Ryan Brandham, Head of Global Capital Markets NA
One of my favourite quotes, from one of my favourite historical leaders, is when Winston Churchill famously said after the successful Allied invasion of North Africa during World War II: “Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
At the risk of diminishing the importance of that moment in history and the horrors that were occurring in the world at that time, I was reminded of that quote recently when reflecting on the latest developments in US markets and the application of US Monetary Policy by the FOMC.
After the November 1st FOMC Meeting where the Fed left rates on hold for a third consecutive time, markets seemed to call a top in US interest rates and declare the tightening cycle over. Equity prices soared, US yields headed lower, the USD sold off sharply and in general asset markets rallied. Yet, when we listened to Chairman Powell’s message, we didn’t necessarily hear the same thing as the market seemed to.
Powell reiterated that although The Fed was pausing at the November meeting, “the process of getting inflation down to 2% has a long way to go”. When asked about cuts, he said that “the committee is not thinking about rate cuts right now at all, we are not talking about rate cuts, we’re still very focused on the first question…which is have we achieved a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2% over time?”
He went on to outline how the FOMC’s thinking could be thought of in a series of questions. First, are interest rates at a level that is restrictive enough to bring inflation back to the 2% target? (They are currently at this stage). Second, for how long will the Fed need to hold rates there? They will need to be confident that inflation is on a path to returning to 2% before moving on from this stage. Rate cuts aren’t worth addressing at this point because of the importance of getting the first question right.
It was this line of thinking that reminded me that “now this is not the time to talk about interest rate cuts. It is not even the beginning of the time to talk about interest rate cuts. But it is, perhaps, the end of the time to talk about interest rate hikes”. And with an emphasis on perhaps!
Powell then touched on a point that was subsequently elaborated on by Thomas Barkin in a speech on November 9th. To date, a lot of the progress on inflation has been related to unwinding pandemic-related distortions to supply chains – which is the type of progress that can be made without increasing the unemployment rate or experiencing slower growth. Powell expects that even when this type of progress is exhausted, it will likely still leave “some ground to cover” on the path to fully restoring price stability. This ground will have to made up by restrictive monetary policy reducing aggregate demand, which is a more painful path that likely will include those two painful things.
Barkin took this a bit further and explained that post-pandemic, we are operating in a very different economy than the one we have experienced for the last 20+ years where globalization, big box stores, offshoring of production to lower-cost countries, and other factors led to disinflationary global forces that overpowered individual companies and took away their ability to raise prices. The corporate toolkit only consisted of ways to cut production costs or find other efficiencies to increase margins…but if higher costs presented themselves, businesses generally felt they could not increase prices to the consumer. The pandemic has changed all that, and now you have companies that feel they can raise prices to consumers – and despite the supply chain distortions being repaired, they are hanging on to this pricing power at all costs. This contributes to inflation being more stubborn than originally thought. Supporting their pricing power is the reversing of a lot of those disinflationary global forces…de-globalization means that production is being strategically re-onshored for security reasons (low cost isn’t the only concern anymore), clean energy goals compete with a singular focus on low-cost production, and the risk of more countries becoming involved in the Russia-Ukraine war or the Israel-Hamas war could be an inflationary spark as well.
Since the latest Fed meeting, some important economic data has been released and it almost uniformly points to a goldilocks soft landing scenario for the US economy. Nonfarm Payrolls released on November 3rd showed a softening, but still growing, US labour market. US CPI data released on November 14th came in softer than expected, as the series resumes lower and challenges the lows made at 3.0% in June of this year. Oil prices have softened over 10% month-to-date in November. And, just to confirm the rosy feeling in markets, President Xi and President Biden managed to have a constructive and positive discussions in San Francisco last week, lessening tensions between the two countries and perhaps the risk of future war.
This has resulted in the markets pricing in a 0% chance of a hike at the December or January meetings, and almost four full cuts to come in 2024. At the latest Fed meeting on November 1st, Powell explained that at every meeting they will be evaluating the “extent of further tightening that is needed”. He further highlighted that, even if they were to pause in December, debate about the need for further hikes could extend into 2024 and hikes could potentially take place at that time. The September dot plot contained one more hike in this cycle and won’t be updated until the December meeting. Once again, as has happened throughout 2023, this stands in stark contrast to market pricing.
There seems to be a majority view in the market that the Fed is done hiking, and by paying lip service to the option of more hikes verbally they are just trying to keep inflation expectations anchored and financial conditions tight. People might feel that way because they can feel economies softening, and therefore it feels like no more hikes are needed. But what if that link can’t be trusted? What if global economies slow down, and US inflation persists anyway? What will the Fed do then?
Could all of this be a self-defeating prophecy? If stock markets continue to rally as they have, if US yields continue to head lower as they have, and if the USD continues to sell off as it has, doesn’t this loosening in financial conditions (the very ones Powell has said he watches closely) increase the chances that more hikes will be necessary to travel the last mile and get inflation back to target?
We are not making a bold call for more rate hikes in the US – they may not happen. What we are saying is that the risk of further US rate hikes is very real and continues to be underpriced by the market. Risk managers would be well advised to keep this in mind heading into 2024 even if the FOMC holds again in December as the market expects.
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