From 'no landing' to a 'hard landing'?

March 03, 2023

It’s been a good week for Rishi Sunak but the UK macro picture remains bleak.

Key Points

  • January optimism has faded as the market is grappling with strong economic data.
  • Monetary policy may take longer to work than may have been anticipated.
  • Risk is growing that rates will need to go materially higher, if demand is to be slowed.
  • We think we will either see a ‘soft landing’ or tighter policy will bring about a ‘hard landing’.

Interest rate expectations continued to re-price higher over the course of the past week, with Europe leading the way. Money markets now discount the European Central Bank (ECB) raising rates by a further 150bp in the next few months, to a level just below 4%.

Economic data continues to show signs of improvement, while the trend lower in inflation has taken a pause in February, with CPI prints across the Continent surprising to the upside of analysts’ expectations. This is likely to keep the ECB in hawkish mode at its March meeting and it seems unlikely that Lagarde will be in a position to signal a forthcoming slowing in the pace of rate hikes, for a time yet.

Across the Atlantic, the Federal Reserve is also likely to signal its commitment to bring inflation lower. In both the US and Europe, this will see interest rates well above the assumed neutral rate, R*, and so it is unsurprising that this should fuel hopes that we may be near to the top in the rate cycle.

However, in the wake of strong data, we have detected a growing level of angst in a number of circles that monetary policy is not seeing the traction, in slowing economic activity, which one would normally expect.

In assessing these trends in conversations with policymakers, there has been some debate as to whether the persistence of negative real interest rates (with nominal rates remaining below prevailing levels of inflation), means that monetary conditions remain more accommodative than some models may suggest.

Meanwhile, we have previously discussed how the US (and a good number of European) mortgage holders, have hedged themselves from the rate shock for the next 30 years, when rates were at historic low levels. From this standpoint, if household borrowings are on a fixed rate, but income from savings moves higher in line with interest rates, it can be seen that some households will actually be better off, as interest rates move higher.

The transmission effect from more hawkish monetary policy may also be dulled at a time when asset owners (including central banks and private markets) are not under pressure to mark losses to market. These factors may serve to delay a tightening in financial conditions.

Elsewhere, a further narrative we have also looked at in the past week, is to question whether interest rates lose their effectiveness when nominal rates are at very low nominal levels. In the past, we have noted that when central banks cut interest rates from 2% to 0% and below, in an economic slowdown, so policy can appear to be ‘pushing on a string’.

In the same way, we are inclined to wonder when policy starts to rise, so rates need to move above a threshold such as 2% before they start to have any effect whatsoever. If that were the case, then we could suggest that the US hiking cycle only really started six months ago and in Europe, it is only just getting underway.

Regardless of the merit of this debate, it certainly seems to be agreed by policymakers that policy is working with longer lags than may have been anticipated, and just now it is difficult to predict much in the way of recession risk in the next three to six months.

Nonetheless, the narrative that policy will slow growth and inflation, but is just somewhat delayed, seems to continue to hold sway in policy circles. This should still point to rates peaking in the early summer. However, there are growing risks that rates will need to go materially higher, if demand needs to be slowed.

From this point of view, measures of financial conditions remain only marginally restrictive and not far from their average level over the past 30 years. There remains an abundance of data uncertainty and resurgent Chinese demand could represent upside risk, to both growth and inflation, across the global economy.

Yet, aside from this, there remains a prevailing sense that higher rates will just need a bit more time to work. After delivering a substantial amount of restraint already, there is also concern among some that monetary policy could become overly reactive. Those in this camp will also note that recent data surprises may have been skewed by historically mild winter weather conditions.

For this reason, we think that the FOMC will only hike in 25bp increments from this point, unless startling data forces its hand to change this path. In this context, market projections for a 5.5% peak in Fed Funds and remaining north of 5% through next spring appear broadly reasonable, in our view.

This said, we continue to think that ‘no landing’ can’t be a final destination in this economic cycle. We think we will either see a ‘soft landing’, or else tighter policy will bring about recession and a ‘hard landing’ in due course.

From this perspective, we see risk assets as potentially vulnerable to higher rates, higher inflation, or slower economic growth. Multiples remain elevated, partly on a belief that earnings can keep growing and that bond yields will eventually fall, with inflation returning to its target.

However, to get to this destination requires us to walk a very narrow path of ‘immaculate disinflation’ and it seems easy for the economy to fall to either one side or the other, meaning a defensive posture is warranted.

Meanwhile in Tokyo, the Bank of Japan (BoJ) continues to assert its allegiance to a policy of Yield Curve Control (YCC). In the past week, the BoJ has squeezed repo in order to make it expensive to borrow bonds it has been buying, and thus act to flush out those trying to speculate at its expense.

However, we continue to believe that a change in policy will be dictated by changing economic conditions, more than it is by the actions of external parties. The reality is that core inflation is now above 4% in Japan and there is a growing inflation problem. We see this leading to strong gains in the Shunto wage round and we see businesses, which were originally reluctant to put prices up, are now increasingly happy to do so.

Ultra-accommodative monetary policy is feeding inflation pressure, and it is also ironic that the fact that the BoJ is having to purchase securities and grow its balance sheet at an accelerated rate means that policy is actually becoming more accommodative, even as an exit looms.

Meanwhile, it interests us that the RBA in Australia also squeezed repo on 3-year bonds just before they abandoned YCC, and thus we wonder if recent steps could be a prelude to the same. For now, we look for an adjustment to the 0.75% yield at the March BoJ meeting.

Equities traded lower over the past week, fitting the pattern we have anticipated, whereby the front end of the rates market sells off first, followed by the long end, followed by risk assets. However, credit continues to trade with a deal of resilience, and it seems that the storm clouds of an eventual economic slowdown are still far enough away that they haven’t disrupted appetite for corporate and sovereign bonds at absolute yield levels, which appear attractive to many.

Elsewhere, in FX, it appears the recent strength of the dollar may be losing momentum. Certainly the Fed appears to have less to do, in terms of hiking rates, relative to some other central banks. Having been biased slightly long of the dollar during February, in the past several days we have been moving in the opposite direction, adding to exposures in India, Israel and the yen.

Looking ahead

Next week’s payrolls report will be closely watched in the wake of the surprisingly robust February report, which saw over half a million jobs added. Thereafter attention will turn to the CPI report, with these two data points seeming to be of paramount importance both to market participants and also to policymakers.

For now, there seem indications that February’s data may contain more of the same than has been seen in the past month. If this is the case, we might think that if yields continue to rise, then hopes of ‘no landing’ may soon become replaced by fears of a ‘hard landing’ once more.

Meanwhile in some rare good news, Sunak’s deal with Von der Leyen may set the tone for increasing rapprochement between the EU and the UK, in the months to come. We sense that the EU is looking to act constructively, on the view that a ‘re-join’ referendum could be on the cards in the next five to seven years, under a Labour government.

The UK’s military role (in intelligence as much as in hardware) is reminding those across the Channel of the benefits of bringing the UK closer to the fold and we wonder for example, how long it will be before British citizens can start to re-use e-gates at European airports. That said, the UK macro picture remains bleak. Persistent inflation means rates going higher, but this risks accelerating a housing collapse.

From this point of view, we think that the UK will remain trapped between a rock and a hard place. Consequently, we retain a negative stance on UK assets and the pound. At least Rishi is making a few friends again….

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