“Hello darkness, my old friend“
Paul Simon, The Sound of Silence
Last week, we discussed the implications of the ongoing credit conditions repricing in the US, in the context of the Fed narrative, highlighting the change of emphasis from a number of speakers following the recent credit events. Also in this context, we offered an assessment of the minutes from the March Federal Open Market Committee (FOMC) meeting and by extension our underlying view that the Fed have done enough from a policy normalisation perspective, arguing that ‘something’ doesn’t feel right.
This week has been very light from a US data perspective, and relatively sparse in terms of Fed speakers. On that basis, markets have been eerily quiet. However, we have some thoughts on the underlying macro themes.
It is increasingly clear that there are two dominant camps in the macro space: the first is the view that the hit to US growth from the credit events in the US banking sector will be modest (somewhere between 1 and 2 rate hikes in magnitude) and contained. Thus, interest rates will need to be edged modestly higher and then remain high for an extended period, to weigh on the labour market, cap demand and bring inflation back to target.
The second is a more negative or recessionary view, whereby higher rates and or lagged effects of previous rate hikes induce a sharper slowdown in growth, and thus rates will ultimately need to be cut to support growth (or maybe even risk assets). We subscribe to neither camp.
Our central view of the underlying macroeconomic evolution is one driven by a more obvious rebalancing or normalisation of the supply and demand backdrop, and thus a more substantial drop in inflation. As China growth re-accelerates from the strict lockdowns of the turn of the year and supply backlogs in semiconductors resolve, there are more clear signs of supply chain normalisation across a plethora of indices. Falling inflation, alongside other growth supportive factors such as the investment from CHIPS and IRA in the US, would provide a much more supportive backdrop for risk assets and Emerging Markets.
On the demand side, we have argued for a while now that there are likely non-linear downside risks to growth from the sharp increase in interest rates that we have seen over the past year (an unprecedented pace of tightening). The heightened cost of money or credit has taken place against a backdrop of historically high nominal prices and declining asset prices (both equity prices - where US Treasury finances, which were likely significantly lower this month as a function of low capital gains tax take from FY22, will attest - and perhaps more significantly, lower house prices). Significant negative wealth effects.
The recent banking sector issues have likely made a significant contribution to the sensitivity of this demand factor. Markets and analysts alike have been quick to view the recent stabilisation in deposit exodus from small banks as a sign that the situation is contained and thus the economic impact enacted. We are more cautious on this front, firstly from the perspective that the resultant bank responses (Higher deposit rates, higher pressure on credit, more conservative lending standards and likely liable to tighter regulation) and secondly, from an industry perspective, reviews to the Federal deposit guarantee scheme likely further tighten credit through increasing the cost of insurance.
Ultimately, this increase in the cost as well as the availability of credit likely have significant implications for consumer sentiment - especially against a backdrop of a substantially higher debt profile (sharp reversion to trend of credit card debt and the erosion of pandemic-induced excess savings).
From our perspective, the perception of excess demand in the economy is at best transient.
Circling back to our inflation-centric view of the macroeconomic evolution, approaching the problem from this angle gives a very different perspective for forward looking monetary policy (and the USD). We would argue that from a balance of risks perspective, the burden of proof has now more clearly shifted from inflation to growth i.e.i.e., it is no longer clear that the Fed should be prioritising inflation risks (erring towards additional rate hikes), rather that the balance of risks to growth (and by extension demand and thus inflation). These risks have clearly shifted more negatively, and thus deserve a more cautious approach as a function of tighter credit conditions - a point echoed by NY Fed Governor Williams this week in stating that “banking stress likely to tighten credit” (even though it is not yet clear how much); and the Beige Book, that highlighted that banks across various Fed districts tightened lending standards, amid increased uncertainty and concerns about liquidity.
From our perspective, downside risks to the USD are increasing - even without the more acute risks from a failure to reach agreement on the debt ceiling.
Lastly, in the UK, we had a busy week for data, and one which will undoubtedly add to the policy headache facing the Bank of England. A slight uptick in the unemployment rate and decline in vacancy rate would likely have been warmly received in Threadneedle Street. However, the unexpected rise in wage growth (after two subdued months) complicates matters. Furthermore, the CPI print once more failed to drop back below the 10% level as expected, due to increases in food prices (+19.1% y/y) and ‘Housing and household goods’ (+26.1%). It is not clear to me that raising rates from here will do anything to reduce inflation from housing costs; rather the opposite. The overriding inflationary impact in the UK is the result of the energy price surge and - admittedly after some frustrating second round effect ripples - property exacerbated by the sharp pace of interest rate rises not solved by it. We remain in the Tenreyro, Dhingra camp in relation to the UK economy, believing rates are already likely sufficiently restrictive. Indeed, Silvana Tenreyro said this week that “we may have already tightened too much”!
Despite all this, the market continues to view the recent stabilisation in US small bank deposit flight to warrant a resumption of the hiking cycle in Developed Markets (even if expectations in the medium term diverge). We remain more cautious and believe that the likelihood is increasing that the US in particular is misjudging the balance of risks, by taking interest rates higher from here. Furthermore, if, as we expect, inflation falls substantially further through the rest of 2023, real rates become higher without moving, and thus as growth slows and downside risks become more apparent, the case for lower rates likely becomes clearer.
It has indeed been a quiet week for US data, but from our perspective there has been a significant Sound to the Silence!
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