Has Yellen inserted her chip into the mindset of the Fed?

Hopefully the robots aren’t taking over yet!

US yields rallied in the wake of the Fed removing its tightening bias at this month’s FOMC meeting. Although Powell sought to downplay the idea that rates will decline as early as March, the market has shown appetite to front-run the Fed, and a narrative gaining traction is that where the market leads, the Fed will now follow.

The Fed will have known that removing the bias would invite near-term rate cutting speculation. In this context, if the desire was to downplay and not feed these expectations, the FOMC could have retained the existing bias for a little longer, yet it chose not to do so.

In a number of respects, it is interesting to see the Fed tilting in a more dovish direction, considering that pretty much all data since the prior FOMC meeting has surprised to the strong side of expectations. Core inflation remains above target, the labour market and consumption are strong, and growth in the fourth quarter was above trend and considerably higher than consensus forecasts.

The stock market is at its all-time highs, thus supporting wealth effects, and a rally in credit spreads has eased financing conditions. Meanwhile, housing market activity is already picking up on the back of lower mortgage rates.

In our thinking, it seems fair to reflect that rates may not be too far from appropriate levels and that the economy is doing as well as anyone might expect or reasonably hope for at this time. Yet there is a sense that the traditional central bank calculus is now subject to another narrative which is starting to have an impact on decision making.

In this context, there have been suggestions building that former Fed Chair, Janet Yellen, has been lobbying for lower rates in order to boost the economy as much as possible, in the hope of boosting Biden’s re-election prospects.

As it stands, Trump is a strong favourite in the presidential race, and this is prompting a degree of desperation in the Democrat ranks. Yet in this regard, it is far from clear that the economy is going to be the decisive political issue this year, save for Biden being blamed for the past inflation overshoot.

Moreover, any sense of the FOMC acting on political bias could well come back to haunt the Fed under Trump. In this case, one would normally expect Powell to reaffirm Fed independence. Yet it is tempting to conclude that someone is whispering in his ear all the same.

Across the pond in Europe, recent comments from ECB policymakers have been more dovish. There is a growing sense that growth, as well as inflation, is now the more prevalent concern under Chair Lagarde. With inflation declining, this may suggest that the ECB is ready to start lowering rates in April, in our assessment. We still remain inclined to discount fewer rate cuts than markets are discounting, though we feel that there is a growing case to expect the ECB to begin to lower rates ahead of the Fed.

Wages and structurally tight labour markets remain a concern at the ECB (noting that unemployment in the bloc stands at a record low). However, economic prospects continue to look very muted for the foreseeable future and potential downside risks linked to geopolitics mean that the ECB is now getting closer to acting.

GDP data in Europe showed the Eurozone just avoiding a technical recession in the fourth quarter last year, with the trend for the time being for output to hover around 0%. Within the region, there have been some marked dissimilarities though, with much of southern Europe continuing to outperform, even as Germany continues to struggle.

Spain, Portugal and Greece have all been outperforming for some time and increasingly, it appears that the old model of the Eurozone ‘periphery’ is starting to look out of date. Peripheral spreads have been rallying over the past several months and further compression may be warranted – especially relative to a sovereign such as France, whose credit fundamentals have tended to trend in a weaker direction over time.

This week saw Greece spreads break below 100bps, with a new 10-year issue heavily oversubscribed, as passive investors chase GGBs, now that they are incorporated into Eurozone government bond indices after moving back to an investment grade credit rating in December.

Based on the experience of Portugal, this trend may have further to run on the back of a supportive technical, though clearly much of the money from owning Greece has now already been made in the past 10 years, since the restructuring of Greek debt saw bonds trade at single digit prices at their lows.

Meanwhile, a 0.5% GDP expansion in Italy was also welcome. With the stock of Georgia Meloni also continuing to trend higher in EU policy circles, so it seems that volatility can remain subdued. That said, there will be a lingering concern related to Italy until it can demonstrate more of an ability to grow on a consistent basis, and in this context, we continue to see more value in other investment grade-rated sovereigns offering higher yields on their euro-denominated debt, including Romania, Mexico and also Poland since last year’s election of Donald Tusk.

In the UK, we think that prospects for monetary easing look more distant. Inflation remains close to 5% and headline-grabbing wage gains continue to demonstrate how tight the labour market is, notwithstanding a muted economic backdrop. Meanwhile, with the Sunak government readying tax cuts in March, this is also likely to negate any case for easing monetary policy.

In this context, despite a three-way voting split among the MPC this week, the BoE’s message was clear in the sense that disinflation is progressing but it’s too soon to declare victory. Even by its own forecasts, headline inflation will be close to 2% in the summer but should rise again towards 3% by year-end – a substandard outcome given the Bank’s target of 2% inflation on a ‘sustainable’ basis. We continue to see the BoE struggling to endorse a cut in 2024, notwithstanding policy actions elsewhere.

Over the past month, growing hopes for a soft landing have helped propel equity markets to new highs, with risk sentiment broadly bullish at the start of the year. Notwithstanding a heavy month of supply in investment grade and high yield, spreads have continued to compress as end investors allocate cash to the market, having maintained a structural fixed income underweight for a number of years.

As rates peak, so flows have benefitted the fixed income asset class and as we have highlighted, the backdrop of net negative supply of corporate bonds in IG and HY in 2024, on both sides of the Atlantic, creates a pretty powerful technical that can continue to drive spread compression in cash bonds.

Meanwhile CDS indices are essentially unchanged over the past month, meaning that there has been a strong performance in the basis between cash bonds and CDS. We continue to think this can have further to run and so using CDS as a hedge to overall market beta, in case risk appetite sours, remains an attractive strategy from our viewpoint.

FX moves have been largely contained over the past month. On the one hand, evidence of further ongoing US growth exceptionalism continues to favour the dollar. However, the elevated valuation of the greenback, plus an upturn in risk sentiment, runs counter to this and has contained dollar strength, with expectations for coming US rate cuts also limiting enthusiasm for the currency. In a broad sense, we think this regime can persist a while longer.

Away from the broad dollar theme, the yen remains interesting and further comments from the BoJ signalling upcoming policy tightening are seen as supporting the case for a turn stronger in the yen. However, with carry continuing to undermine the Japanese unit, it strikes us that a more material move won’t occur until such a time as the BoJ matches its words with actions.

Looking ahead

We still think that the most likely path for US rates is for the Fed to begin easing in the second half of this year, as we expect data to remain robust over the next few months, given the current momentum in the economy. However, our confidence in understanding the Fed's reaction function is more uncertain at this juncture than it has been in the past, and so we don't hold a strong view on US rates for now.

The other point worth highlighting is that conventional wisdom will hold that monetary policy tends to go ‘up the stairs and down the elevator’. This might suggest that once the Fed starts to cut, then rates will drop by a significant amount over a short space of time. However, this is the sort of behaviour that exists should the economy experience an abrupt slowdown (a.k.a. a hard landing), or if there was a sharp slump in financial markets.

Yet, if we are in a world of a soft landing, then any easing cycle could be much more shallow and also much more short lived. Based on past precedent of policy easing cycles, it could easily be the case that cumulative rate cuts total 100bps or less before the next hike, at a later point in time.

In this way, we think that where markets become too entrenched in a conclusion that rates are on a journey back to pre-pandemic norms, then this could represent an opportunity to take an opposing view. Anyway, in a world where humans are now inserting chips in their brains for real, there is plenty left to ponder following the past week. Yet it still seems that we are a long way from the robots taking over (we hope).