“I know of no single formula for success. But over the years I have observed that some attributes of leadership are universal and are often about finding ways of encouraging people to combine their efforts, their talents, their insights, their enthusiasm and their inspiration to work together.”
Queen Elizabeth II
In our last piece, we discussed the latest iteration of Fed rate policy guidance from the Jackson Hole Symposium. Essentially, we argued that the US economy remains on a glide path to a soft landing but that the market oscillations around that glidepath (and the respective Fed reactions) are generating a higher baseline volatility. Well, this week, the volatility has continued… and not just from the Fed.
This week we have seen huge volatility in the US rates space, following a (modestly) stronger than expected US services ISM print - likely exacerbated by momentum accounts and mortgage convexity hedgers at the long end of the curve (10 year yields rose 15bps on Tuesday and largely unwound the move on Thursday). We have also seen huge volatility in the commodity sector, oil in particular, as the extension of the China Covid lockdown in Chengdu and surrounding areas heightened concerns of a more protracted demand slowdown. Oil prices are now down ~17% from the end of August and almost 30% from the June highs. The main focus of the market has been, first, on inflation, and a higher term structure for yields; and second, on the implications of global demand slowdown. Europe, in that regard, is in an uncomfortable position, with both near term inflation worries and an acute (energy driven) activity slowdown.
That is not to mention the UK! A week that started with a new Prime Minister, a new cabinet and a very expeditious announcement of a £150 billion plan to cap energy prices, the set-up of a new energy price task force to bring down the cost of energy (and by extension the cost of the taxpayer intervention), end the moratorium on shale gas extraction and a bold aim to make the UK a net energy exporter by 2040; and which very sadly ended with the death of Elizabeth II, our Queen.
From a markets perspective, the energy cap plan is a double edged sword for the Bank of England. On one hand, it will clearly reduce the headline inflation projections (by as much as 5%, according to government calculations), but they will remain significantly above target. On the other side, the cap is at a level that is still double the cost of energy, year on year, and thus in the context of the broader (global) activity slowdown, the inflation growth/trade off remains acute. Thus, much of the volatility has played out in the rates space, with the fiscal support having the potential to drastically change the inflation backdrop and thus the BoE reaction function.
Lastly on the global monetary narrative, we have heard from Fed Chair, and from members of the Federal Reserve Board over the course of the week. The Fed’s Chair was consistent with the Jackson Hole narrative, erring towards caution on potential future easing (from restrictive monetary policy territory), while maintaining the communication pressure to bring inflation under control. For me, this remains an active communication policy, but does not necessarily preclude a slowing of the pace of rate hikes this month.
The Fed’s Vice Chair and a member of the Fed, however, made two very clear points this week; a) that there is an increasing focus on the global slowdown and the implications for demand and terms of trade in the thinking of central bankers; and b) that there is a natural lag between the tightening of policy and the full effects of that tightening being felt on the economy. The Fed Vice Chair even referred to this as a risk of overtightening. This narrative - that the risks become more two-sided at some point – are more in line with the soft-landing flight path view that we continue to hold, a path that is not consistent with the market’s current very bearish view on risk assets and the financial conditions doom loop that we continue to question.
This week, the dominant emphasis should have been on the ECB. The expectations of sharply higher near-term inflation projections, the continued underperformance of the EUR (and the implications of exchange rate weakness in exacerbating the inflation problem), and the seemingly clear communications from ECB speakers (most notably the Isabelle Schnabel commentary from Jackson Hole) meant that markets had pretty much fully priced a 75bp hike going into the September ECB. Failure to live up to that expectation would likely make the job of the ECB even more complex going forward; the ECB duly obliged.
I say ‘should’ have been the dominant emphasis for the market this week, but as it turns out, after the fact, 75bps from the ECB, 125bps in the past two meetings after a decade in negative territory barely raised an eyebrow! From my perspective, it is likely that the ECB have done enough for now to stabilise the EUR. However, the WSJ ‘leak’, or the article this week (from the journalist that is widely accepted to have officially leaked the last minute pivot to 75 at the July meeting) suggesting that “the FOMC appears to be on a path to raise by 75bps” at the September 21st meeting meant that the ECB move this week may just mean keeping pace – even if it is not clear that there is an obvious case for another 75bps at the Sep meeting. CPI on Tuesday will play a large role in that discussion.
However, while the initial market response was relatively modest, there were some significant updates and we have some thoughts:
The ECB decision to raise rates 75bps to 0.75% met market expectations and the communication struck a further hawkish tone on the policy outlook, with the explicit reference that rates are “far below” the level of rates consistent with a return of inflation to the 2% target and thus further hikes will be needed. In an odd step, the President of the ECB stated that there are likely between 2 and 5 hikes to come, the magnitude of which will be data dependent.
Encouragingly, the current economic dynamic in the euro area has been better than anticipated, something we have alluded to in the past with reference to the hard or physical data holding up better than the soft or survey data - this week’s upward revision to the Q2 GDP estimate is testimony to that. However, the growth projections of the ECB appear somewhat optimistic.
The Governing Council expects the economy to slow down through the rest of the year due to i) issues related to gas supply disruptions, ii) a waning of the reopening momentum that has boosted the economy in H1, iii) weakening global demand, worsening the terms of trade and, iv) a period where uncertainty is likely rising and confidence is falling. But the forecasts of +3.1% in 2022, +0.9% in 2023 and +1.9% in 2024 are significantly above those of the market. The ECB account for this by the fact that they outline two scenarios: a downside scenario, where there is a total shutdown of Russian gas, rationing of energy and no mitigation from other sources (a scenario that doesn’t seem too far removed from the current situation) and a ‘baseline’ scenario, which as we suggest above (certainly relative to the current geopolitical backdrop) appears optimistic.
There is, however, some more persistent robustness in the euro area labour markets area, and total hours worked continues to climb. The president of the ECB also referenced an increase in demand for credit from firms across the region, though this is unlikely to have its usual positive connotations when increased borrowing is likely a function of energy, not investment. Furthermore, on the liquidity front, the ECB committed to keeping excess liquidity in the system for longer.
Overall, the ECB developments were broadly as expected and, from our perspective, likely enough to stabilise the EUR. Front end rate differentials have narrowed in favour of the EUR and we are increasingly sympathetic to the view that the Fed cycle has become fully priced, and that there are multiple risks, spanning from the weakening global economic backdrop to the Fed being able to meet market expectations. To paraphrase the Queen, there may not be a single formula for success for the EUR, but we remain encouraged by its efforts and enthusiasm.
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