“But I won’t cry for yesterday“
Duran Duran, Ordinary World
Last week, we discussed the evolution of our views on the DM growth and inflation backdrop in the context of Fed policy minutes from the June meeting and the raft of jobs data from the US for June. In highlighting that the minutes themselves brought very little new to the table, we reiterated our view of the importance of the reference that “almost all participants judged that keeping the federal funds rate unchanged was appropriate or acceptable, while some preferred or could have supported a 25bp hike in June”, essentially maintaining the hawkish split that was more clearly defined through the June meeting ‘dots’; nothing more.
Furthermore, we discussed the reference to ‘pace’ - “a further moderation in the pace of policy firming was appropriate” as likely a reflection of a rising desire to further assess the cumulative impact of previous rate hikes, and tightening of financial conditions via other means (notably through the credit channel from the recent ‘small bank shock’). This is a sentiment the market has broadly accepted as being an ‘every other meeting’ approach from the Fed (although perhaps awkwardly misaligned with forecast update meetings). Thus, while an inflation risk premium remains for a further rate rise in November (after a near fully priced July – even though we believe this is a policy step too far), it is likely that the economic momentum, and most importantly, inflation momentum, will preclude a further rate hike in November.
We continue to believe that the reference to pace, and by extension a recognition of the cumulative extent of previous tightening, is significant, particularly when put into the context of the SEP’s from the July meeting. Noting that the upgraded ‘dots’ from the FOMC in June came in the context of Summary Economic Projections (SEP’s) that upgraded growth, downgraded unemployment and upgraded inflation expectations - essentially as we have been arguing, this raises the bar to further rate hikes in the event that the data is not consistent with this expectation of tight labour market, high (or sticky) inflation, resilient growth backdrop.
Over the past couple of weeks, there have been increasing signs of rebalancing of supply and demand in global goods and services and even in domestic labour markets, as tighter monetary conditions (as well as the indirect tightening of higher prices and higher taxes) attract workers back into the labour force. Global supply chains and delivery times are no longer an implied driver of higher prices; indeed, you could now legitimately argue that from a supply perspective, the global position is increasingly disinflationary.
Indeed, the backdrop is becoming more conducive to our long-held view that disinflation will be notable through 2023 in its significance and persistence - the exact opposite of the prevalent analyst consensus of ‘sticky, persistent inflation’.
After closing last week with a US employment report that, while mixed, highlighted a clear decline in the job creation trend (especially when accounting for significant downgrades to previous estimates) and perhaps most significantly implied that the sharply stronger ADP report was in fact likely anomalous, this week brought the inflation stickiness narrative into the spotlight and into question!
The (likely anomalous) jump in the ADP private job gains for June last week brought with it a capitulative sell off in US Treasuries and thus a spike high in yields across the curve. In our view, this is an important peak and is in our view likely to presage a persistent duration bid in DM more generally.
This week, we had a downside surprise to the June CPI, with a drop of half a percent in the core measure to just 4.8%. To put this into perspective, this is broadly consistent with a core PCE of around 4.0% - a whisker away from the updated year-end core PCE projection in the SEP’s of 3.9%. Further downside surprises in inflation will not only continue to question the dominant ‘sticky’ inflation narrative, but will also undermine the case for the monetary tightening implied by the dots. The subsequent headline PPI print at just 0.1% y/y highlights a distinct lack of pipeline inflation pressure and reinforces the argument of normalised supply chains.
From our perspective, there are increasing signs that our (again, long held) views that supply and demand rebalancing, after the significant distortions of covid, are likely to correct substantially and will thus bring significant disinflation.
If we bring this back to the point we made last week about the volatility of the US curve - while the front end of the US yield curve (or the strip) could be described as well-behaved, inflation risk premia and likely to a greater extent market positioning in the sovereign curve are far more volatile - in addition to the fact that from a quantitative perspective, markets are more volatile around turning points - we can perhaps expect significant volatility and asymmetry in rate price action if, as we expect, the inflation stickiness narrative is properly questioned and, with the market likely stopped out of long duration trade in the post ADP capitulation, lower yields across the curve are now more likely.
Lastly, while the focus of this week has been on the US inflation data (and the subsequent market reaction function), it may well be remembered for something different. Markets, and indeed even many Fed officials, have been quick remove the risk premia from the recent small bank shock on interest rate pricing and forecasting. However, this week closes (and next week begins) with a raft of US bank earnings reports. From our perspective, markets have been far too sanguine about the implications of declining credit creation into a slowing economy. The Q2 earnings numbers will be closely watched for signs of credit provisions (prudent capital set aside) as well as earnings and growth expectations for the coming quarters. Particularly against the backdrop of the Fed’s regulatory chief Michael Barr calling for increased regulatory capital - itself by definition will dent credit creation from banks.
It is very possible that the adjustment to a slower pace of credit is already in train, with significant implications for the Fed and for the US curve. From our perspective, as far as supply chains, inflation and central bank policy rates we are headed (if we are not there already) to a more Ordinary World!
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FOMC Statement, 14 June 2023: https://www.federalreserve.gov/newsevents/pressreleases/monetary20230614a.htm
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