermore, we are also of the view that we are at the point of peak divergence and that the US exceptionalism argument that has supported the dollar is a function of a global economy at its most divergent point (C+I+G), and that continued disinflation and rising risks to growth (moderation, not collapse), support a long duration, long risk asset and short dollar stance going forward.
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