“As long as I gaze on Waterloo sunset, I am in paradise“
The Kinks, Waterloo Sunset
Last week, we expanded upon our recent discussions on the US inflation trajectory and the resultant and extrapolated Fed policy narrative - importantly in the context of the ongoing extraordinary US (procyclical) fiscal stimulus. Ultimately, the dominant factor for global financial markets at the current juncture is the rise in US long yields on the broadening view that growth persistence, despite significant tightening of financial conditions and progress on disinflation, implies higher equilibrium rates – a view that we contest.
However, as we argued last week, while the rise in yields is very much US driven, there is increasing evidence that the rising US term yields and resultant tightening of financial conditions are impacting the global economy (i.e. other countries are feeling the effects of higher US yields on their growth). In the very near term, the inference that many have drawn from this - at least while the implied US growth momentum remains ‘exceptional’ - is likely for further USD strength. However, this must also be true on the flip side. Easing US term yields (as a function of moderating growth or else) would be supportive for global growth and thus not just USD negative, but also alternate currency positive.
Furthermore, we argued that all the move in long end yields has effectively been driven by real yields, with breakevens unchanged. Thus, you could make the argument that the rise in long yields is not about an embedded higher growth and inflation equilibrium but a more hawkish (and credible) Fed reaction function. If this is the case, then it could be argued that it would require a more modest growth slowdown to remove the Fed’s hawkish policy bias (reduced of late but still clear), return them to truly neutral and thus undermine the repricing of the curve.
From our perspective, Chair of the Fed, while remaining cautious on declaring victory on the battle against inflation, was clear that the recent data had shown “ongoing progress” towards the Fed’s dual mandate goals of maximum employment and price stability in his remarks last week. While acknowledging that the path down for inflation is likely to be bumpy and even take time, the Fed’s Chair was clear that there “may be meaningful tightening in the pipeline from past hikes” and that there are “very many signs that the labour market is getting back into balance” - ongoing progress. The clear and obvious trigger for the Fed to pivot towards a greater emphasis on the forward looking tightening and labour market rebalancing remains growth. This is now the dominant factor for macro projections for the US and for the global economy.
Indeed, while the Fed narrative remains defensive from the perspective of higher-than-expected growth (against a level of inflation which, while falling, is still above target), there are increasing signs that the recent (fiscally induced) growth spurt is faltering - not least as the Q3 US earnings season progresses, from deteriorating consumer and corporate demand outlooks. The growth outlook implied by corporate earnings projections is more in line with our viewpoint - certainly relative to that implied by rates markets at the current juncture.
However, while we are in the Fed blackout period, official commentary about the macro growth backdrop turns to other central banks. This week it was the turn of the ECB.
The ECB left rates unchanged at 4.00% this week after 10 consecutive rate hikes from -0.50% in July 2022 and essentially shifted the active policy tool from rate hikes to the duration over which policy will be held in restrictive territory. Rates will be held in ‘sufficiently’ restrictive territory, for a ‘sufficiently’ long duration.
While going into the meeting the overwhelming expectation of markets was that the Governing Council would initiate discussions on the phasing out of PEPP reinvestments, the ECB left the language around PEPP unchanged and affirmed reinvestments until the end of 2024 - perhaps as a function of maintaining the transmission mechanism across member states amid current global uncertainties. Whatever the motivation, peripheral bond spreads breathed a sigh of relief.
President of the ECB was very clear that the ECB are now data dependent - on both the level and duration of policy settings - and even stressed that “now is not the time for forward guidance” in a further underlining of the data dependence. On the growth front, the commentary was clear that the near-term view of the economy was weak and that credit conditions had weakened further amid a tightening of financial conditions ‘imported’ from the US rate sell off (not reflective of European fundamentals). However, while the Governing Council maintain the balance of risks are to the downside, the core view remains that declining inflation and a still strong labour market generates a more positive forward demand profile for the economy, as real wages turn positive and support consumption - even if the monetary transmission is not yet complete (i.e. there is still some further tightening effects from previous rate hikes yet to feed through to the real economy).
From our perspective, the message from the ECB is more balanced than the current market bias. Q3 GDP in the US this week came in very strong (although this was fully priced). However, we are increasingly of the view that the Q3 global divergence (US strong, China and Europe weak) peaked in Q3, and that market sentiment (relatively late to the party) is pricing divergence, not convergence going forward. US growth momentum will be key. We are less confident.
As we look forward to the FOMC next week (amid the October employment updates, and ISM activity data) with clear and defined implications for global asset markets, it is also worth mentioning the Bank of Japan. While the Fed and other DM central banks have undergone a sharp monetary tightening cycle, the BoJ has kept its foot to the floor in its accommodative monetary policy settings - retaining a negative policy rate and unlimited bond purchases - despite significant rises in headline and core inflation.
While global central banks are far from in paradise, to paraphrase The Kinks, they are likely gazing at the sunset of their respective policy tightening cycles. For the Bank of Japan, however, it may well be the start of a sunrise!
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Monetary policy decisions, 26th October 2023: https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.mp231026~6028cea576.en.html
Speech by Chair Powell, 19th October 2023: https://www.federalreserve.gov/newsevents/speech/powell20231019a.htm
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