“Retiring gives the impression you are relieved that your job is over"
- Michael Douglas
Last week, we discussed the minutes of the November Federal Open Markets Committee (FOMC) meeting in the context of recent market developments, essentially highlighting three main inferences from the meeting. (i) Uncertainty over the (in)transience or ‘transitory’ nature of the inflation pressures emphasised by the upgraded forecasts and risks to the inflation outlook. (ii) More uncertainty on growth. However, as we pointed out, the period since the FOMC meeting in early November has been suggestive of rebounding consumer and broader economic activity, alongside a receding Covid wave, and recent data has continued to point to a very strong level of consumer activity and essentially excess demand. (iii) The Minutes acknowledged that the proposed pace of tapering was broadly accepted by participants, but also noted that “some participants preferred a somewhat faster pace of reductions that would result in an earlier conclusion to net purchases”.
There have been two significant developments since last week; the discovery of a new Covid variant with significant spike protein mutations - Omicron - and a further hawkish pivot from the, newly reappointed, Federal Reserve (Fed) Chair Jerome Powell at this week’s testimony before Senate and House panels, a pivot that builds upon the points we highlight above. These two developments, however, likely have conflicting implications.
The discovery of a new Covid variant has been the dominant news flow this week, after its initial headlines on ‘Black Friday’. Perhaps it is an indication of our general outlook, but we retain a notably more ‘glass half full’ view of the recent Omicron variant developments. It is true that the potentially more transmissible variant possibly holds some negative connotations for the global economy. However, it is also true that many of the early signals/categorisations are of mild symptoms, and furthermore there are some encouraging signs in terms of vaccination/immunity from real world data (even if some scientists - notably the Moderna CEO - seem less positive about the vaccine response) and also some positive news in terms of therapeutics. There is likely a volatile few days (perhaps weeks) until we find out more, but I don’t think we can yet rule out the dream scenario that the Omicron variant is more transmissible (thus likely to become dominant) and milder strain. The beginning of the end of Covid? Fingers crossed at least.
There were two key parts to the hawkish pivot from the Fed Chair this week. Firstly, the explicit notion of accelerating the pace of tapering asset purchases to create optionality to raise interest rates earlier, should inflation become more pernicious. Indeed, this explicit recognition extends from the November minutes and more recent range of opinion on the Fed board of governors. Secondly, the Chair explicitly discussed the concept of a more sustained period of low labour market participation - the direct implications of which are a tight labour market, higher NAIRU and thus the need for earlier monetary tightening.
This hawkish pivot from the Fed comes against a backdrop of increasingly clear excess demand in the US - very different from the picture in Europe and much of the developed world, where the inflation backdrop is more dominated by supply side issues (exacerbated further by the Brexit impact on supply chains). We have mentioned on previous occasions that there was likely an intentional ‘positioning’ from the Fed Chair ahead of reappointment - closer to the more expansionary bias of his opposing candidate, suggesting that his appointment may bring a hawkish pivot. Whether this was a key factor or not, the hawkish pivot is clear. However, we remain of the view that the Fed remains behind the curve on inflation and the market remains behind the Fed.
Bringing the two factors together, markets appear a little more confused. The prospect of tighter monetary policy, through an earlier taper and thus potentially earlier rate hikes from the US, has seemingly caused a modest (at least so far) wobble in US equity markets. But in EM (the epicentre of the 2013 ‘Taper Tantrum’), markets have been stable, if not positive in response. Furthermore, the market reaction in the US yield curve has been to keep (albeit with a little short term volatility) rate hikes in place at the very front end 2022 and 2023, but to slow or remove them thereafter - almost a back-loaded compromise to the impact of Omicron on growth.
Ultimately, we retain a positive view of the US economy and the ability of the Fed to normalise monetary policy in a way that does not derail the recovery nor undermine the US equity market (as pricing power and earnings growth likely counter the impact of higher financing costs - especially if long end real yield contraction continues). Furthermore, we believe that the current policy mix of the US - expansionary fiscal policy and (increasingly) tight monetary policy will continue to drive the USD higher.
In Europe there is a constraint to this. Looser fiscal policy against a backdrop of idiosyncratic and differentiated virus intensity and fiscal responses has widened the credit dynamics between member states (German public finances have been hurt much less significantly that those of the peripheral nations - even when accounting for the contributions to the RRF). Thus the prospects of tighter monetary policy - in the first instance through the removal of QE - also removes the main mechanism for suppressing intra eurozone credit differentials from being reflected in market pricing. We have argued before that this has essentially been an unsustainable credit intervention from the European Central Bank.
Ultimately, at the risk of sounding like a broken record, we retain the view that the current market backdrop continues to support the USD in FX markets - at least relative to the EUR. The Fed Chair may well have retired the word ‘Transitory’ from the Fed’s inflation narrative, but we are not quite ready to retire ‘lower EURUSD’ from ours just yet.
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