“Something’s going on that’s not quite clear. Somebody turn on the lights“
Lionel Richie, Dancing on the Ceiling
In our last piece, we discussed the most recent developments in the inputs and official commentary on central bank monetary policy. We made the point a couple of weeks ago that the shift towards data dependence at the May DM central bank meeting round was an important watershed for the respective monetary policies and the global rate cycle. However, we also briefly discussed the added complexity of the intensifying debt ceiling risk.
This week, there has been a further intensification of the debt ceiling negotiations; and while both sides maintain the rhetoric that the US will not default and that there will be a deal, it likely remains in the political interests of both sides to be seen to be fighting for the best (partisan) deal possible under the circumstances. This, by default, comes with risks; risks of misjudgement, risks of application, risks of Federal cash balance anomalies relative to projections of the ‘X’ date. Over the past week, markets have been attempting to quantify the impact and incrementally add risk hedges.
While rating agency Fitch has also added to the volatility, with commentary about the potential for rating downgrade in the event of default (the suggestion being that the non-payment, or delayed payment, of funds due under securities expiring - even if they remain eligible collateral - would be deemed as default in this instance) suggesting that their internal model would subsequently imply a rating of AA-. Indeed, Fitch also touched on recent underperformance of public finances and a deterioration of governance, which is seen as a relative weakness to AAA peers. This emphasises the point we made last week about the absolute levels of US debt - “The absolute levels of debt and the CBO projections are also very concerning and offer a debt trajectory that likely undermines the USD, perhaps for many years to come”.
Ultimately, we would expect the US to agree a debt ceiling increase, likely at the 11th hour, perhaps even erring into technical default territory. However, while the near term knee-jerk reaction of markets has been increasingly to hedge risk via higher US rates and a higher USD, we would expect the inference of the proximity to a self-inflicted crisis, the focus of markets on the debt dynamics of the US, the likely fiscal contraction (as a result of compromise to reach agreement on the debt ceiling - a point that I have not seen discussed in a robust way in any commentaries about the situation) and initially the unwinding of risk hedges to be USD and US rate negative going forward. Albeit a very difficult dynamic to trade.
This week, we have had three events that have focussed attention on the global rate cycle (the good, the bad and the ugly?). The first was the RBNZ meeting this week, where the OCR was raised by 25bps to 5.50%. Markets were pricing 36bps going into the meeting, so there was an initial element of disappointment. Disappointment that was compounded by the fact that two of the policy board members voted for unchanged rates and more significantly as the committee rate projections signified an expectation to hold rates unchanged at 5.50% until Q3 2024 (markets saw rates approaching 6% by August, before turning lower). A weaker NZD ensued, but as far as the inflation battle is concerned, so far so good.
In the UK, rate path expectations were thrown into disarray by the May CPI print. While the headline print was the lowest since March 2022, expectations for a bigger drop were disappointed. Some of the miss was a function of indexed price hikes in mobile hand internet contracts (that perhaps should have been accounted for in expectations), similarly tobacco and alcohol tax rises also kept the series buoyed. However, other factors such as used car prices and hotel price inflation that were better than expected may not read through as being directly domestic demand driven. From our perspective, the growth backdrop is more fragile in the UK than the macro data currently suggests and thus the inflation vs. growth trade-off faced by the BoE is very complex. While it is likely that acute labour market pressure - driving 7.5% unit labour cost increases - are a key factor, it is also true that there are increasing signs that the supply and demand for labour is reaching a closer balance. The ugly growth/inflation mix in the UK likely means that while the BoE may feel compelled to raise rates from here, the likelihood that rates can remain higher for an extended period is low in our opinion.
So, I guess that leaves the bad? The Minutes to the May FOMC meeting essentially focussed on the proximity of ‘sufficiently restrictive’ policy. The meeting itself noted that the extent to which further monetary policy tightening was appropriate had become less certain. The Powell press conference narrative implied a preference for pausing rates at the June meeting and the minutes appeared consistent with this bias, as while ‘some’ participants noted that additional policy tightening would likely be needed given the slow progress in returning inflation to target, ‘several’ noted that “if the economy evolved along the lines of their current outlooks, further policy firming after this meeting may not be necessary”. In the Fed lexicon, we assume that several > some and thus the minutes are likely supportive of the general view of a pause in June.
Over recent sessions, however, the pause narrative has been questioned, as markets have moved to fully price a 25bp June hike. This brings us back to the debt ceiling debate. While higher US yields have been driving a stronger USD, we see this as a function of debt ceiling related risk premia in the rates market and safe haven flows in the USD, and the dominant dynamic to evolve from its resolution to be weaker US growth expectations. Indeed, the fact that Fed staff continue to expect a ‘mild recession later this year’ is perhaps testament to the fact that underlying growth remains on the back foot - lower US yields and a weaker USD.
Lastly, in relation to last week's discussion points, we highlighted the Mester comment that “Current trends point to slow long run growth”. This week, we have also seen the reinstatement of the Fed publication of r*, and it too has highlighted little change in the equilibrium rate since before the pandemic. A number of commentators have pushed back against the dovish knee jerk connotations that this has for the US curve, but from our perspective, it offers no reason to think that the long run rates should be higher than the 2.50% figure that the Fed has stuck with in the dots - perhaps a further reason to favour long duration from a macro perspective.
Ultimately, our views remain unchanged, that the underlying macro themes (lower US inflation, peak US rates, weaker USD) will emerge as dominant through 2023, and although (to borrow from Mr Richie) “somethings going on that’s not quite clear” in relation to the debt ceiling… “Somebody turn on the lights”!
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