In our last piece, we outlined a more granular description of our views on the US macroeconomic trajectory. We highlighted a broad market that has become increasingly confident in the US economic strength narrative, and by extension linking the more resilient economic viewpoint to stronger aggregate demand and thus more persistent inflation - ultimately, raising question marks about the ability of the Fed to pause now and or cut later.

Further, we highlighted our view that aggregate demand is likely weaker than the recent data surprises suggest (and we would continue to argue that when viewed through the lens of absolute value, rather than relative moves, the broader economic data remains weak).

However, it is not our central view that growth collapses into something significantly more recessionary. There are a number of factors that likely underpin the growth trajectory, such as remaining pandemic excess savings and even the fact that the already negative output gap likely reduces downside risks. Rather we see aggregate demand and supply coming back into better balance - from a global as well as US perspective. Aggregate demand likely continues to expand but aggregate supply likely expands at least as fast (indeed, from a global perspective, you could make the case that demand deficiencies or excess supply are apparent in the oil market at the current juncture). The net result of this rebalancing should be lower inflation pressure and ultimately a higher prospect of Fed easing going forward.

This week brought the eagerly awaited FOMC meeting where markets, having been given a firm steer by the Chair of the Fed at the May FOMC and by Jefferson in a clear speech just before the blackout window, were expecting a pause after 10 consecutive rate hikes.

While the Fed delivered on their promised pause, the accompanying statement and economic projections pointed sharply more hawkish than expected - at least at first reading. The statement was clear that “additional policy firming may be appropriate”, the extent of which will hinge on the economy. The revised ‘dots’ (or individual FOMC member rate forecasts for the forecast horizon) shifted the median level up 50bps to 5.6% - a further two rate hikes from the current policy setting.

However, from our perspective, the ability of the Fed to raise the policy rate to the new median dot is not obvious for a number of reasons: (i) The Summary of Economic Projections pushed the forecast for core inflation significantly higher (3.4% to 3.9%) in 2023 and the headline rate to 3.2% - Cleveland Fed inflation NowCast puts headline inflation at 3.2% in June, six months early, (ii) the projected unemployment rate was revised down and (iii) the growth rate revised higher. If we combine i, ii and iii then we would argue that the new sensitivity of the Fed to weaker growth and/or weaker inflation means that there is a higher bar to delivering on the projected two further rate hikes. Of course, it is entirely possible that the FOMC dots were a deliberate attempt to forward guide a higher near-term policy path such as to tighten financial conditions to a point whereby the projected rate rise(s) may not be needed. Indeed, the TGA rebuild (that we also discussed last week) that is putting upward pressure on yields is also a tightening of financial conditions that is technical in nature - again reducing the propensity of the Fed to hike rates further.

Indeed, this is not to mention the dampening growth prospects from further fragilities in the banking sector and thus reduced credit creation. Going into the meeting, WSJ Fed whisperer Nick Timiraos published an article emphasising prospective weakness in the Banking channel and the implications for credit concerns to feed through into the real economy.

Lastly, and again likely damping the Fed’s ability to hike rates further, is the inclusion in the debate at the Fed about the appropriate ‘pace’ of potential future rate hikes. If, as some have suggested, the new tightening pace is once a quarter, then set against a slowing growth trajectory and rebalancing supply/demand dynamics, it is less likely that there will be a prolonged period of inflation persistence, and thus less likelihood that hikes that are further apart will be enacted. Current market pricing suggests that the broad market agrees with this broad analysis, with front end curves implying around 80% chance of a 25bp rate hike in July, but no more tightening - broadly in line with pricing before the ‘hawkish dots’.

Following the Fed this week was the ECB.

The ECB hiked rates by 25bps (as expected) and effectively pledged to do the same in July (absent a material change in the economic backdrop). The ECB communications had effectively guided market expectations in terms of the near-term policy path and thus in itself the rate hike had little impact on market pricing.

However, once again we see some interesting inferences from analysis of the forecast revisions. Going into the meeting, the market had become increasingly concerned about the growth trajectory, and the sustainability of the growth trajectory against a rising rate profile. The ECB forecasts, however, increased Core CPI projections significantly for 2023 and 2024 with very minor amendments to the growth trajectory. Essentially, that the ECB can continue to raise rates further without pushing the eurozone economy into recession.

Essentially, the eurozone continues to have a more hawkish inflation trajectory and thus likely a tighter monetary reaction function relative to the Fed in the near term. From our perspective, this likely weighs on the USD relative to the EUR.

The divergence in monetary trajectories between the Fed and the ECB was put further into perspective globally this week as China cut its rates (initially the LPR and then the MLF).

Ultimately, our macro views remain unchanged - You could argue that the combination of the Fed and ECB ‘cast no shadow’. We continue to see inflation falling, as global aggregate demand and aggregate supply move back into balance. As inflation falls, real yields become higher (a point that was directly corroborated by Powell this week in the Q&A) and bond yields can resume their declines. As this happens, equities can continue to rally, aided by a broadening of the positive contributors. Against this backdrop the USD should continue to weaken.