Fed and ECB Are Barking. Will They Bite?

US

Summary

• Chair Powell was hawkish at Jackson Hole, with limited market impact.
• NFP to surprise on the upside.

Fed

Chair Powell’s Jackson Hole speech was hawkish but had only limited market impact. The speech implied that the Fed would seek a sustained period of below trend growth that would be painful to households and businesses. It stressed that 75bp at the September meeting was in play and that policy would remain restrictive until the Fed ‘was confident the job was done’.

The speech was intended to push back against, since mid-June, market expectations of 2023 cuts and an easing of financial conditions. As of this writing, the speech only had a limited market impact: 2y and 5yr yields are up 4bp relative to Thursday’s close, and 10yr yields are roughly unchanged. The spread between the futures implied end 2022 and end-2023 FFR is narrower by 3bp since yesterday close. The market continues to expect about 45bp cuts in 2023.

In my view the lack of credibility of the Fed tightening plans reflects in part its unwillingness to admit that a hard landing is the most likely scenario (its previous ultra-dovish stance also plays a role). Repairing its credibility will take more than a few hawkish speeches. It could require a 75bp hike in September as well as a significant increase in the SEP terminal FFR, or more broadly, an internally consistent macro scenario. But even with a more consistent economic narrative and inflation fighting plan, the difficulties the Fed is experiencing with the transmission of policy tightening to the real economy could continue as they reflect the flaw of the abundant reserves regime. 

My base case scenario for the September meeting remains 75bp because I expect the hard data to show robust/accelerating growth and because I do not expect financial conditions to tighten much ahead of the meeting.      

On the other hand, I expect only a limited increase in the September SEP terminal FFR, perhaps 25bp. The Fed is not convinced yet that it needs to get much more aggressive to bring down inflation. 

For the Fed to shift tightening into higher gear, rising inflation prints will be required and those may not come for another few months. Right now, a decline in goods price inflation is offsetting a limited increase in services price inflation. But, as the improvement in global supply chains reaches its limits, and as wages continue to accelerate, I expect these trends to reverse, core inflation to pick up and the Fed to change its tune. Meanwhile markets are likely to continue to price cuts in 2023.

Next week’s speakers are Brainard, Barkin, Williams, Mester and Bostic.

Data

This past week saw the hard data remain in line with strong/accelerating growth momentum. Nominal consumption income and PCE inflation were lower than expected but real income and consumption growth accelerated MoM and the savings rate remained unchanged, and low. Initial claims fell for a second week.

Covid related hospitalizations fell (Charts 6 and 8).

The most important data for the week will be Friday’s NFP, where I expect another positive surprise relative to the consensus of 300k. Employment growth is going back to trend but more slowly than consensus expects. I am also expecting a positive surprise in wages due to the very low unemployment and high inflation, as well as a negative surprise on participation, that has turned south since Q1.

Other key data include:

• House prices (Tuesday): I expect a positive surprise due to low listing that are helping to keep inventories low. 
• Conference Board consumer confidence (Tuesday): I agree with the consensus that expects an improvement in line with today’s U-Mich consumer confidence positive surprise.

Events/Political Developments

Forgiveness of student debts by the Biden administration could see its approval rating lift up ahead of the mid-terms. At the same time, it is likely to add to inflation pressures by transfering the equivalent of roughly 0.5% of household income to debtors. Longer term it is likely to encourage colleges to raise tuition fees and therefore add to upward pressures on education costs.

Links to New York Fed POMOs/TOMOs:  Repos, Treasury, MBS, CMBS

Europe

Summary

• A range of ECB speakers to hear from – expect them to add fuel to the need for more tightening. That could see stress in credit spreads, particularly as we approach the Italian election.
• A heavy weak for European data, which includes August CPI, Final August Manufacturing PMIs and unemployment data. While there will be headwinds from transportation inflation, expect the core and headline readings to continue to climb.
• BoE Decision Maker’s Survey important to see whether longer-term UK inflation expectations have continued to rise.

ECB on the Verge of a Hawkish Surge

Following last Friday’s ‘ECB Sources’ announcement that policymakers want to discuss 75bp for the September meeting, the focus this week will be on August CPI outturns, and more specific comments from ECB speakers. Recently ECB speaker comments have been relatively sparse, but one thing that is coming clear is that near-term surprises are gaining more weight in decision-making. June surprised to the topside, so did July, leaving the ECB’s June inflation forecasts (which first raised the prospect of a 50bp hike) looking very stale (Chart 1). Now, the first reading of the August CPI outturn (Tuesday and Wednesday) is likely to provide further upside risk.

The market is looking for further MoM rises in inflation readings, suggesting a YoY rise to 9%. This would be supported by recent surges in electricity prices, even while transportation prices will probably provide a downward offsetting factor. The importance of electricity and gas prices cannot really be downplayed into the ECB’s inflation outlook, and as we set out in our pre-mortem, it wouldn’t take much to keep inflation double its target into 2024. For context, back in January, the ECB Board Member Schnabel warned that if electricity prices remained at their (then) current levels it risked an overshoot in medium term inflation. Gas prices have since tripled (Chart 2).

We see the risks as skewed to the upside for ECB hawkishness, and recent comments have added to our conviction. Even a conservative Taylor Rule would suggest a hike out to 6% (Chart 3). And while the popular line is that European corporates would not be able to sustain such a rise in interest rates, we find that they are actually surprisingly robust (Chart 4).

The near-term risk while the repricing takes place is to credit spreads. 10Y BTP/Bund has undone its recent tightening, and outright 10Y BTP yield now sits north of 3.6%. 4% could be a stress point, and we would not be surprised if it was tested soon, helped by Italian electioneering. Ultimately though, we believe the ECB and TPI have the capacity to fight it.

BoE Surveys and Credit Data

Tuesday sees the release of July’s consumer credit (inc. mortgage) data. While the market expects these to remain relatively stable on June, they could make for some interesting reading, especially when combined with August house price data from Nationwide (released some time this week). By our calculations, further BoE hikes will only exacerbate the cost-of-living crisis, considerably reducing household capacity to save and boosting future need for credit (Chart 5).

We do not ultimately believe that the BoE will be able to sustain the hiking cycle that is currently being priced in.

The release of the BoE’s Decision Maker’s Panel survey (Thursday) will also make for interesting reading. Of particular interest will be whether expected price growth into the longer term remains at the 4% seen in June.

$-Bloc

Central Bank Watch

Reserve Bank of Australia

We continue to see the RBA hiking the policy rate to 2.35% (+50bp) on 6 September.

Bank of Canada

We see the BoC hiking the policy rate to 3.25% (+75bp) on 7 September.

Reserve Bank of New Zealand

Governor Orr highlighted that the RBNZ is in a ‘comfortable position’ with their hikes affecting the economy (retail sales -2.3% QoQ for 2Q). As a result, the central bank sees ‘another couple’ hikes, and then they will become data-driven. We think it means they likely take the OCR to 4%, through two 50bp hikes in October and November, and then re-assess the situation. I may mean another 25bp further down the line.

Data Preview

Australia

• Retail Sales (Monday, 02:30 GMT +1:00): A 50bp move from the RBA came through the middle of July while another was hotly anticipated (and delivered) in early August. I agree with the consensus that expects 0.3% MoM growth, though volumes will be of interest.
• Building Approvals (Tuesday, 02:30 GMT +1:00) & Home Loans Values (Thursday, 02:30 GMT +1:00): Both are expected to fall amid a housing slowdown vis-à-vis rising interest rates and dwindling demand.
• Final Manufacturing PMI (Thursday, 00:00 GMT +1:00): The manufacturing sector proved resolute in the preliminary numbers. I am looking for a repeat in the final numbers.

Canada

• GDP (Wednesday, 13:30 GMT +1:00): I agree with consensus who are looking for the economy to continue growing while it likely begins to slow later in the year.

New Zealand

• ANZ Business Survey (Wednesday, 02:20 GMT +1:00): An important survey following a weak retail sales print. As usual in these surveys, we will be watching for any marked changes to inflation expectations and its companions.

Links to BOJ Rinban , BOE OMO

China/Japan

Key data releases this week include China’s and Japan’s PMIs .

COVID-19 Monitoring

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Ben Ford is Researcher at Macro Hive. Ben studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)