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“One step beyond“?

Madness, One Step Beyond

In our last piece, we discussed the extraordinary, current macroeconomic backdrop, whereby global central banks are tightening aggressively to offset the effects of largely supply driven factors on inflation. A topic that has been the acute focus of global financial markets with a wide array of Central Bank actions this week - from the Fed, Bank of Japan and the Bank of England, but also Indonesia, South Africa, Brazil, Turkey, Switzerland, Norway and Sweden.

We discussed the UK’s big short on energy markets, with a fiscal guarantee on prices a factor that had a significant influence on the Bank of England’s inflation projections this week (reducing peak inflation by 500bps). As the week closes with a significant, as yet undisclosed, fiscal boost, the BoE's tightening cycle remains complex (as the three-way voting split this week already suggests!)

We also made the point that there are many components of the CPI basket that may have negative base effects just as the full effects of the extraordinary monetary tightening begins to take effect - when growth is slowing, and housing markets are weaker. In short, inflation caused by supply factors now, will likely induce a response of restraining demand after the significant components of the supply shock have passed and growth is already weaker. Going into this week’s Federal Open Market Committee (FOMC), markets had a different view. That the Fed had no choice but to crush demand - to break the labour market, and to curb the inflation persistence.

The Fed delivered on market expectations of a third consecutive 75bp hike and also provided significant updates to the rate and economic projections. We have some further thoughts.

The key focus was the level of the 2023 dot - taken by the market as the best reflection (or nearest comparison) of the Fed median expectation of the terminal rate. It is much more likely that the peak in rates is more consequential for markets than the pace at which we get there. If we refer to the median ‘23 dot as the ‘terminal dot’, then we should compare it to the peak Fed Funds Futures pricing going into the meeting as a gauge of peak rate comparison. Prior to the FOMC the April Fed Funds future was at 95.515, or just below the 4.50% level before the curve envisaged rates falling back around 100 points by the start of 2025.

In eventuality, the Fed ‘out hawked the hawks’, or marked the dots to market - two common terms used to describe the FOMC member Fed Funds rate path projections at the September meeting (updated from the last forecasting round in June). The updated median dot for the end of 2022 rose by 100bps to 4.375% and for 2023, also up 100bps to 4.625%. Thus, the median dots imply a further 125bps of rate hikes this year and a further 25bps next year.

However, for me there is an important message in the Fed narrative. The Chair of the Federal Reserve stated that long-term inflation expectations remain well anchored (something that is very clear from both survey based and market implied measures) and the Summary of Economic Projections (SEP’s) contain relatively modest rises in the unemployment rate and declines in growth (to below equilibrium or potential growth but still in positive territory). In essence it is likely that the evidence from the most recent CPI and employment reports - that inflation is more stubborn and the labour market more resilient - has given the Fed the confidence to push a little harder on the monetary brake.

Regular readers may recall our discussions about the Fed regaining control of the inflation narrative and the importance of communication in order to prevent the un-anchoring of inflation expectations. At this stage of the cycle, it is more important for the Fed to talk-the-talk now, than walk-the far end of the walk when the time comes.

However, the Fed’s Chair was also keen to point out that there are a significant group of forecasts at 100bps of implied further tightening this year (suggesting at least a marginal prospect of some downside risks to the Fed median projections - or at least highlighting the uncertainty band). Indeed, the first half of the press conference was very heavily biased towards the criteria for slowing the pace of rate hikes including the statement that the Fed believes policy is now modestly in restrictive territory, following this week’s hike - a setting which by definition requires a more cautious approach - especially given the pace of tightening and the fact that the full impact of previous hikes is yet to be felt.

This week there has also been significant commentary from the Norges Bank, Riksbank and the RBA in relation to slowing the pace of rate hikes going forward after significant front loading - in fact, in Emerging Markets (EM) the Brazilian Central Bank has even indicated a tentative end to the cycle. For many, most notably Japan (but also clearly Switzerland, Sweden and even the Eurozone, the currency is increasingly becoming an issue, fuelling the inflation concerns, dramatically altering current account flows and increasing uncertainty).

Another interesting point raised by The Fed’s Chair, was in relation to the prospect of a soft landing, which was in direct contrast to the market expectation of a pernicious financial conditions doom loop for risk assets (higher risk assets loosens financial conditions and thus tightens the implied Fed reaction function - is essentially the jist of it). He emphasised the three conditions as to why there could be a soft landing or a more growth friendly decline in activity and inflation pressure (specifically labour market tightness):

  1. Job openings remain extremely high; therefore, if hiring plans moderate then the labour market tightness can reduce without significant layoffs.
  2.  

  3. Long run inflation expectations remain well anchored - reducing the risk that the Fed will have to raise rates in a renewed expeditious manner to head off an inflation spiral.
  4.  

  5. Supply factors have and continue to play a part in underlying inflation, some of which are easing - indeed the base effects in some commodity markets suggest deflationary impulses in some sectors of the economy next year.

For me, the overall tone of the statement, the hawkish communication iteration and the well-behaved economic data suggest that we are moving towards a narrowing of the distribution of possible terminal rate paths. Thus, in many respects we are a step closer to fully pricing the Fed reaction function and the extent of the monetary tightening cycle. With housing markets slowing, headline inflation peaking, the global economy slowing and global Central Bank tightening outside the Fed significant, beating the 125bps priced into the Fed dots feels like a pretty tough ask. If as we suspect, inflation starts to fall as we move into Q4, it becomes even more so.

Subsequent price action in the long end of the curve has been surprising. 10-year yields at 3.70% are not really consistent with the Fed communication that I listened to this week, but it highlights the concern the market has for a regime shift in the underlying inflation dynamic - or indeed an upward shift in the equilibrium growth rate of the US. Neither of these factors appear to be consistently represented across asset classes and thus I am inclined to view the backdrop as a noisy process of topping out.

If, ultimately, the view of a narrowing of the distribution of possible terminal rate paths is correct, then for me the most exciting inference is for carry - particularly for high yielding EM (MXN, BRL and even ZAR spring to mind). The backdrop remains very complex and uncertain, so we refrain from jumping in with both feet at this stage. But when the market settles, I suspect that we have moved a significant step closer to the end of the USD upcycle.

The last reference in the press conference from The Chair of the Federal Reserve could be referred to as a direct comparison to Mario Draghi’s ‘Whatever it takes’ moment - this time in the context of the US battle with inflation - when he said “the Fed path will be enough to restore price stability”. Markets now have to decide whether 4.60% is enough; while market volatility remains, I suspect it may well be… it may even be one step beyond!

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