Quick Notes Heading into Friday
Federal Reserve Governor Christopher Waller is on the calendar tomorrow. Waller is also on the calendar for next week ahead of the blackout period, but he likely has enough information at this point to provide guidance for the May FOMC meeting, and tomorrow’s topic is the economic outlook, a good opportunity to provide that guidance. As of today, market participants have 70% odds of a rate hike, and Waller can push back on that if he wants. I don’t think he will.

As a reminder, this is what Waller was thinking prior to the SVB collapse:

Fortunately, we will get the next employment report and CPI release ahead of the March 21–22 FOMC meeting, information that will affect my assessment of the appropriate next step for monetary policy. If job creation drops back down to a level consistent with the downward trajectory seen late last year and CPI inflation pulls back significantly from the January numbers and resumes its downward path, then I would endorse raising the target range for the federal funds rate a couple more times, to a projected terminal rate between 5.1 and 5.4 percent. On the other hand, if those data reports continue to come in too hot, the policy target range will have to be raised this year even more to ensure that we do not lose the momentum that was in place before the data for January were released.

This was a two-part test. If job creation fell AND CPI inflation moderated significantly, then the projected terminal rate could remain at 5.1 to 5.4% rather than be revised higher in March. Of course, SVB changed that, but the overall first quarter job growth came in at a faster pace than the fourth quarter, and while there has been improvement in headline inflation, core inflation remains quite elevated.

By his test, absent SVB there would still be room to raise the expected terminal rate. Now, I don’t expect him to say that post SVB, and Fed officials don’t need to make any decisions about the terminal rate until June. But he can say that banking stress has eased and reaffirm the March SEP, which like in December has a projected terminal rate range of 5.1 to 5.4%. That would point toward another rate hike in May and a possible hike in June. I mention the latter because that’s not on anybody’s radar.

Bottom Line
The incoming data will likely support another rate hike at the May meeting. The Fed wants to avoid pausing prematurely as that would open the door for an easing of financial conditions that would threaten to undo the progress it has made on slowing activity. Evidence that stress in the banking sector will place a substantial drag on the economy in the near term, however, would push the Fed toward a more cautious outcome. It’s wait and see on that point. Although market pricing anticipates a May hike would be the last and the Fed will soon start cutting rates, I caution that even if a recession happens over the next year, those dynamics will likely play out more slowly than current pricing.

We think it will be difficult for the Fed to pause this month with inflation elevated and job growth likely still exceeding 200k.
Bottom Line: While market participants pulled down the odds of a May rate hike below 50% after the JOLTs numbers, a solid labor report for February could quickly reverse that move. If the decision is based on the level of the data, the Fed would most likely hike rates again. While the Fed already has communicated the policy lags story, and the shift in the language in the FOMC statement toward less certainty about future rate hikes signals the Fed is strategically thinking about when to operationalize that story, it will be hard to operationalize that story just yet with strong job growth and elevated inflation. We emphasize that the Fed’s perception of the extent of banking stress will be a key issue in its next rate decision. If the Fed sees evidence that banking sector stress is likely to create a substantial drag on activity later in the second quarter, it will lean toward a pause.

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.

Last Minute Thoughts Ahead of the FOMC Meeting
Quick reminders as we head into this week’s FOMC meeting:

The Fed will likely leave QT unchanged. The regulatory response to the banking stress is not “undoing” QT. The current expansion of the balance sheet is temporary and will reverse on its own as institutions exit from the programs. QT is about the amount of money in the economy on a permanent basis, and the Fed is determined to “normalize” the permanent component of the balance sheet. The Fed expects that the regulatory response allows for it to use its monetary policy tools to manage inflation; QT is one of those tools, along with interest rates.

…Last Minute Thoughts Ahead of the FOMC Meeting

The rate cuts priced into markets make no sense if the economy does not experience a sudden stop. This isn’t 2008. The economy was already in recession when Lehman collapsed, and the banking sector is not vulnerable in the same way. The pattern of borrowing at the discount window indicates the challenges are largely contained to regional-specific banks with a common business model. If there is no sudden stop, these rate cuts will need to be priced out quickly. This could happen quickly if the “risk off” mood in fixed income reverses. The Fed is not going to validate that pricing in the dots tomorrow. As noted above the Fed will predict more rate hikes in the SEP.

…Last Minute Thoughts Ahead of the FOMC Meeting

Quick reminders as we head into this week’s FOMC meeting:

We expect the Fed to hike rates 25bp. The Fed is caught between managing elevated inflation and pressures on the banking system. Persistent inflation and faster than expected growth were pushing the Fed into a 50bp rate hike prior to SVB. It will likely be compelled to adapt to the financial situation by scaling that hike down to 25bp. It will be hard-pressed to walk away entirely. The risk is that the Fed responds as it has in the past to financial market instability and pauses to assess the impact of its cumulative tightening.

Monday Morning Notes, 3/6/23

If You Don’t Have Time This Morning

Powell will be on Capitol Hill this week for his semi-annual monetary policy testimony. He will present to the House on Tuesday and the Senate on Wednesday. Powell will stick to hawkish themes, but will he be more hawkish than what’s already priced into rates? Powell will reiterate that inflation remains too high and emphasize that even after the series of rate hikes this cycle there is still more work to be done. I expect he will add that if inflation or growth data continue to surprise on the upside, the Fed will hike higher and remain at that level longer than it currently expects.

Tuesday Morning Notes
Whereas the Fed expected the economy would continue slowing this year, incoming data indicates that first quarter activity firmed. Worse though for the Fed, inflation also firmed, and now it threatens to decelerate more slowly than the Fed, and markets, expected. Both point to a higher terminal rate, and Fed officials increasingly recognize that they will not be able to pause as quickly as they anticipated. We think there is enough momentum in the economy to bring policy rates to a peak of 5.625%. If the Fed continues with 25bp rate hikes, that takes us out to the July meeting, but of course the actual outcome, as well as the pace, are data dependent. July is a long way off still; at this juncture, we are waiting for the next round of data to give the Fed additional direction.

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.