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“All these things into position"

- Radiohead, Street Spirit (Fade Out)

Last week, we talked about the expectations of the European Central Bank (ECB) going into this week’s meeting. October had been billed as a non-event (policy decisions around the end of the pandemic emergency purchase program/transition to the asset purchase programme had already been postponed to December). However, since then, “there has been a dramatic energy price increase, an intensification of supply chain disruption and even rising longer term inflation expectations, with markets pricing in an, albeit modest, rate rise in 2022.” Expectations going into the meeting were that the ECB central message would be to push back against near term pricing of rate normalisation.

To add context to the meeting, in relation to the recent rise in global inflation expectations, we had already heard from the Reserve Bank of Australia (RBA) and the Bank of Canada. The RBA decision not to announce further purchases of the April 2024 government bond this week (the anchor of its Yield Curve Control – YCC – target) and the commentary of RBA members (who didn’t push back against the recent disconnect between the sovereign curve, constrained by YCC, and the swap curve, pricing in rate hikes as soon as next year), left the RBA reaction function uncertain; as such, the RBA meeting next week will be a very complicated communication challenge for the RBA.

Also this week, the Bank of Canada ended its quantitative easing programme earlier than expected and accelerated the potential timing of rate hikes, by bringing forward the estimate of closing the output gap to Q2‘22 from H2’22. The Bank of Canada Governor also stirred rate bulls, by emphasising his commitment to ensuring there will not be ongoing inflation. This is not to mention the race to get ahead of inflation in the emerging world, which has recently seen a surprise 75bp hike from Russia and 150bp hike from Brazil – both pledging to go further.

Against that backdrop, the expectations of the ECB pushback should perhaps have been put into context. Acknowledgement of the more acute global inflationary pressures are a clear and obvious consideration for all central banks – even if the reaction functions are diverse.

Indeed, with no new forecasts or projections from the ECB, the press conference and Q&A focussed on one specific factor – “Inflation, inflation, inflation”. The ECB President was clear that the debate of the Governing Council (GC) centred clearly around the understanding of the drivers of inflation, and that they were (i) energy (oil, gas and electricity), where in September, energy price rises accounted for half of the overall inflation print, (ii) demand outpacing supply, as the global economy reopening demand continues to outpace supply and (iii) base effects – most notably the expiry of the VAT cut in Germany. But, that the GC expect the influence of all of these factors to reduce, or fall out of the calculation, over the course of 2022 – at a pace that is admittedly slower than previously expected.

On market pricing, the ECB President was explicit, but perhaps not as forceful as the market may have liked, in her pushback, simply stating that the analysis of the GC does not support rate lift off at the time markets are currently pricing, “or anytime soon thereafter.” Towards the end of the press conference, there was a slight dip in confidence about the transience of inflationary pressure, in mentioning the fact that in the event that inflation pressures persist for even longer than anticipated, the ECB would have to pay close attention to the wage negotiations and potential second round effects - a voice on the GC that is likely weakened after the departure of Herr Weidmann.

Ultimately, therefore, the disconnect between the markets and the ECB is, as the President alluded, a function of whether the ECB forward guidance is understood and believed. We remain in the camp that the ECB has very little space for monetary tightening, in the near or even the medium term. A good example of this inability is the recent widening of peripheral spreads. As the market prices inflation and policy normalisation, they must by default price out intra-eurozone spread support (not to mention the support via national central banks emanating from the tiering of TLTRO – targeted longer-term refinancing operations – programmes) – at a time of acute debt burden and acute divergence. This is an important implicit policy restraint in the medium term.

Furthermore, as we referred to in the opening paragraphs, it is important to add context. Markets are pricing rate hikes in the eurozone, where there remains a way to go to get back to pre-covid growth levels (expected by year end), medium term inflation forecasts are below the 2% (symmetric) ECB target and interest rates are at pre-pandemic levels. In the US, the interest rate hike pricing has remained very modest by comparison, when you factor in the attainment of pre-covid growth levels, above target inflation at the forecast horizon and where interest rates are around 150bps below where they were pre-pandemic. Inflation likely continues to be a global phenomenon. It sets up a significantly more complicated tradeoff, with growth the key determinant of the central bank reaction function.

To sum up, the emphasis of the ECB Q&A was ‘is the market mispricing the reaction function of the ECB’; the President pushed back (however convincingly). In my view however, at least in terms of the FX implications, what is important is how the ECB repricing (and the ability of the ECB to tighten policy in any material fashion over the medium term) compares to what is priced and what is possible from the Fed. From my perspective, it is still the Fed curve that is mispriced.

A few thoughts on the UK budget

Firstly, it was clearly an evolution of Conservative philosophy – one that has been described as ‘a fundamental shift in the philosophy of conservatism’. While the Chancellor may (profess to) aspire to small state, low tax, and high wages, for now the UK government is a high tax (highest tax burden since the 50’s) and high spending (big government) state.

There was some good news in the Office for Budget Responsibility forecasts (public finances GBP 51B better than expected in March, enabling the Chancellor to close the budget deficit by the start of the next parliament, 24/25), but essentially the backdrop for the budget revolved around the tax hikes that had been announced a month or so ago (higher National Insurance, dividend taxes – Health and Social Care Levy) as the base for a significant fiscal expansion. It is likely that the additional fiscal spending will boost growth forecasts (perhaps 0.4% to GDP ‘22-’23) and potentially even underlying inflation.

There are some interesting targeted spending plans, notably education, but more broadly skills innovation and economic infrastructure that may bode well for the long term productivity of the UK (the levelling up funding of 1.7B and home nations payments of GBP 8.7B should help boost productivity which has been historically weak outside of London); and the 50% cut to business rates for hospitality may go some way to rebalance activity back towards services.

As far as markets are concerned, I still think that the communication / timing of the Bank of England rate hike is complicated, and it is not clear to me that November is the ideal time for lift-off.

That said it is also clear that the direction of travel for monetary policy is towards tightening, just as the direction of travel for fiscal is loosening – this should be a positive for the currency.

In many respects, this is a core view of ours. In the US, even if the Biden economic stimulus plan is USD 1.75B, as was mooted this week, the trend of looser fiscal policy and (potentially significant in the US) tighter monetary policy should continue to support the USD.

The ECB President was clear this week that the three drivers of higher near-term inflation would “fade out”. From our perspective, so too will the arguments for a higher EUR against USD at the very least once the Fed gets its chance to respond next week.

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