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“You’re turning into something you are not“

Radiohead, High & Dry

Last week, we discussed the recent policy decisions from the ECB, BoE and the Fed and how their respective monetary policy trajectories - or perhaps more pertinently, the likely extent of the remaining respective tightening cycles - were affected. Furthermore, we discussed the recent US employment report (for January), where we described the data as potentially anomalous and misleading from a policy perspective. While there have now been further strong data prints for January (ISM, CPI and retail sales) our views remain unchanged.

In early December we discussed our view that there is a rising probability that the Fed hike 25bps in January and no more. The data for January have not altered our view that the current level of interest rates is likely appropriate. But, the data that we have seen cause sufficient uncertainty in the prospect of the near term trajectory of inflation from the perspective of the Fed (given that we are so far above the target), that 25bps in March now looks likely (and is fully priced) - barring a spectacularly weak reversal in the data for February (which from our perspective certainly cannot be ruled out - as seasonality swings back in the opposite direction).

Furthermore, if inflation continues to decline as we expect, rate cuts should follow in the second half of 2023 - If inflation slows meaningfully and growth slows moderately then the Fed will need to cut rates as the inflation gap collapses and the output gap turns more negative. Indeed, if inflation starts to fall back meaningfully then real rates will quickly become ‘sufficiently restrictive’, without the need to raise rates. In this regard it is also worth noting that the market is pricing a higher terminal rate based on the Fed projections and the stronger (if distorted) data, when the Fed ‘dots’ that form this basis were driven by inflation expectations above the current levels (2022 PCE expected at 5.6% in the Dec SEP’s against an actual print of 5.0%; Core 4.8% against 4.4%). Thus, it is not clear, that there are material upside risks to the ‘dots’ in March.

While we retain our conviction in the macroeconomic evolution, despite the near term noise, the near term noise has caused much consternation in markets. A higher than expected jobs number, smaller than expected annual CPI decline in January and a higher than expected rebound in retail sales have led many commentators to abandon calls of a weaker USD, longer duration and / or stronger risk assets. Indeed, markets are not only pricing a higher terminal rate (modestly above 5.25%), but also higher term rates and a weaker USD - though interestingly, markets are also erring slightly more positively on US Equities as an upgraded growth profile drives further short covering.

We have some further thoughts

Jobs:  Further analysis of the data have led us to maintain our scepticism of the January US employment report in terms of its representation of the underlying strength of the US labour market. Indeed, last week we suggested the data was anomalous (due to distortions from weather, strike and seasonal adjustments) and misleading (due to the implications from the perception of a tight labour market to higher aggregate demand and thus widespread price pressure, when we see labour market tightness contained at the low end of the pay spectrum and thus still likely synonymous with falling AHE and modest, or even falling aggregate demand). Anecdotal evidence from the UK (Labour supply increasing as a function of pandemic retirees returning to the workforce) and Australian (declining employment and rising unemployment rate) labour markets imply that labour market loosening has begun as a function of tighter financial conditions. We would expect this to be a common theme globally.

Inflation:  We are still of the view that markets, analysts are paying too much attention to the prospect of ‘persistent’ inflation on the Fed reaction function and likely not enough on the impact of the absolute level of prices on aggregate demand. We have seen in the January data in both US and the UK, where airfares, hotels and used cars (areas with high nominal prices relative to pre covid, have started to lag). Price cuts from Tesla and even Waitrose in the UK are also signs that price competition forces remain.

Retail sales:  We continue to believe that while there are compelling arguments for a relatively soft landing - either as a function of continued stimulus effects or of the natural buoyancy of an economy already operating significantly below potential output - we are less inclined to see demand as a driver of inflation (rather inflation can ease as demand and supply come into better balance). The January US retail sales figure is likely to be exaggerated by the multitude of seasonal adjustment uncertainties (as well as higher Social Security benefits following the implementation of a large cost of living adjustment in January).

In essence, we are of the view that US rates have repriced too much relative to the Fed December inflation projections, relative to the reliability of the seasonal adjustments (given the acute disruptions of the pandemic lockdowns at the end of 2022 and 2023, and relative to the non-linear risks to US aggregate demand at the current levels of nominal prices and the price of money. For those reasons, we are less inclined to believe that there are material upside risks to the terminal rate - given that we are already in restrictive territory.

With regard to the USD there was an interesting note by DB published this week that calculated that the impact of a warmer winter and energy saving / substitution efforts across Europe could mean as much as EUR 100B that will not have to be spent on gas - that is EUR 100B that will not have to be sold to buy USD to buy the gas. If we add this to the arguments we have made about the arrest and reversal of structural eurozone bond outflows the medium term case for a stronger EUR, weaker USD from a capital flow perspective remain compelling.

Powell and the Fed have made it clear that they are moving to a more data dependent stance on monetary policy and thus the recent higher than expected prints in payrolls, CPI and retail sales have led the market to raise the prospective Fed Funds terminal rate. From our perspective, anything but awful data from the upcoming employment and CPI reports likely mean that the Fed will err on the side of (inflation) caution and raise rates 25bps. The dots and SEP’s that accompany the decision will also be very closely watched but on this front, given the fact that the inflation data has slowed faster than the forecasts from the December projections and thus it is not clear to us that the dots will be revised materially higher. Furthermore, while the payroll, CPI and retail sales data were (anomalously?) higher in January, NFIB (small business optimism) and Philly Fed Business Outlook are at their lowest levels since 2013, Consumer confidence and Empire manufacturing all at the low end of multi year ranges.

To paraphrase Radiohead, we remain comfortable with our view that inflation will slow substantially in 2023 and we continue to see the backdrop as conducive to a weaker USD - the seasonal distortions in the data risk turning the inference of these indicators into something they are not!

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