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“Don’t let the sound of your own wheels drive you crazy“

Eagles, Take it Easy

In our last piece, we discussed the UK’s ‘Mini - Budget’ and its Maxi - reaction. Harold Wilson once quipped that ‘a week is a long time in politics’ and if that is the case, the three weeks since we last wrote feels like a lifetime. While we refrain from direct political comment, the events of the past weeks have in many respects shone a light on both fiscal trajectories (the UK is certainly not an outlier in this regard - IMF projections highlight a far healthier medium term debt trajectory in the UK relative to Japan, much of Europe and even the US) and perhaps more significantly, the interactions between fiscal and monetary authorities more broadly.

While the UK monetary / fiscal balance remains complicated, in the near term at least, the fear of the IMF - that fiscal policy was working at cross purposes to monetary policy under the Truss/Kwarteng (short-lived) expansionary fiscal backdrop - has dissipated, and market concerns of exacerbated inflationary pressures have calmed. Indeed, markets are now expecting further fiscal tightening to close the estimated £35b hole left by higher funding costs (among other factors). Even if the delay in the Fiscal Event - now upgraded to a full Autumn Statement (November 17th from October 31st) will reduce that ‘hole’ significantly, due to the lower natural gas and gilt yields forming a lower baseline for projected liabilities.

As the hyperbole around the imminent collapse of the UK (and the pound) fades - and the more conventional government approach sees the removal of risk premium in rates, FX and FX volatility markets - and with some very important central bank meetings over coming weeks, we expect that the focus will shift back to the global monetary trajectory and the evolution of ‘Central Banks emphasis’ as the inflation/growth balance becomes more delicate into year end and beyond. We continue to argue that the direction of the USD is key from here - more so than the likely transient concerns over the pound (especially if the combination of the BoE and the Autumn Statement can, as we would expect, further stabilise the real rate backdrop)

In a number of recent pieces we have also discussed the the rising likelihood that as policy rates approach neutral, central bankers become more likely to pivot towards (or signal a future pivot towards) smaller rate hike increments, particularly due to the fact that full effects of the previous rate hikes are unlikely to be fully felt in the economy yet. When I joined the industry (24 years ago today!) it was generally accepted as a rule of thumb that the full effect of a rate hike would not be felt in the economy for 9-13 months. This front loaded global normalisation cycle is unprecedented in pace and in respect of the full economic impact of rate hikes already enacted, flying somewhat blind. In this regard, the BoC Governor Macklem comments that the Bank of Canada are “trying to balance the risks of under and over tightening” are significant. Perhaps, more significantly they also noted that the effects of past interest rate increases are "becoming evident" in the interest-sensitive sectors of the economy. Under market assumptions, the Bank of Canada rate will move from just above 0% in March of this year to just below 5% by March of next year - an unprecedented move in a period of time where it is possible that the full effects of the very first hike are yet to be felt! 

So as Canada follows Australia into a pivot to a slower pace of monetary normalisation (as rates approach estimates of neutral), focus of market attention shifts towards the implications for next week and the Bank of England and the all-important Federal Open Market Committee (FOMC) meetings. This week, however, the main focus was the ECB.

Going into the meeting markets were united around an expectation of 75bps - a supersized rate hike (and let’s not lose track of the historic significance of the pace, or incremental size, of front loaded policy normalisation globally - even more unprecedented when you consider an ECB hike of 75bps in the context of PMI’s in the 40’s and an economy already in recession by many expectations) justified by the September precedent, the continued upside inflation risks, the resilience of the hard data through the summer (even if that looks more vulnerable moving into Q4) and the uniformly hawkish commentary from Governing Council members which suggested a relatively unanimous vote.

Beyond the rate hike itself markets were also looking closely at the prospect of QT (How developed the discussion of balance sheet runoff is - and how it may work given the difficulties around the periphery and reliance on PEPP flexibility as an active policy tool), there was even some focus on potential changes to the TLTRO programme to make the system less attractive to banks (again a complicated debate), but the real focus was, or should have been on the language around the future path of normalisation, and or tightening - especially given a 75bp rate hike would take the ECB towards the top of its own range projection of the neutral rate (near 2%).

What we got was interesting and I think retrospectively will be viewed as an important ECB meeting in terms of the normalisation cycle.

Effectively the ECB did two things: Firstly, they raised rates 75bps to 1.50% and in doing so ended forward guidance and implied a slowing in the pace of policy normalisation going forwards – adopting a meeting-by-meeting approach that is data dependent. The statement did not rule out a further 75bps and highlighted some concerns around stronger wage growth and risks to inflation from energy prices BUT was also explicit in emphasising “clear” downside risks to growth (a sharp fall in Q3 followed by further contractions in Q4 and Q1) and did omit the word ‘several’ in relation to prospective future rate hikes. Lagarde also pointed to the lagged effects of past policy tightening.

Secondly, the Governing Council implemented a change to the remuneration of the TLTROIII programme. The President of the ECB explained that the improved terms at the time of the pandemic was to encourage bank lending and that the revised technical measures are aimed at reducing liquidity and reducing collateral scarcity in the system by encouraging banks to terminate the programmes early.

Furthermore, the ECB President was clear that the discussions and decisions around QT (or likely very specifically balance sheet reduction of the non-PEPP asset holdings – as PEPP flexibility remains an important policy tool) will be made at the December meeting alongside the new economic projections. Clarification later suggested, however, that this will not include a start date.

For me this is an important meeting and one which will ultimately be viewed as the ECB pivot – the end of front loading. However, in the near term it is likely more important in shaping expectations for next week’s FOMC. The WSJ pivot tweet from a week ago, Fed member comments on concerns of lagged impact of previous front loaded policy action (again it is important to put into context the historic connotation of 75bps rate hikes - three times the standard increment) and the RBA, BoC and ECB direction of travel will all weigh on the Fed narrative - especially as the Fed is the only one with a dual mandate and thus more compelled to factor the implications of the growth slowdown.

Set against the release of the triennial BIS FX turnover survey highlighting a 14% rise in volumes from 2019, we continue to see FX at the forefront of market moves for the remainder of 2022 and through 2023. However, for us, while we retain the view that a Fed pivot or moderation in rate hikes (further reducing the distribution of possible rate paths) is a positive for some high yielding EMFX, ultimately it will be a USD story. Rate hikes (and ultimately rates) increasingly appear to be peaking. With that so too should the USD.

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