Markets are still favoring a pause and are pricing a European Central Bank rate hike this week at less than even odds.

But we are switching our expectations for the ECB interest rate decision this Thursday from a pause to a 25-basis points hike.

The more we re-run in our minds what we have heard from ECB officials, wargame their tactical choices, and analyze the data and risk management dynamics that will be debated at the Governing Council meetings tomorrow and Thursday, the less comfortable we are with our briefly held, and highly unusual for us dovish call that they will pause at this meeting.

The forecasts, as characterized by ECB Vice President Luis de Guindos, are likely to show a lower growth trajectory than expected in June, and an inflation outlook that is “more or less” as expected in June.

Putting a finer point on that inflation outlook, analysts expect that is likely to translate into a slightly higher figure in the near term, and perhaps a small tweak lower to the 2.2% outlook for 2025 due to slower economic activity. But even a small revision to 2025 inflation, if it does show up in the numbers, will be insufficient progress for ECB hawks, and the leadership, to hang their collective hats on.

Despite what looks like still solid growth in Q3, low inflation keeps the Fed on track for holding rates steady at the September FOMC meeting. I think the growth will be strong enough to keep another rate hike in the SEP and that more likely than not, the Fed will deliver that hike at the Oct/Nov meeting.

....If You Don’t Have Time This Morning
Despite what looks like still solid growth in Q3, low inflation keeps the Fed on track for holding rates steady at the September FOMC meeting. I think the growth will be strong enough to keep another rate hike in the SEP and that more likely than not, the Fed will deliver that hike at the Oct/Nov meeting. That said, I suspect the Fed also worries that policy is getting too tight, and hence we get mixed messaging that “maybe we need another hike, but rate cuts will be on the table in 2024.” The Fed can’t let policy become too tight if it wants to stick the soft landing, but I don’t think it can change its reaction function without letting inflation expectations rise. I don’t think sticking the soft landing will be as easy as the consensus increasingly appears to suggest.

As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.

The State Council has solicited ideas from megacities such as Shanghai and Beijing. As both cities reported double-digit growth in real estate investment and new home sales in H1, the State Council will not adopt a national real estate stimulus policy, but will rather support first, second, and third tier city efforts to improve city-specific policies according to individual situations.

In order to support the real estate sector in super-large and mega cities, the State Council also just ordered all 21 of these cities to promote the construction of both “Emergency and Dual Use” facilities in H2 2023, recreational facilities that can be used also in case of pandemic and emergencies. The State Council also ordered all 21 super-large and mega cities with a population greater than 5 million to speed up the transformation of the lower income “cities within cities,” to ensure the stability of the national real estate industry in H2 2023...

...Going straight to the numbers, fiscal spending for H2 was bumped up from the original budget and is targeted to increase by just under 7%, 6.9% to be precise, from H1 spending.

In H1 2023 China’s fiscal spending rose 3.9% over the same period last year, to 13.39 trillion yuan. This 13.39 trillion-yuan figure, comprised of 1.67 trillion in central government spending and 11.72 in local government spending, represents 48.7% of the total 27.51 trillion yuan allocated for 2023, leaving 14.12 trillion yuan for H2 spending.

Thursday’s CFEAC meeting approved an additional allocation of 200 billion yuan to H2 2023 spending, to bring the total spending for H2 to 14.32 trillion yuan, about 7% higher than fiscal expenditures for H1. The extra 200 billion yuan also symbolically bumps year-on-year comps by more than 1 trillion above the 13.17 trillion that was spent in H2 of 2022, by 1.15 trillion to be precise.

The CFEAC predicts that these levels of spending will pull China’s H2 GDP growth into the 5.3-5.5% range.

The additional 200 billion yuan will be allocated as follows: 11.5 billion to subsidize targeted semiconductor and artificial intelligence enterprises, 52.5 billion to advance the “transformation of villages in super-large and mega cities,” essentially urban slums, 55 billion to spur the private economy, and 81 billion towards stimulating consumption. Local governments are urged to encourage more nongovernmental investments, including in integrated circuits, new materials, and next-generation information technology.

The CFEAC meeting stressed that fiscal policy should also be used to extend the duration of temporary policies such as value-added tax relief for micro and small-scale taxpayers.

Premier Li Qiang pledged an additional 46.5 billion yuan towards meeting the country’s “Made in China 2025” high tech objectives, of which 35 billion yuan will come from the secretive “Premier Fund.”

As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.

...Conditions are falling into place for the Bank of Japan (BOJ) to tweak Yield Curve Control (YCC) again as the central bank takes its first tangible steps toward exiting a quarter-of-a-century-old easy policy equilibrium.

Since he landed back at the Bank of Japan (BOJ) in April as governor, Kazuo Ueda has been dropping clues about conditions under which he would change Japan’s monetary policy settings.

While at its policy meeting last month, Ueda and his BOJ colleagues held fast to their position that preconditions for changing interest rates had not yet been met, they have been less clear about what might prompt the BOJ to again widen the control cap on 10-year Japanese government bonds (JGBs).

The Bank reiterated that rates would stay put until inflation is stably and sustainably at 2%, and accompanied by wage rises.

Its July 27-28 forecast round will likely raise the fiscal 2023 (Apr-Mar) inflation projection above 2% from 1.8% in the April round, yet continue to show inflation slowing from fiscal 2024.

On YCC, when BOJ Deputy Governor Shinichi Uchida was asked about the possibility of a tweak, he said an adjustment would seek to maintain “easy monetary conditions, while taking into account (the) impact on financial intermediation and market function.” By failing to rule out the prospect of a tweak, Uchida in fact fueled speculation it was in the offing this month.

We have been warning that the BOJ might look to tweak its YCC policy again this meeting before it abandons the program later this year(see SGH 6/13/23; “BOJ: Ueda Games Exit Timing”)...

...While at its policy meeting last month, Ueda and his BOJ colleagues held fast to their position that preconditions for changing interest rates had not yet been met, they have been less clear about what might prompt the BOJ to again widen the control cap on 10-year Japanese government bonds (JGBs).
The Bank reiterated that rates would stay put until inflation is stably and sustainably at 2%, and accompanied by wage rises.
Its July 27-28 forecast round will likely raise the fiscal 2023 (Apr-Mar) inflation projection above 2% from 1.8% in the April round, yet continue to show inflation slowing from fiscal 2024.

At the latest State Council Executive Meeting, Premier Li Qiang stated that the guiding role of government investment policy and incentives should be to effectively stimulate private investment. He called for a raft of policies to boost the healthy development of the real estate sector to be implemented, while boosting big-ticket consumption like automobiles and home appliances. Supportive policies including tax and fee cuts are still needed to extend the services sector recovery.

With Japan’s wages continuing to lag prices and core CPI likely to slow to 1.6% over the next year, newly minted Bank of Japan (BOJ) governor Kazuo Ueda will be looking beyond his first meeting on April 27-28 to change policy.

The upcoming forecast round by the BOJ will feature fresh quarterly growth and inflation forecasts extending through fiscal 2025.The update may plot a path back to the 2% goal in 2025.

The BOJ expects Japan’s current 3% inflation rate to slow to below its 2% target in the latter half of this coming fiscal year.

CPI data due out April 21 is expected to show core inflation around 3%, little changed from February and with global growth set to pick up after a period of slowdown, and Japan’s wages to continue to rise.

Against that backdrop Ueda is eying an appropriate time to make a move on exiting the BOJ’s yield curve operations.

The sequence will likely be a tweak to yield curve control (YCC) in June as the technocrats simultaneously work on a framework that allows them to review, and then exit YCC, altogether thereafter.

The BOJ’s rates outlook is an entirely different contemplation, and we don’t see the BOJ raising its official rate this year.

Von der Leyen, who represents the 27-nation EU in all trade matters, will go a step further on this trip than repeating the West’s warnings to Beijing not to deliver weapons to Russia. She will say that how China positions itself regarding Russia’s invasion of Ukraine will determine EU-China relations in the future.

Intended to make clear that China will have to strike a balance between its drive to enhance its role as a global superpower on the back of an increasingly dependent Russia, while keeping key economic partners like Europe close, that message has been consulted at least with Paris and Berlin, if not more capitals, according to sources in Brussels.

With daily trade between the EU and China rising to 2.3 billion euros in 2022 from 1.9 billion in 2021, both sides stand to lose a lot if trade falls victim to political tensions.

The EU, reeling from its bad experience with excessive dependence on Russian fossil fuels, is already talking about “de-risking” in its relationship with China, while admitting a full “de-coupling” is simply not possible because of the level of integration between the two economies.

The “de-risking” is to take the form of diversification away from China in various sectors where Beijing has near monopoly in dealing with Europe, including solar panels, rare earths, magnesium, and lithium. Europe will be looking to find alternative suppliers lest it be left helplessly stranded in the future should China decide to cut it off to exert pressure, like it did with rare earths sales to Japan a decade ago over tensions in the East China Sea.

We think the Fed will need to raise the terminal rate, and market participants increasingly think the same. Markets have priced in a roughly 50% chance of a June rate hike. This helps the Fed in that it puts upward pressure on long rates, but only if the Fed follows the markets. We remind readers that while the Fed acknowledges it could continue to hike rates, it has not yet concluded that it needs to guide the terminal rate higher. I think the Fed does not want to raise rates past 5.125%, it leans toward the idea that “longer for higher” will be good enough and sees the SEP inflation forecast as “aspirational” in that, although unsaid, it thinks it can settle for an optimal control-type outcome with ongoing elevated inflation (see our Monday 2/13/22 note). All that said, we think stronger growth will eventually force the Fed’s hand, and we look forward to this week’s numbers on housing and retail sales to see if they will fall in line with our expectations.

Watching inflation breakevens rise this week primed me to think along these lines. For instance, the two-year breakeven is up about 70bp since January 19, with about 40bp of that coming after the January employment report:
If the Fed is really pursuing the 2.7% core-PCE number in 2025 estimated by the Cleveland Fed paper, breakevens have room to move higher after adjusting for the average difference of 30bp or so between PCE and CPI inflation, and even higher after adjusting for a lower path of unemployment. And remember the Fed now signals that it doesn’t need to see unemployment rise. Indeed, as noted above the Fed began looking for the pause in October 2022 when doves first identified 4.625% as the stopping point. Since then, unemployment has fallen from 3.7% to 3.4% and the Fed has yet to guide market expectations higher than they were in October. That’s what we call “revealed preference.” Regardless of this paper, I am watching to see if inflation breakevens generally climb higher in a stronger growth environment until the Fed meaningfully guides the terminal rate higher.

We expect another 25bp rate hike in March and an upward revision to the SEP dots. The SEP dots will move up a minimum of 25bp, which means rate hikes in May and June and a minimum terminal rate of 5.375%. That said, if my take on this data is correct, the Fed will eventually need to compensate for downshifting to 25bp rate hikes with a meaningfully higher terminal rate to bring financial conditions to an appropriately tight level. I don’t think limping the terminal rate up 25bp at a time will tighten financial conditions sufficiently. I think the terminal rate needs to be revised up by 75bp for the Fed to get a handle on the evolving situation, but the Fed isn’t anywhere near there yet.

Markets participants still price in rate cuts beginning in July. That pricing feels very vulnerable after last week. If the economy is re-accelerating, the Fed will still be hiking in July, and rate cuts won’t happen until 2024. That said, I sympathize with market participants here. The Fed has a credibility problem after it tipped its hand last week. It’s making a run for the soft landing when the unemployment rate is still falling. Can we really believe it won’t turn course to protect jobs the instant the unemployment rate starts to rise?

As to Beijing’s immediate response, a senior government official takes the strident position that:

The Chinese side will not allow Blinken to visit China until the US side gives a reasonable and detailed explanation for the shooting down of the Chinese airship, compensates, and returns the airship debris to China. US Treasury Secretary Janet Yellen’s planned visit to China in April will [otherwise] also fall through.

Washington is clearly not going to return the pieces or compensate Beijing for shooting down a spy balloon, similar to a balloon which has been reportedly sighted over Latin America, and surveillance balloons which it appears have been sighted in the past over Japan as well.

We expect another 25bp rate hike in March and an upward revision to the SEP dots. The SEP dots will move up a minimum of 25bp, which means rate hikes in May and June and a minimum terminal rate of 5.375%. That said, if my take on this data is correct, the Fed will eventually need to compensate for downshifting to 25bp rate hikes with a meaningfully higher terminal rate to bring financial conditions to an appropriately tight level. I don’t think limping the terminal rate up 25bp at a time will tighten financial conditions sufficiently. I think the terminal rate needs to be revised up by 75bp for the Fed to get a handle on the evolving situation, but the Fed isn’t anywhere near there yet.

Market Participants Moving Past the Fed

The Fed stepped down to 25bp rate hikes today as expected and signaled more to come. We think a March rate hike is a virtual lock and odds of a May hike underpriced by market participants. Still, we acknowledge that a May rate hike is a bet on a reacceleration of economic activity. As we expected, however, Powell did not try to guide the terminal rate higher, and if the Fed isn’t ready to move in that direction, it needs to just accept an easing of financial conditions.

Moving on to the May 4 meeting, by which point the ECB benchmark rate will be at 3%, Lagarde backed off from an explicit commitment to another 50 bp hike. That said, she was as clear as she could be that from this distance the ECB in all probability will hike rates again, by 25 or even 50, and that more may follow.
Does that mean we have reached the “pinnacle, peak” in rates after March, Lagarde asked rhetorically, to which she answered, “No, no, no, no,” and pointed to the ECB’s assessment that it will still have some ground to cover, even after the March hike, before it gets to the rate that is appropriately restrictive to bring inflation down to 2% in a timely manner.
Likewise, when Lagarde discussed the range of possibilities at the May meeting, she said it could be 25, it could be 50, but carefully steered clear of saying it could be zero, even if this is in theory always a possibility.
Indeed, while refusing to be drawn into comparison with the US, Lagarde, acknowledging the drop in energy and headline inflation (“inflationary pressures are more balanced”), said she would “certainly” not say the disinflationary process is in play in the eurozone.
In short, we believe fading the 3.25% priced at this time by markets for the ECB peak rate is in all likelihood a very good one-way bet

The Reserve Bank of Australia (RBA) will hike another 25 basis points to 3.35% on Tuesday and resume tough talk on inflation after data in the final months of last year showed prices reversed direction and rose to 7.8%, the highest level since 1990.
The year-over-year consumer price index for the December quarter outcome, though still shy of the Bank’s projected 8% peak, follows a 7.3% rise in the prior quarter and was accompanied by 8.4% inflation in the relatively new monthly CPI index from 7.3% in the prior month.
Though the RBA board will likely entertain discussion of a 50bp move at the meeting with a view to seeing that represented in the minutes due February 21, the Bank is largely resigned to finishing out its hiking cycle in 25bp increments.
Its forward guidance in the accompanying press release will warn of further adjustment, though it will continue to counsel that it is not on a pre-set course and take account of lagged and full effects of what will then likely be 325bp of tightening since May 2022. With evidence that prices are still running hot, the Bank cannot afford to sit on its hands to wait for supply side pressures to ease.
Another 25bp hike to 3.6% is likely at its March 7 meeting which may represent a point to pause if the inflation data relent, but it still may not prove to be the terminal rate of this hiking cycle. The next set of inflation reads (January CPI due March 1 and Q1 CPI out April 24) will help inform the Bank whether prices have peaked.

Fed Speak and Discussion

The FOMC will hike rates 25bp this week and signal that this won’t be the last hike of the cycle.

The Fed will need to update the FOMC statement to address the deceleration in the pace of rate hikes. This line was already stale when the Fed repeated it in the December FOMC statement after slowing to a 50bp rate hike:

In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

Left unanswered was the policy guidance of which of these elements justified slowing to 50bp. After stepping down again to 25bp, the Fed could in theory just drop this line entirely, but we think it more likely the Fed will update the language to explain that it is appropriate to proceed with a slower pace of rate hikes given the cumulative tightening in place and the softer, though still elevated, inflation numbers and indications of slower growth. Such language would be consistent with recent Fedspeak.

Similarly, the language regarding “ongoing increases” in the policy rate also feels stale, but I have lower conviction that it changes. This sentence indicates the rate hike cycle is still open-ended...

...Bottom Line
The Fed will hike rates 25bp this week and point to more rate hikes in the future. Powell will reiterate that the job isn’t done, inflation remains too high, the labor market remains too tight, and that the Fed will continue to hike rates as needed to restore price stability. I think this commentary will cover largely familiar ground and should sound unambiguously hawkish. Still, we can’t see that Powell will move expectations for the terminal rate higher. Policy rates now sit in restrictive territory, the Fed sees evidence of slower growth, inflation though high has softened and created more confidence the peak is behind us, and the Fed thinks the full impact of cumulative policy still lies ahead. The scope for large jumps in the terminal rate like last year are limited by the downshift to 25bp. There is limited room for the Fed to tighten financial conditions if it won’t raise the expected terminal rate. We are particularly attentive to Powell’s view of what needs to happen in the labor market to sustain disinflationary trends. Fed speakers have drifted toward a more dovish take on unemployment that we believe market participants will interpret as sharply reducing the odds of recession. We want to see if Powell accepts or rejects that line of thought.

The BOE wants to step back down to a pace of 25bp increments to give it more flexibility to either pause or continue if the data dictate it should but it needs credible reasoning to do so.

Though this week’s messaging will focus on the “primacy” of the 2% inflation goal the reality is the BOE only has one or two more 25bp moves left to do before it concludes its campaign.

Late last week an article came out flagging the possibility that after a 50 bp hike at the next ECB meeting on February 2, and another 50 bps on March 16, lifting the benchmark deposit rate from 2.0% to 3.0%, the “doves” within the ECB’s Governing Council might push to slow the pace of rate hikes to 25 bp increments at the following meeting on May 4.

Whether there is a stepdown or not in May, when policy rates are at 3%, is an entirely reasonable question to ask, and it may not even have to result from a Manichean struggle between doves and hawks as analysts like to frame such stories. The more debatable question to us is where the landing zone will be once the ECB crosses the 3% threshold, a zone which we continue to expect will end up in the 3.5% to 4% region.

Today, markets were jolted by a Bloomberg news article saying the ECB may consider a 25 bp hike -- not in May -- but as early as at the March meeting, when rates will be at 2.5%.

Filled with caveats (“the prospect for 50 remains likely”), that article does not capture the dynamics that matter at the ECB, and only serves to needlessly shake some positions out on the back of what has been a powerful, and very cyclically different, downdraft in US rates.

A 25 bp hike in March flies entirely in the face of the eurozone’s inflation dynamics, rate position, and explicit guidance from ECB President Christine Lagarde and a host of her colleagues after what was in fact a seminal, hawkish meeting on December 15. Unless there is a truly dramatic and completely unforeseen change in the world, it is simply not going to happen.

The Bank of Japan (BOJ) will tilt guidance toward an April exit of ultra easy policy at next week’s meeting as Prime Minister Fumio Kishida prepares to hand over the reins to a new Governor ahead of Haruhiko Kuroda’s departure before April 8.
A breach of the BOJ’s upper limit on 10-year government bond yields (JGB) Friday, forced a round of central bank bond buying and has increased pressure on the nine-member board to move again after it raised the upper limit on the 10-year yield to 0.5% from 0.25% in December.
Whether the BOJ opts to tweak the limit again at this or at the March 9-10 meeting, we expect the BOJ to eliminate yield curve control (YCC) during April, once Kuroda’s successor takes office.
At his December post meeting press conference, Kuroda stridently characterized the move as a technical tweak to improve market functioning. Since 2016 the BOJ has operated the YCC limits to achieve its 2% inflation target. The policy is a band set around the 0% target to allow long-term rates to move up or down by 0.50bp.
The January 17-18 meeting has been billed as a “technical” discussion to prepare the market for the BOJ to end its curve control policy (YCC) before April, once Kuroda’s successor takes office.
In particular the BOJ is uncomfortable with the kink in the curve, an inversion that shows a gap between seven- to nine-year yields and 10-year yields. In addition to how to correct ongoing market distortions from YCC, the meeting agenda will include an upward revision to the outlook for consumer prices and support further bond purchases.

The employment report sent mixed messages between solid job growth, a low unemployment rate, and weaker wage growth. While this may appear to be a “Goldilocks” outcome, that’s only the case if it encourages the Fed to back down from its current policy direction. That’s not going to happen just yet. The Fed can’t really back down without revising downward the 2023 dots, which is not crazy if the then high but now lower wage growth drove December’s 50bp increase in the SEP policy rate forecast, but that is not something Powell wants to do anytime soon. That would be as good as a rate cut from the market’s perspective.

Fedspeak will not yet retreat from the December SEP. Once the Fed digs itself in on a position, it takes a great deal of time and evidence to dig it out. One report isn’t going to do it. More likely it would take the totality of the data between now and the March meeting to convince the Fed it went too far with the December SEP, but even then, that view creates a potentially disastrous communications challenge for the Fed as I will explain below.