“These are my salad days, slowly being eaten away“
Spandau Ballet, Gold
Last week, against a lull in the global macro data calendar, we discussed the importance of what we referred to as “likely historically significant” upcoming DM central bank meetings - Bank of Japan, ECB, and the Federal Reserve. This week we have a few thoughts on our assessment of the situation going into the meetings and a few thoughts on their implications, ex-post.
We argued that the decision and narrative from the Fed would likely be by far the most wide-reaching and consequential of the week. Yet, with 24bps priced by the market going into the decision, it was likely that it was the narrative and the nuance of the communication (devil in the detail) that would be the most consequential. We argued that, while delivering on the expected 25bp hike would be significant for being a ‘dovish hike’, “one in which the Fed do not give a clear directional bias, for the first time in the cycle”, our view was that the explicit end to the cycle would likely come alongside the new Summary of Economic Projections (SEP’s) at the September meeting.
Furthermore, we also highlighted the importance of retaining the language around the “pace” of further potential tightening, arguing that the case for adding to the policy restriction, when inflation is clearly slowing (from both supply and demand) and growth is already running below equilibrium, was already a weak argument, ultimately risking a much sharper demand hit, and implying a need for rates to be cut faster in the future.
Essentially the Fed delivered. The committee delivered the 25bp hike that was effectively fully priced by the market; and they delivered on the retention of the discussion on the appropriate ‘pace’ in considering the extent of additional policy firming needed to curb inflation. However, the statement (and ultimately the press conference) was a clear step back from the hawkishness surrounding the higher dots at the June meeting, with a clear emphasis on the extent of previous cumulative tightening and the lag with which that would be fully felt on the economy (and inflation) and the need to continue to assess additional information on both sides of the dual mandate - price stability and maximum employment - as “tighter credit likely weighs on activity” going forward.
In addition to the policy being dictated by the Fed’s dual mandate, Chair of the Fed emphasised throughout the press conference the extent (525bps) of previous cumulative tightening and the clearer signs of disinflation through slower spending, weaker housing activity and (clear) declines in business investment. Notably, while the Fed’s Chair stopped short of stating that the risks to the Fed mandate were balanced (an admission that would explicitly imply a peak), he was clear that “there are risks on both sides” - with further emphasis that it would take time for the full effects of tightening to impact, and that there are significant uncertainties over economic and financial developments. We are increasingly confident that the explicit announcement of peak rates will come in September (alongside updated SEP’s).
This is a concept that is consistent with the Chair of the Fed in the Q&A, where he appeared to alter the definition or inference of the term ‘sufficiently restrictive’ (in a manner we have argued on many occasions - that sufficiently restrictive is a factor of inflation and economic momentum and not just nominal rates), in suggesting that “policy had not been restrictive enough for long enough”, BUT, that real Fed Funds rates are meaningfully positive and therefore restrictive. As inflation falls, policy becomes more restrictive with unchanged nominal rates.
The message from the Fed’s Chair was that there would be no forward guidance, but that the notion that the Fed would keep tightening until inflation reaches target would clearly mean policy had gone too far; a similar message was, to a certain degree, also apparent in the ECB messaging.
Last week, we suggested that, while a 25bp hike was fully priced and thus uncontroversial, the narrative surrounding future policy expectations in the context of the ECB’s three guidance pillars - the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission - would be key.
The ECB acknowledged that the near-term economic outlook had deteriorated (with spending, housing, and business expenditure all displaying weakness - though services remain strong, especially tourism), but that it will be supported over time by incomes from both labour market strength and moderating inflation - not to mention the still very generous national fiscal support schemes and the huge stimulus of Next Generation EU funds being disbursed over the next few quarters.
Markets were quick to respond to the more dovish growth narrative from the ECB, despite the fact that the ECB mandate is singular (price stability), and quickly reduced future rate hike expectations from ~50bps to ~25bps (2 more hikes down to 1). The key line (often repeated) was: “Future decisions will ensure that policy is set at a level that is sufficiently restrictive, such as to bring inflation to the ECB’s medium-term target in a timely manner”. This was a subtle change in the wording, but one that likely accounts for the recent disappointing growth momentum across the region, most concerningly in Germany.
Lagarde emphasised that there was a unanimous decision to hike rates 25bps today and that going forward decision(s) will be data dependent, with the options being to pause or hike (emphatically not cut). Furthermore, that a decision to pause does not rule out subsequent hikes. She was clear – as was the Chair of the Fed – that there is a lot of data between now and the next meeting. Essentially, for us, the critical near-term factor for ECB policy remains the ECB staff projections at the September meeting in relation to the medium term inflation projection - and whether the data between now and then will support the projections. If it remains above target, it will be a hawkish shock relative to today’s narrative. Not forgetting there is still significant pandemic support, and Next Gen EU funding to support growth across the region over coming quarters (as the French Q2 GDP data and rebound in Spanish core CPI in July may attest).
Last week, we highlighted that the BoJ meeting held by far the least likelihood of policy action - given their recent direct commentary about the transience of inflation and thus lack of urgency to change monetary policy settings at the current juncture. On the face of it this appears a misjudgment as the BoJ announce a ‘shock’ adjustment to YCC. However, we have some thoughts.
The BoJ announced that it is keeping the policy rate unchanged at -0.10% but is adding flexibility to the YCC target. Some commentators have already argued that the move is an effective widening of the band to 1.0%. Market price action and the rhetoric of the BoJ would disagree. From our perspective, the move from the BoJ was very clever central banking. Ueda was clearly aware that a rigid line in the sand for 10-year yields, “affects market volatility” particularly if conditions change such as to warrant higher yields (Ask the SNB). Instead, the BoJ has facilitated a YCC policy that allows the 10y yield to move flexibly (above 0.50% if macro conditions warrant) and thus creates a staging post between the perceived need for monetary accommodation through the yield curve and freely tradeable rates. The very modest reaction in the 10y yield and indeed equities and the currency is a testament to the effectiveness of the policy. Ueda can legitimately claim that this is not a change in policy as he pledged going into the meeting!
Amid all the central bank volatility, the release of US Q2 GDP also appears to have added to the volatility as the data beat expectations, driving the US yield curve higher and steeper. However, the breakdown highlights a clear distortion from (likely one off) capex and a clear weakness in personal consumption and price pressure. While the context, late this week, of stronger US GDP data and an incrementally more dovish ECB appear to have dominated market sentiment, we still believe that the decision and narrative from the Fed will likely prove to be by far the most wide-reaching and consequential. Our views of US equity and duration gains and a protracted USD decline remain.
In many respects, the ECB narrative and policy progress continues to mirror the Fed’s with a lag of one to two quarters. The ECB are now signaling a potential pause at the September meeting similar to the Fed in May in relation to the June meeting. Indeed, to paraphrase Spandau Ballet you could say that while DM central bank’s policy tightening is more clearly in its ‘salad days’, in terms of the proximity to the policy peak, the US likely still claims gold!
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Fed Minutes July, 2023 - https://www.federalreserve.gov/monetarypolicy/files/monetary20230726a1.pdf
Monetary Policy Decisions, July 2023 - https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.mp230727~da80cfcf24.en.html#
Bank of Japan Minutes, July 2023 - https://www.boj.or.jp/en/mopo/outlook/gor2307a.pdf
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