Coronation (versus) chicken

The bunting is going up in the UK, but it’s a little more tense in Washington….

The decision from the Federal Reserve to hike interest rates to just above 5% this week came as little surprise to market participants. However, with Chair Powell signalling a possible pause by removing forward guidance, the outcome for the next meeting in June remains more uncertain. With inflation still higher than cash rates, there may continue to be uneasiness in some quarters at the Fed, that policy is sufficiently restrictive to deliver a return to a 2% inflation target.

Labour data, such as Wednesday’s ADP labour report, which was the strongest in the last nine months, suggest that the jobs market remains surprisingly resilient to policy tightening thus far, and it will be interesting to see whether a similar impression comes from today’s US labour market report.

That said, there is now more widespread evidence that restrictive monetary policy is slowing growth. A tightening of lending standards is expected to be shown in the Fed’s Senior Loan Officer Survey, which is due next week, and which Powell already referenced in the FOMC Q&A.

Moreover, ongoing turmoil in regional banks threatens a tightening of financial conditions, which will gradually slow economic activity, into a full-blown credit crunch. Were this to occur, then risks of a more rapid and premature slowing of economic activity could manifest, thus bringing forward a possible Fed pivot.

In the wake of the demise of First Republic Bank, so it seems that investors have not taken long to identify the next possible candidates likely to come under pressure. Sharp declines in the stocks of PacWest and Western Alliance have seen commentators speculate on the next domino to fall, notwithstanding comments seeking to reassure markets, from the Fed and from bank management.

As written previously, the fundamental issue with banks is confidence. Confidence in the US regional banking system has been built over many years but can seemingly be called into question in a matter of a few days. This will be a concern to the Administration, and one sees some echoes of problems in European banks a decade ago, which led to a significant consolidation within the sector around larger, systematically important and highly regulated banks.

In this context, the whole banking model in the US may be subject to change. However, it is also possible that volatility begins to settle, especially if there is little evidence of further deposit flight actually taking place. There is a sense of elevated uncertainty and unpredictability around recent events, and this may warrant some caution for the time being. It seems the only certainty at this point is that further regulation to curb banks’ risk taking is likely to follow.

US interest rate markets currently discount just over 75bp of cumulative Fed cuts by December. This may appear overly optimistic. However, we would note that if there is a sudden and abrupt slowing of activity, and if inflation is also seen on a declining trend, so the Fed now has plenty of room to lower interest rates, as and when the time is appropriate. With interest rates above 5%, this level is now well ahead of perceptions of a neutral rate.

Consequently, any monetary easing could progress in clips of 50bp at a time, or even faster, were the conditions to warrant this. On the face of it, future pricing of 2-year Treasuries, on a 1-year forward basis on a yield at 2.96% (which is more than 200bp below current cash rates), looks very rich. However, the outlook is more uncertain and we don’t feel there is a compelling case to express a clear directional view on rates, especially with the looming uncertainty surrounding the debt ceiling also facing us.

Across the Atlantic, the ECB also hiked by 25bp this week, raising the deposit rate to 3.25%. The ECB bank lending survey for the first quarter also painted a picture of tighter lending standards. Monetary conditions have moved to the most restrictive setting since the Financial Crisis in 2008, yet this is entirely intentional and in line with the ECB’s desire to restrain demand and restore price stability.

Last week’s German data surprised to the soft side, but broadly speaking, the European economy remains in a relatively healthy position. Eurozone unemployment data, released this week, shows an all-time low since the creation of the Monetary Union. Business confidence is robust. Wage growth is elevated and inflation is well above the ECB target. Consequently, there is no sense from Lagarde that the ECB is likely to pause on rate hikes soon and we continue to see rates at 3.75% this summer.

Elsewhere, we think that the recent rally in JGB yields, following a relatively dovish Bank of Japan (BoJ) meeting from incoming Governor Ueda, will prove short lived. Inflation continues to trend higher in the country and the BoJ may come to regret not seizing the opportunity to adjust policy last week when levels of speculation were relatively low.

Also, the longer that the BoJ allows inflationary pressures to build, the bigger the upward correction in policy and bond yields may ultimately be. There is a sense that authorities in Japan are slow to recognise the return of inflation as they have not seen it for such a long time.

Moreover, when last in Tokyo, we were struck by a central bank still willing prices to go higher. This strikes us as potentially a very risky game for a central bank to be playing, at this particular moment in time.

In FX markets, the dollar has come under some pressure, as the possibility grows that the US economy could begin to underperform on a relative basis. Building worries related to the debt ceiling are also not helping the greenback. It seems sadly predictable that negotiations around this will go to the 11th hour and 59th minute, as Republicans and Democrats seek to score points from one another.

However, there is a real risk that the deadline for when the Treasury runs out of cash is actually passed, on this occasion. Should this occur, we would be confident that the Administration would prioritise debt payments in order to avoid a default and the resulting chaos, which would ensue in global financial markets.

However, the period around this could see elevated uncertainty, and indeed some pressure in financial markets may be necessary, in order to force both sides to a point of compromise. In this context, we would be generally cautious on the outlook for risk assets and also the dollar, until this can be resolved.

In EM, we witnessed a weaker Chinese PMI report this week, suggesting that the re-opening bounce may be starting to lose momentum already. We continue to see reasons to be structurally cautious on Chinese assets. Moreover, we continue to be struck by comments from policymakers we meet, broadly endorsing a roll back of globalisation and a move to more of a multi-polar world.

As geopolitics re-shape, so the upcoming elections in Turkey may be very close and may have significant ramifications for years to come. A win for the opposition parties would see a more Western and European Turkey, whereas an Erdogan win could strain Turkey’s NATO membership and move the country more into the orbit of other regimes in the Greater Middle East.

Looking ahead

We have always thought that after a drop in volatility in April, so May and June could be bumpier months. We need to wait to see if inflation is behaving as policymakers are hoping, or if further tightening will be necessary. There is elevated uncertainty around US regional banks and also a clear sense that tensions around the debt ceiling will need to grow, even if they are eventually resolved. Against this backdrop, waiting for clearer opportunities seems to be the stance which is warranted.

In the UK this weekend we will be celebrating the ascent of King Charles III to the British throne. Notwithstanding mixed opinions in some quarters of society around a hereditary monarchy, the Royal Family would appear to (mostly) consist of a number of individuals dedicated to a degree of selfless public service. There is little doubt their presence generates far more in tourism receipts than it costs the country to run the Institution.

At a time when public sentiment around our elected officials is at record low levels, so there is a sense that having a king or a queen is no bad thing. Many of us have long grown up with the assumption that democracy is a fundamental right and produces the best form of government.

One hopes sometimes that this assumption is not taken for granted, and hence elected officials will take time to do what is right for their countries and their people, rather than what simply suits themselves, their friends and their own re-election chances.

Against this backdrop, crowning a king in London in 2023 seems to make a lot more sense than the game of chicken in Washington DC, which is about to unfold….