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“So close no matter how far“

Metallica, Nothing Else Matters

Last week, we discussed the evolution of the US data, emphasising our view that the US economy is not as strong as it seems, with a number of real growth variables showing further signs of weakness alongside clearer signs that the consumer momentum that drove the services led inflation boom of the past few years is starting to fade.

We also argued that forward guidance from consumer-focused equity earnings releases earlier this month and even the personal spending component of the PCE report further add to signs of consumption slowdown.

We discussed the ECB and the ‘hawkish’ first cut in Europe - a very well-telegraphed 25bps. We argued that the general narrative about the future path of rates was intentionally and specifically cautious. The updated projections also gave a more hawkish bias, with inflation forecasts revised higher by two-tenths in 2024 and 2025. Although it could be argued that the inflation forecast being unchanged at the policy-relevant forecast horizon leaves the direction of travel on rates unchanged (down), the upgrades to the near-term forecasts go against the first (and possibly second) of the ECB’s three criteria for cutting rates - i) the inflation outlook, ii) the path of underlying inflation and iii) the transmission of monetary policy.

Essentially, we argued that the combination of weaker US growth momentum (and in many respects stronger than expected European data - both in contrast to the general consensus)

In short, we have disagreed with the divergence story that the market has been so keen to price. Rather, we see policy, rate and growth convergence. In conjunction with a current US policy rate in restrictive territory is a macro configuration that likely has significant consequences for markets. We argued positive for Bonds, equities and more negative for the USD.

Labour market normalisation?

Since we last wrote, there have been a number of important data releases and an FOMC meeting (in addition to the evolving narrative around the ECB cut last week).

The first was the non-farm payroll which, after JOLTS data that showed declining demand for labour (reduced job openings) and ADP that showed moderating jobs growth in the private sector, NFP surprised to the topside.

There remains much debate around the continued divergence between the establishment and household surveys (one having a smaller sample size but capturing second (or third jobs) and likely lacking any adjustment on migration - and the other a survey of employers with low participation (if greater coverage) and likely issues with seasonal adjustments). No single measure on the labour market is without fault, but we continue to see supply and demand factors showing an easing of labour market tightness.


Next up was the US inflation reading. The May core CPI rose just 0.16% m/m, the lowest reading since August 2021 and substantially below the central expectation of 0.30% m/m. Some commentators have pointed out that the decline in airfares and car insurance prices may have been exaggerated or unsustainable. However, discretionary consumer goods prices continue to fall, and the Cleveland Fed trimmed mean measure rose at its slowest pace since January 2021. Indeed, we continue to believe that Q1 was the outlier in terms of upside surprise.

The monthly CPI prints have taken on additional significance in recent months (and will continue to do so over the coming months) due to the base effects. The second half of 2023 saw contained inflation, or low monthly prints, which means the y/y comparison will rise unless the 24 prints match the low prints in H2 2023. If the data comes in at 0.3% m/m for the rest of the year, then it is likely that the annual PCE rate (the Fed's preferred gauge of inflation) will rise back towards 4.0%. If the monthly prints come in consistently at 0.2% m/m then the monthly prints keep pace with the 2023 trajectory, and the PCE print will likely remain around current levels 2.6%-2.7% through to year-end. This is important.

Joining the dots

This week was also important because it brought the FOMC meeting, the updated Summary of Economic Projections (SEP’s), and the ‘dots’. The dominant market focus going into the Fed meeting was the new projections for the rate path - and, more specifically, would the median dot for 2024 suggest one cut or two (down from the three it indicated in March). The reality saw a close call: 8 members saw 2 cuts, 7 saw 1 cut and 4 no cuts at all in 2024 - The median being 1 cut.

However, the context is important. Firstly, Powell clearly emphasised that the decision between 1 and two cuts this year was a very close call and ultimately will prove data-dependent. Indeed, it is also important to note that Powell gave a clear indication that the ‘dots’ were not adjusted for the downside surprise in inflation (released earlier in the same day), thus the confidence that the Fed needs to cut rates, which depends on inflation being (and staying) on a 0.2% per month pace would have been obviously weaker than it may be now.

Secondly, while the median dots suggested just one rate cut this year, the implied rate cuts for 2025 and 2026 were increased to 100bps and ultimately arriving at the same place (3.00 - 3.25%). For us, this skews dovish, as any blip or confidence in a weaker trend in the data will bring those cuts forward. Thirdly, Powell was explicit that 2.5% - 2.6% is “a good place” for the PCE trajectory. Thus, confidence that the inflation rate is not accelerating (i.e. monthly readings of 0.2 or below) will bring rate cuts. Any further weakness in the labour market (the Unemployment Rate has risen 6-tenths from the low point already), likely brings about earlier and/or more aggressive rate cuts. In short, we maintain our view that the reaction function of the Fed is asymmetrically dovish.

The Long & Short of it...

Ultimately, we remain of the same view - that the dominant macro themes continue to be disinflation and growth moderation (but still positive growth…for now). Our view remains that the current macro configuration remains positive for bonds, positive for equities and negative for the USD.

Indeed, to paraphrase Metallica, rate cuts in the US are so close no matter how far (some members of the Fed are currently indicating!)... and in broad financial markets sentiment remains driven by one factor, the Fed… nothing else matters.

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