Developed Market Policy Restriction Sliding Away?

“Slide away, and give it all you’ve got” ? ? Oasis, Slide Away

Written by Neil Staines, 13th September 2024.

Last week, we discussed the more recent market developments concerning our long-held weak dollar view - essentially, the combination of a deterioration in the US twin deficits, USD overvaluation and a macro setting that suggests the dollar is at the bottom of the ‘dollar smile’. We argued that, from our perspective, we are just at the start of what could be a significant USD depreciation and that our view that continued disinflation and growth moderation will remain the dominant macro driver, with logical implications for bonds and risk assets (positive) and for the dollar (negative). And, that in the near term, it is perhaps the USD that is the most interesting.

We made the point that our macro views remain unchanged - continued disinflation and growth moderation. Importantly, however, in the near term, we also argued that the higher level of baseline volatility across asset classes will remain and suggested this may well prove a headwind to equities and some risk assets in the near term. However, we do not see a recession in the near term, and thus, with 525bps of Fed easing to counter any growth (and labour market) deterioration and beyond near-term political uncertainty and further fiscal support in the US, equity markets are likely to wobble, but not likely to fall over.?

Essentially, we stated that we expect higher volatility across financial markets in the near term as markets wrestle with recession probabilities and the Fed reaction function. Ultimately, we see a soft landing in the US, but near-term volatility may see this questioned.

Back to Europe

This week the ECB meeting brought a 25bp rate cut as expected. However, despite updated staff projections and a press conference, it brought little else! There certainly will have been some market participants who were looking for a more specific dovish adjustment to the expected rate path or more explicit dovish forward guidance from the ECB - For those, this week would have been very disappointing.?

Apart from a very well flagged technical adjustment to the deposit rate - MRO spread (to 15bps from 25bps and not policy-relevant), the ECB maintained its ‘data dependent’ approach and gave no guidance about future policy decisions beyond a clear reiteration of the data dependence regime from July. There was certainly not a more urgent rate cut narrative – although downside risks to growth were again emphasised.

Poker Face?

It could be argued that by not emphasising the ‘amount’ of new data before the October meeting relative to the December meeting in the way that Lagarde guided policy activity towards September and not July at the June meeting (by stating that there was “some data ahead of the July meeting but a lot more data ahead of September”- particular with reference to the ECB’s quest for greater confidence on the inflation path at the time) is a mild dovish iteration. Mild, but it does keep October on the table for policy action - markets are currently pricing 14bps or 56% chance of a 25bp cut in October.?

In terms of the data dependence narrative, Lagarde was clear to emphasise that it is the entirety of the data that will determine the Governing Council's confidence on the path of inflation with reference to the three guidelines: i) the path of inflation, ii) the projected path of core inflation and, iii) the transmission of monetary policy. Specifically, Lagarde highlighted the September eurozone inflation print, which she stated was likely to be on the low side due to base effects (before normalising subsequently). Essentially, this was a warning to markets not to extrapolate the data or price steeper cuts as a function of this release independently of the wider data progression.?

One very interesting question during the Q&A was about the impact of monetary easing on growth. “How much of boost to growth will come from rate cuts, given most of the problems are structural?” Lagarde emphasised the current situation - where the lagged effects of previous rate hikes are still dominant (although past their peak from a GD perspective) and not yet rate cuts – which by default also have a lagged impact. She did not address the issue of structural growth problems in the eurozone, aside from giving the preliminary (Lagarde was clear that the ECB has not had time to assess the 400-page report in great detail) ECB seal of approval on the Draghi report.?

… and believe me, it will be enough?

Former ECB President Mario Draghi is infamous not just for his competent management of the ECB through the eurozone crisis but also for the popularisation of the phrase - and indeed the increasingly popular concept of doing (or threatening to do) - whatever it takes… in Draghi’s specific context to preserve the euro. In that context, it is interesting to note the direction in which the Draghi report on EU Competitiveness (‘Looking Ahead’) travels. The core of the recommendations are around increased structural investment (circa EUR750B annually) via joint liability eurozone debt issuance and the completion of capital markets and banking unions.

Essentially, it could be argued that the ECB policy decision and subsequent guidance was modestly hawkish relative to market expectations of the growth and inflation outlook of the eurozone and more clearly relative to the evolving dovishness of the expected Fed reaction function. Following the ECB, US rates markets began gravitating towards a 25bp cut at next week’s FOMC meeting. However, the concurrent release of FT and WSJ articles debating the rationale for 50bps has seen that market pricing for Sept 18th swing back to almost a 50% chance of a 50bp cut. Baseline volatility, as we suggested last week, is likely to remain elevated.

The Long & Short…

Taking a step back, the wider macroeconomic evolution remains consistent with our core views. Disinflation continues to be pronounced, and risks remain to the downside. Furthermore, while the balance of risks to growth remains to the downside for the ECB, we continue to see the prospects for a soft landing in the US as outweighing something more recessionary—growth moderation. In the near term, however, we continue to see policy and macro settings as conducive to maintaining a higher baseline volatility.?

Against this backdrop, we see the USD as vulnerable to a deeper correction from overvalued territory. As the rest of the year progresses, we view hedge ratio adjustment (perhaps a topic for future discussions) as a potentially significant accelerator to the dollar's decline. With global dollar-centric investment flows over the past twenty years or so being extremely significant, small changes to hedge ratios could be very significant in weakening the dollar. Indeed, to paraphrase Oasis, it could be the dollar as well as policy restrictiveness that slides away over coming months.

What is happening next week?

Sources:

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