“...building to building, street to street, we pass each other on the stairs“
INXS, The Stairs
Last week, we discussed the dominant macroeconomic focus, the global central bank reaction function to the ongoing threat of inflation amid increasing signs of a slowing of global aggregate demand. Indeed over the past couple of weeks we have discussed the ECB, the BoE and the FOMC at some length, each with their own idiosyncratic demand dynamics, each with different dominant inflation drivers, each with their own specific mandates (something we will come back to later), but all with the complicated problem of how to ensure inflation expectations remain anchored while inflation remains high and growth begins to falter. Furthermore, how to judge the pace at which the stimulus demand effects will fade over time and how the effects of the ‘long and variable lags’ of previous cumulative monetary tightening will increase over time.
Last week we also discussed the fact that the dominant impression of the November FOMC seemed to be the hawkish press conference commentary. Notably, the specific responses Powell gave (arguably in response to an intentionally misleading question): (i) the Fed has “a ways to go” and “some ground to cover”; (ii) That incoming data suggest that the level of rates will be higher, though this was clearly a reference to the September ‘dots’ and not market pricing at the time of the press conference; (iii) that it is premature to discuss pausing; (iv) that markets should understand the Fed’s commitment to get this done and thus the Fed will not, not do enough, or withdraw policy too soon.
All pretty hawkish in isolation. However, the Fed also introduced two new factors, firstly, the explicit concept of “sufficiently restrictive” and secondly, the intention of the Fed to slow the pace of policy tightening or reduce the active increment - not dependent on data, but instead on the Fed judgement of the cumulative effects of previous rate rises and the absolute level of rates - above neutral.
We discussed the synchronous global tightening and its likely natural propensity to slow as the economy slows, which is likely key. As global demand slows and evidence suggests that global supply is increasing (certainly from some of the covid supply bottlenecks that have underpinned global inflation), at the same time as the lagged effects of price rises and interest rate rises weigh on sentiment, it is likely that inflation falters. This is critical to the Fed, and critical to financial markets. As inflation falls, real rates (and thus the ‘restrictiveness’ of monetary policy) rise - “sufficiently restrictive” is thus dependent on the path of inflation.
Last week we stated “Thus we would argue that rates and the USD will likely be asymmetrically vulnerable to inflation (and labour market) misses to the downside. We do not see inflation as structurally higher as a function of the events of the past 2 years and on that basis continue to view the USD, US long rates and risk assets in overshoot territory.” This week - while one swallow does not a summer make - the US inflation print disappointed markets to the downside, and we saw very sharp (asymmetric) declines in the USD and US yields, and a sharp bid in risk assets.
This week, there has been a rising debate in financial markets about the wider macro trends. One sell-side proposition that has gained a lot of airplay is that the underlying strength of US demand implies a higher neutral rate, while the persistence of inflation pressure means that the Fed will have the desire - and with thus modest demand destruction, the ability - to raise rates to a higher terminal rate. By extension, the fact that Europe will suffer, amid the pressures of a significant decline in the current account, dampening the ability of the ECB to maintain momentum to higher rates (at least relative to the US) and thus the ability of the EUR to trade higher. The argument was extended to USDJPY, where it was proposed that higher US yields and a lower recession probability should see a further cyclical upswing in USDJPY (in addition to the further cyclical downside to EURUSD).
Our view remains that we are at the beginning of a structural decline in the USD… from very overvalued levels
Again, we would argue that this thesis only makes sense if you believe in inflation persistence. It is hard to believe that the Fed will keep their foot hard on the brake, with growth slowing (even if not into sustained negative territory - but the impact of cumulative Fed hikes on secured and unsecured debt is already clear to see), and, with inflation slowing! Indeed, the argument that the Fed monetary impulse will positively diverge from Europe (wider spreads) is not clear either. The ECB have a singular mandate, price stability. The Fed have a dual mandate, price stability and maximum employment. If we add rising employment to slowing growth and falling (demand driven) inflation then it is not clear that the ECB will blink first!
We have, throughout the inflation crisis, noted the ‘inflation decorrelation’ between major economies. In the US stimulus driven aggregate demand surge, in Europe, the energy price shock as a function of the Russia/Ukraine conflict and in the UK a combination of the European energy woes, US stimulus boost and structural labour undersupply as a function of the Brexit adjustment (among other factors). Markets retain the dominant view that inflation persistence or structural changes to inflation mean smaller CB rate hike increments mean extended hiking cycle duration and higher terminal rates. We are not so sure.
This is especially true if we consider the potential right tail trifecta. We have outlined many times the three dominant threats against the three dominant global economies - inflation in the US, zero covid in China and the energy crisis / Russia,Ukraine conflict in Europe. Recent data or events have suggested (and it is only the suggestion so far) positive progress on all three. There is clearly a long way to go for resolution, but while monetary policy works with ‘long and variable’ lags, markets pre-empt.
If there is one thing that we can take from this week above other things, it is likely that the inflation risks for financial markets continue to be dominant (and asymmetric). The implications of slower growth and slower inflation (through the usual demand channels) are clearly positive for bond markets. In the bigger picture this dynamic is perhaps more mixed for the USD and for risk assets, but in the near term we continue to see the US rate dominance undermining the USD and boosting risk.
The real question is likely how steep the stairs are on the way down?
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