US Federal Reserve (Fed) chair Jerome Powell’s Jackson Hole speech on 26 August was intentionally short. It was clearly designed by Powell to deliver a direct, unambiguous message to the markets. Despite a lower-than-expected US Consumer Price Index (CPI) for July, there is no victory dance at the Fed yet: far from it, just a dogged determination to get inflation down to 2%. Powell’s omission of risks to the economic growth outlook added weight to his focus on battling inflation. There could not be a greater contrast with his marathon speech at Jackson Hole last year. In 2021, he used the annual speech to set out all the reasons inflation was expected to be ‘transitory’ and why the Fed had the luxury to support economic growth. His tone this time surprised the market, which had been increasingly looking for a Fed pivot to lower interest rates as soon as next year.

Euphoria over lower headline inflation, as commodity prices have fallen and supply chains have improved, had contributed to the dovish stance taken by the market prior to the speech. However, these factors alone will not be enough to get inflation down to the Fed’s target. Domestically-driven inflation from services, and higher rents emanating from a tight labour market, are still huge problems. What’s more, economic data have started to re-accelerate, with the fall in gasoline prices spurring a rise in real incomes, reigniting the market’s expectations of higher inflation in the future. A divergence between soft data (opinion surveys) and hard data (collected facts) has been building in recent months, with the soft data notably weaker than the actual economic outcomes. In a ‘cost’ crisis, it makes sense that vicious falls in consumer and business sentiment might paint a worse picture than reality: economic actors may complain a lot but in the end they tough it out. Economic data have surprised to the upside recently, although this has not been getting much airtime as it is not in line with the current ‘crisis’ narrative. In any case, the cascade of fiscal support happening everywhere should shift the balance towards the hard data signal being the one to follow.

The Federal Reserve is rightly focused on the tight labour market, and a universal effort is underway by Fed speakers to remove the interest rate cuts priced by the market into 2023 and beyond. This is likely a Fed that will get rates up and keep them there, reacting asymmetrically to economic developments by keeping more tightening on the table and not taking the risk of cutting any time soon. Powell’s speech cited the case of the 1970s, when the Fed chased its own tail, cutting prematurely on economic weakness, which lead to inflation oscillating out of control as the economy went through a boom-and-bust cycle. Things are different today, but there are some similarities, as labour and capital become less globally mobile. He also threatened the market that the Fed ‘dot plot’ of individual Fed views on the path of policy rates will be updated at its September meeting. A case for less 2022-front loading and more use of the yield curve to tighten financial conditions is being made by the Fed here. Most clearly though, all this points to a higher terminal rate in the US being priced into markets.
Reality check in Europe
European Central Bank (ECB) sources have reportedly suggested that a 75bps hike will be considered at the next ECB meeting. This is another reality check for a market that has been focusing on the energy crisis impact. As inflation expectations rise, and with a tightening labour market, they cannot sit idly by and focus on weak growth risks. Weak currencies, as Europe’s balance of payments deteriorates, only make the problem worse by fostering higher inflation through higher import bills. Governments will likely end up footing the bill (as we are now hearing about in the UK) and central banks will be taking this into account. Huge fiscal bills will make funding these governments unattractive at current yield levels. This is a medley of reasons why the selloff has been so rapid over the last few weeks as the strain shifts from the currency to the interest rates markets. The market has been too timid on central bank pricing in Europe, focusing too much on the growth risk side. Moves into restrictive policy need to be priced in, and yield curves in Europe and the UK need to flatten hard, as the market balances policy rate hiking into a sluggish backdrop. We are cognisant that the recent aggressive downward move in European natural gas prices, after months of rises, might symbolise the extreme pessimism priced into European growth. Demand to fill gas storage tanks has been a large part of the price moves, and as this process nears completion it should in the end serve to ease prices and concerns somewhat.

China remains a risk for the global economy, with its housing market and constant lockdowns a deadweight. However, the commodity price declines this has supported is helping growth and inflation profiles in the global economy, as it eases the pressure on resources. What’s clear is that the link between a weaker China and global interest rates of the pre-Covid years has broken down with the rise of inflation pressures. A sharp decline in the Chinese yuan would likely halt the global yield sell off; however, the Chinese authorities are acting to steady the decline in their currency. Monetary easing and stimulus efforts have been ratcheted up in recent weeks, but likely more needs to be done to support growth, especially regarding the housing market.

Overall, the market’s pricing in of an easing in US financial conditions, as bonds and equities rallied in recent months, looks unjustified. There’s little question that the Fed is going to be tough. The outcome for markets now hinges on whether it will a soft or hard landing for the economy, to achieve the necessary fall in inflation. A soft landing would require labour supply to return and job openings to fall without causing too many job losses to help wage gains ease back. This path would likely mean risk assets have already found the bottom and would add support for under-priced cyclical assets. If wages stay high, much higher yields and lower equities will be required, creating more recessionary conditions. On the day, Powell’s message was received loud and clear by the markets, as equities fell sharply and bond yields rose. In summary, we see ‘higher for longer’ interest rates and ‘stronger for longer’ economic outcomes as key themes during the rest of 2022.

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