“We’re dealing in the limits … and we don’t know who with”
New Order, Regret
Over the past months we have written at length about the relationship and the global sensitivities between inflation and growth - as a function of the monetary reaction function - a theme that continues to take centre stage in financial markets. Perhaps interestingly, this week it seems that Central Banks focus’ have ebbed back towards more of an inflation focus or concern, just as the markets have erred towards growth risks.
Earlier in the week we have had the RBNZ and the Bank of Canada raising rates by 50bps, and an inflation print in the UK driving a repricing of the front end of the UK curve - at the very least relative to the US.
RBNZ hiked 50bps and were relatively hawkish but the response of the market was to push NZD and yields lower as the MPC highlighted the trade-offs and essentially targets of monetary tightening in reducing demand (particularly the demand for labour and housing, driving wage and house price inflation). The RBNZ refer to this as the policy path of least regret (and a ‘stitch in time’), a strategy to bring the cash rate closer to neutral, sooner, given the inflation challenge. Not increasing the terminal rate but getting there sooner.
The Bank of Canada hiked 50bps and announced that their QE purchases would be turned into QT sales (at least passive sales, or runoffs) as of April 25th. Again, inflation projections were raised and the board of directors signalled its intention to raise rates towards the 2-3% range it considers to be the neutral rate.
There are perhaps a couple of signals here for the US - notably the RBNZ (where markets are also pricing a very significant further rate hikes) that there is a notable difference between normalisation (getting rates back towards neutral) and monetary tightening (beyond the neutral level into restrictive territory). There are also signs that economic momentum has begun to fade relatively early in the hiking cycle amid prolonged high inflation - although we continue to believe that excess demand in the US remains more resilient, less fragile.
Indeed, the US curve eased back somewhat this week - led by front end yields as core inflation missed expectations. It is not clear whether the dominant driver is hope of a more proximate peak in inflation, or, concern that the pace of rate hikes priced at the front end has increased the risk of recession, though we would err towards the former.
In Europe, the sensitivity to the balance between growth and inflation is likely most acute. Geographic proximity, supply chain disruptions and knock-on implications from the sanctions in the region are a more direct downside risk to growth - even if, so far, the high frequency data has held up much better than expectations. From an inflation standpoint, the situation is also fragile with a historically tight labour market, ultra-loose monetary policy settings, significant injections of fiscal support through the NGEU fund distributions and energy prices driving core prices sharply higher. Economic, inflation and policy uncertainty are thus very high.
Ahead of the long weekend the European Central Bank (ECB) meeting sought to address some of the issues facing the eurozone at the current juncture.
Going into the meeting market expectations were relatively limited - the ECB would:
- address the sharp rise in inflation over recent months,
- highlight the risks to growth from the Ukraine situation,
- emphasise the fact that the ECB’s normalisation process is still in train (despite the growth risks), and
- emphasise that the policy decision (pace of further QE taper - this time around APP) would be data dependent and be taken in June, alongside the new economic projections.
This is exactly what was delivered.
That said, subsequent price action suggests that market participants were positioned for a hawkish surprise. Firstly, on the currency, there was an interesting question about the ECB’s focus on the level of the EUR and how important it is in terms of imported inflation into the eurozone. This is a point that we have made before - the Isabelle Schnabel reference - that countries should be very careful about enabling currency weakness in periods of high goods price inflation as the problem becomes exacerbated, further squeezing consumer spending capacity. The President of the European Central Bank was clear, that the ECB are always attentive to FX, that it always has an impact and that it was key to concerns on inflation expectations and the attainment of the ECB target - not a forceful comment but potentially important.
Secondly, there was also the suggestion that the inflation forecast profile of the ECB is dominated by the oil price and that while this remains elevated in the near term, that inflation is expected to fall back close to the 2.0% target at the forecast horizon largely as a function of the shape of the forward oil curve. It is not clear that the backwardation in the oil curve does not persist, especially given a potentially structural shift in the demand for increased commodity reserves going forward (and possibly structural underinvestment in the oil sector keeping supply low), thus inflation expectations and second round effects become a more ingrained risk going forward. For the first time in a decade, 10y inflation expectations in the eurozone rose above the equivalent US measure this week.
They say that a week in politics is a long time, well a long Easter weekend in global geopolitics at the current juncture certainly has the potential to be ‘a long time’ and a more cautious approach to positioning into the close may well be expected. However, outside of some well-defined concerns we maintain the view that there are some positive stories even if they are relatively exiguous (TERESA?).
For the ECB and indeed for the Bank of England (BoE), where the growth and inflation trade-offs are much more complicated than those of the Federal Reserve System (Fed), and in this instance the RBNZ. Thus, the path of least regret is not so obvious!
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ECB April press release: - https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp220414~d1b76520c6.en.html
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