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“It's a long road, it's a long and narrow way”

Narrow Way, Bob Dylan

Sometimes it can be helpful, in testing your own belief in a hypothesis, to make a formal (or informal) case, whether written or otherwise, and see how convinced you are by your own arguments. Indeed Boris Johnson is reported to have done exactly that in forming his position on one of the most consequential decisions in modern day British politics - he is reported to have written two articles, one article portraying the benefits and wisdom of remaining in the EU, the other for Brexit. While not as consequential to the economic prospects and global influence of the UK (and likely not even remotely as permanent), last week’s piece arguing in favour of the near term prospects for EUR outperformance (relative to the USD), felt a little like this. After a week of central bank action and reflection (ECB, Fed and BoE), the hypothesis that EUR is forming a short term low continues, on balance, to feel like the right one… at least for now.

Last week, in coming to our EUR positive conclusion, we discussed the clear risks to the eurozone growth backdrop as a function of the (further) supply chain disruptions from the Ukraine war; but we also made the point that risks could potentially be asymmetric, whereby a more positive evolution in the conflict (peace?) could disproportionately benefit the EUR, through the growth expectations channel, and, that a further sharp deterioration in the situation could also benefit the EUR (relative to the USD), as sharp expected rate hikes from the Fed could begin to be pared back. Admittedly, there is a narrow path in between.

This week, the Fed outlined an impressive balance between sharp rate hikes, maintained economic and labour market growth and persistently high inflation - the path to maintaining all of these factors is likely very narrow indeed. We have some further thoughts on the Fed:

The big focus of the market was the updated Summary of Economic Projections (or SEP’s) and the ‘dots’ (the individual FOMC participant projections for the US rate path through 2024). The dots were recalibrated sharply higher to a fanfare of commentary stating a “material hawkish shift” from the Fed. However, it is important to put this into context. This is a material hawkish shift relative to the FOMC projections in December (the previous iteration), but not relative to market pricing. The new dots showed the Fed Funds rate at 1.75%-2.00% at the end of 2022, pretty much exactly where markets had priced rates going into the meeting.

Further, while Powell gave a very comprehensive descriptive narrative of the current US growth dynamic (strong aggregate demand, fast payroll growth, tight labour market, strong household and business balance sheets,...) the SEP’s highlighted a sharp downward revision to the median real growth forecast for 2022 (from 4.0% to 2.8%), alongside a sharp upward revision to core inflation (which now remains significantly above target throughout the forecast horizon).

In many ways, it seems as though the Fed are utilising the dot plot (and consistent messaging from participants on the rate path) as a means to maintain the current expansion, while hoping that at least some part of the inflation trajectory remains transitory. What I mean by this is that the prospect of higher rates in the future, that lead to a tightening of financial conditions, may be an insurance against retrospective criticism that the Fed has neglected its price stability mandate, while at the same time hoping that they will not need to be so aggressive as to go into restrictive territory (as the SEP’s suggest will be the case in 2023).

The important inference here, at least for me, is that there is a very narrow path for USD outperformance from the complicated backdrop for the Fed. Maintaining higher rates, above trend growth, and below equilibrium unemployment, may be enough in and of itself, but on the basis that markets had already priced the new median dot projection from the Fed, it is likely increasingly difficult to expect even higher rates, without damaging the growth and employment prospects - likely denting the USD. It may do in an improving geopolitical situation, but we have already argued that, in an improving backdrop, EUR likely outperforms. AND, this is not to mention the high likelihood that the market is very short EUR as it has, so far, been the only Ukraine war hedge that has consistently performed. In short, we continue to see the risks for EURUSD as asymmetric and to the upside. For now.

This week has also seen a significant policy announcement from the Bank of England. Going into the meeting there was no doubt from the market that there would be a 25bp rate hike, taking the Bank rate to 0.75% - its pre covid level. However, the statement was a distinct surprise to markets. Regular readers will recall our clear viewpoint on the UK policy dilemma.

The Bank of England have been very clear over recent months that the structural shifts in supply dynamics for the UK (post-covid and post-Brexit) likely mean that there should be an upward shift in the equilibrium rate of interest, thus necessitating higher rates in the near term to defend the credibility of the BoE in upholding their inflation mandate. However, despite the hawkishness of the BoE in recent months - including the fact that four out of the nine MPC members voted for a 50bp hike in February - we have been much more skeptical than the market about the Banks’ ability to hike rates anywhere near as aggressively as the market pricing suggests, as a function of the current squeeze on consumer incomes. - sentiment echoed by Sir Dave Ramsden over recent weeks when he warned markets “not to get carried away”.

This week, the Bank of England were explicit in pivoting their main focus away from inflation, and back towards growth – tempering market expectations of the pace of further BoE action. We still think that, on balance, the direction of travel for the Bank of England is towards tightening; however, it is clear from the meeting this week that the path will be much less clear, much more cautious. You could certainly argue narrower!

Dylan’s words “It's a long road, it's a long and narrow way”, seem very fitting this week, as the Fed attempts to travel along a very narrow path to maintain a higher rate trajectory without damaging the economic output, and while the ECB and BoE tread a more careful path, limited by the conflicting inputs of inflation and growth risks. In many ways, we would even argue that for markets, given the extent of uncertainty and stress in financial markets, there may well be a very narrow road through which markets may have to unwind their short EURUSD position, whether the situation deteriorates further or not!

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