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“So tell me what’s changed“

Craig David, What’s Changed

Last week, we discussed the upside surprise to the January inflation report in the US. We argued that, while the commentary following the release struck a hawkish tone, we are much more inclined to view the January print as unlikely to be indicative of the future price trajectory, rather a combination of one-off factors (i) some annual price changes (insurance, care, medical services), (ii) seasonal adjustments and component weighting adjustments. We see both of these as anomalous to the broader disinflationary trend and thus not warranting the extrapolation we saw in US rate markets following the release.

Last week, we also questioned what we saw as too much focus on the specific timing of the first Fed rate cut (in isolation or relative to other DM central banks) and not enough on the trend of disinflation and growth moderation, arguing that nothing has changed from a macro perspective, and we view this as missing the broader point. The trajectory of US rates remains lower, in our view.

This week’s main event was the release of the minutes from the January 31st FOMC meeting, as markets struggle to effectively gauge the Fed reaction function, given the volatility in the underlying data. Essentially, the minutes gave a broader outline of the discussions at the meeting, where voting participants decided to leave rates unchanged at 5.25% - 5.50%, stating that the risks surrounding progress towards the policy goals was “moving into better balance”; but participants struck a more cautious tone than the dovish December meeting. So, what has changed?

On the inflation front, the minutes portrayed notably more optimism. The clear statement that upside risks had diminished was emphasised by the clear curtailment of right tail risk in the statement that the “policy rate is likely at the peak of the cycle”. At the same time, likely ‘twice shy’ from the ‘bite’ of the “transient inflation” narratives of 2022, the Fed is now consciously proceeding carefully. In practice, this likely means to err on the side of tighter policy settings to ensure the anchoring of inflation expectations, as the Fed remains “highly attentive to inflation risks”. Some members even raised the specific scenario risk where “progress could stall if aggregate demand strengthened or supply side healing slowed more than expected”.

From our perspective however, a more cautious tone does not mean significant cuts are not likely, especially, when we consider current policy settings as “deep into restrictive territory”, as was stated at the Jan press conference.

On the growth side, the Fed emphasised the two-sided risks to growth in highlighting the risks of cutting too quickly. However, there were also members who noted the “downside risks associated with maintaining an overly restrictive stance for too long”. Moreover, there was explicit reference to the signs of financial stress for low and moderate income households {increasing usage of credit card or revolving balances, increased usage of buy-now-pay-later offers from retailers and increasing delinquencies}. The Fed still expects GDP to be below potential in 2024 and 2025, with the risks skewed to the downside - exacerbated by any extended period of higher than expected inflation.

Following the stronger than expected US data in February, markets have been quick to reprice the US curve once more, backtracking from an admittedly sharp (and front loaded) rate cutting cycle priced at the end of 2023, to something much more moderate (and in line with Fed dots). Given our views on the February data releases (recounted above), we are more sympathetic to the ‘financial stress’ of US households at the lower (fatter) end of the income distribution - and thus continued growth moderation. By extension we are of the view that current pricing of the US rate path is at the low end of the distribution of likely rate cuts in 2024.

Furthermore, we continue to not see any convincing evidence of an upward shift in equilibrium growth or equilibrium inflation rates in the US, and thus no inference that the medium term r* or equilibrium rate should have moved higher. By this reference, longer term bonds continue to offer value at current levels, from our perspective.

Indeed, while the recent dynamic of the US rate market has been more cautious about rate cuts (and receivers in general in the rate space) as upside growth and inflation risks are mooted by participants), the Fed minutes explicitly referenced the fact that 6m annualised PCE inflation was “near 2 percent” and 6m annualised core PCE inflation was “below 2 percent”. In relation to the Powell (repeated) statement that rates would likely be cut well before inflation hits target, the current inflation backdrop remains consistent with Fed rate cuts, in our view.

As markets have repriced the US rate curve higher, there has also been a debate around tapering of the Fed’s balance sheet, and whether this may constitute an easing that is in any way a substitute for rate cuts. We disagree. Indeed, the discussion (admittedly nascent) in the minutes pointed to a formal discussion at the March meeting and the inference that a reduction in the asset sale pace may enable sales to continue for longer - either way this appears a less volatile debate given the clear recent reduction in demand at the Reverse Repo Facility (RRF).

In Europe we have also seen the release of the ECB minutes from the January 25th Meeting where again the Governing Council continue to pushback against near term rate cuts citing wage growth inconsistent with inflation sustainably at target - despite a demonstrably weaker growth backdrop - albeit one that on the basis of this week’s PMI data is showing signs of bottoming out as per ECB forecasts. Markets continue to try and extrapolate ECB vs. Fed narratives into EURUSD pricing but we continue to see the Fed as the dominant participant given the overvaluation of the USD and the relative pricing and sentiment in rate curves.

Lastly, we would note that the data at the start of 2024 has clearly been contentious. At the very least in questioning market positioning and rate curve pricing, relative to the end of 2023. Ultimately for us this likely means that the headline data (and we would also note that there is an array of higher frequency data that paint a far less rosy picture of the US demand dynamic) released in early March (employment report on the 8th, CPI on the 12th) are likely to be significant volatility events for the US rate space, the USD and wider financial markets. However, from a directional standpoint, we do not see a change in the macro calibration. Markets continue to emphasise and extrapolate the likely Central Bank policy actions at the front dated policy meetings, but over coming months we fully expect the data to confirm that the direction of travel for the US data is continued moderation - not reacceleration. With policy well into restrictive territory, this is significant.

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