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“If only I don’t bend and break, I’ll meet you on the other side”

Keane, Bend & Break: Hopes and Fears

Last week, we discussed the ECB’s (European Central Bank’s) hawkish pivot and the effective end to the negative rate policy of the eurozone. Despite the fact that we ultimately believe that the June ECB meeting will be viewed with significant historical reference, it was clear that from the market perspective, no sooner had the ECB press conference ended, focus shifted towards the US inflation print and the heightened concern that the Federal Reserve (Fed) were becoming further behind the curve. Indeed, the US CPI print for May, released the day after the ECB meeting, clearly disappointed hopes that US inflation had peaked in March/April marking a marginal new year-on-year high in May of 8.6% y/y (hopes that the Fed had referred to on a number of occasions).

In the context of the revised hopes and fears of policy makers and the markets, the debate now is whether or not this high CPI print in May is (as feared) the start of a renewed uptrend in inflation or (the hope) that it is a noisy topping out process in a complicated inflation backdrop, where the confluence of demand and supply-driven inflation pressures, not to mention structural or temporary (transitory as they were once referred to!) make the underlying trend very complicated to distinguish. Interestingly, the core inflation print did slow further in May, as expected (after falling in April), and thus for now we are still in the camp that inflation is in an (admittedly noisy - as important turning points in financial markets often are) topping out process in the US.

This week, the Fed added some more colour to this debate.

On growth, the Chair of the Federal Reserve said that recent indicators of real GDP improved this quarter, as the economy rebounded from the drop in Q1 GDP (largely a function of volatility in government spending, rather than structurally weak factors. Imports, personal consumption expenditure and investment were all positive). However, growth in business fixed investment declined and housing indicators softened (likely as a function of mortgage rates). The direction of travel was clear though, as the Fed Chair re-emphasised the statement that “tightening financial conditions were likely needed to temper growth in order to bring Demand back into better balance with Supply”.

The Summary of Economic Projections (SEP’s) corroborated the narrative that the economy is strong and well positioned to absorb tighter monetary policy, with the Unemployment Rate rising only gradually to 4.1% in 2024 (a number historically consistent with booms, not busts) and a growth rate that bumps along its expected trend (or equilibrium) rate throughout the forecast horizon. All this in the context of a historically very aggressive pace of Fed tightening - the rate forecasts or ‘dots’ point to an average Fed Funds target rate expectation at 3.375% at the end of 2022 and 3.750% at the end of 23 (before coming back down to 3.375% at the end of 2024.

On Inflation, the SEP’s highlight a path that remains well above target throughout the forecast (although forecasts very close to the target at the end of the period as expected – a function of validating the implication of the implied Fed policy path). the Fed Chair did note that aggregate demand has remained strong, and as such price pressures have spread or broadened (though there remains a notable impact from Russia (Oil & softs) and China (Supply chains). These external factors are important, as “uncertainties of the past few months have increased the difficulties and have raised the probability that a soft landing will depend on factors that we do not control”.

On Policy, the Chair of the Federal Reserve was clear that 75bps was an unusual step, and while the July meeting is likely to consider 50 or 75, that the Federal Open Market Committee (FOMC) do NOT expect 75bps to be common; he also stated (in response to a question about Fed reaction to lower than expected inflation) that the Fed is resolved to take inflation on, but will be flexible in the implementation of monetary policy (Fed are NOT aiming at a rate target irrespective of the growth/inflation narrative – There is still a dovish reaction function potential). It could even be argued that the Fed still really believe that at least some elements of the inflation dynamic are transitory – though for obvious reasons it is no longer possible to use such language. The Fed still have a longer run neutral rate expectation that is in the mid-2’s, as the Fed wrestles with the amount of ‘restriction in Fed policy needed- not to induce recession as many commentators have suggested but to bring demand and supply into better balance - as measured by an inflation rate close to 2%.

Ultimately, this meeting was all about messaging, from the dots to the growth and inflation forecast adjustments in the SEP’s, the hastily pre-prepped hawkish pivot to 75bps and language around the determination of the Fed to get inflation under control. It was clear that the Fed had one intention above all in June - to regain its credibility in relation to its inflation mandate, or to regain control of the inflation narrative from the market.

In doing so, the Fed essentially narrow the future path of possible outcomes - by reducing the risk of a more pernicious inflation path and thus sharply higher interest rates at a later date. This narrower path should make the prospect of potential recession (even if there are still factors beyond the control of the Fed - though they work in both directions) more quantifiable, less uncertain and thus ultimately less concerning.

It is possible that in attempting to regain control of the inflation narrative (with a more hawkish, front loaded monetary reaction function) that Fed shifts the market concern to growth from inflation. It is also possible that the market may continue to disbelieve the ability of the Fed to control inflation (there is also the added problem that we have discussed in previous pieces, that the lack of a global safe haven asset for global investors has the effect of increasing the underlying level of volatility and thus complicating the macro picture further). However, from my perspective, this is a positive iteration for risk assets, for confidence in the prospect of a nearer topping out of inflation, a clearer narrative around the terminal rate expectation and thus should at the margin be positive for risk assets. Most significantly perhaps I would also view this as positive for EMFX relative to the USD, where greater clarity around the potential terminal rate likely offers clarity around the USD vs. EMFX rate differential and just as importantly, the rate differential relative to the volatility differential. On this basis, EMFX looks more attractive following the Fed than before, from my perspective. Furthermore, the prospect of broader USD underperformance driven by narrowing rate differentials in DM (as opposed to widening differentials in favour of EM) is significant – most notably perhaps against the EUR.

We have regularly noted that the macroeconomic backdrop since the start of the year has been highly uncertain, and markets continue to trade in a low Sharpe Ratio manner. However, despite the uncertainty in the near term, we remain convinced that the turn in the second derivative of inflation is both critical for sentiment and still attainable over coming months…If only it doesn’t “bend and break”!

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