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This July is shaping up to be warmest on record, and temperatures are high at major central banks too. With the fight against inflation continuing, the US Federal Reserve and the European Central Bank (ECB) both hiked policy rates by 25bp – moves that had been well-telegraphed and were expected by the markets. The surprise came from the Bank of Japan (BOJ) which made another, long-awaited, Yield Curve Control (YCC) tweak, while sending a dovish signal on interest rate policy by downgrading its 2024 inflation outlook.
Although both the Fed and the ECB sought to keep all options open and gave no guidance for the future path for rates, with September being very much “live”, the key takeaway from the July meetings was that the hiking cycles are approaching their end. We believe, however, given the strength of the US economy and stickiness in core inflation, the Fed has further to go (in contrast to market pricing which points to no more tightening), but the ECB is very likely done. The BOJ, on the other hand, is still at the start of a long road to policy normalisation.
Fed keeps its options open
The key question going into the meeting was around the signal Powell would choose to send about further tightening. June’s messaging around the "careful pace" of tightening suggested the Fed would hike rates every other month, and a skip in June and hike in July have so far delivered on that. But in this month’s press conference, Powell claimed the Federal Open Market Committee (FOMC) is still deciding on meeting-by-meeting basis, meaning that the September decision remains 'live'. The Fed is back in full data dependency mode – it’s the data releases between now and September, including two job reports and two inflation reports, that will determine whether rates go higher from here.
Despite easing in headline inflationary pressures, particularly on the goods side, the measures of core and underlying inflation that the Fed places most weight on have only made modest progress since the start of the year, showing a fair amount of stickiness. Given the continued resilience of the economy, which delivered a large upside surprise in its advance Q2 GDP release this week, and the tightness of the labour market, we believe the Fed has further to go to ensure inflation is slowing on a sustained basis towards target, and inflation expectations remain well-anchored. Despite renewed hopes for a soft landing, we still expect the US economy to move into recession in coming quarters, though the timing remains uncertain as the length of policy lags and economy's sensitivity to higher rates seem to differ significantly in this cycle relative to history.
ECB’s last hike
The main focus for investors at the July ECB meeting was on forward guidance around future interest rate moves. While President Lagarde stressed the importance of both data dependency and new staff projections in September in determining the future path for policy, she did eventually offer some hints as to where policy might move next, stating “at this point I wouldn’t say …we have more ground to cover”. The policy statement also moved in a dovish direction, removing the phrase that rates will be “brought” to restrictive levels, saying instead that “inflation will drop further over the remainder of the year” and that financial conditions “are increasingly dampening demand”.
The ECB clearly has increased confidence now that is it no longer behind the curve and that policy is already sufficiently restrictive. With Lagarde’s three tests on policy restrictiveness (inflation outlook, underlying inflation and strength of monetary policy transmission) now met, judging by this signalling, we think the Governing Council is poised to pause.
The ECB’s assessment of the macro outlook in Europe is now in line with our own. We are seeing clearer signals of the transmission mechanism working through the financial system in the Euro area, as tightening continues to move through the credit channel into the real economy. Moreover, the results of latest Bank Lending Survey, together with disappointing Purchasing Managers’ Index (PMI) data, are the latest evidence to suggest that the Euro area economy is sliding into recession. As a result, we believe the ECB’s hiking cycle has now reached its peak, notwithstanding the still-elevated risks of a new supply side inflation impulse driven by weather- or war-induced shocks to food or energy prices.
BOJ’s YCC tweak
The Bank of Japan kept its policy rate unchanged at -0.1 per cent. YCC policy was retained as the central bank pegs 10-year JGB yield at 0 per cent, but the Bank did change its ±0.5 per cent range from a rigid limit into a flexible reference, with a hard cap imposed by fixed rate auctions with an offer to buy 10-year JGB at a 1 per cent reference rate every business day through fixed-rate operations.
At the same time, the BOJ sent one dovish signal by raising its inflation outlook for FY23 to 2.5 per cent but lowering its FY24 forecast from 2 per cent to 1.9 per cent, with downside risks. In the press conference, Governor Ueda reiterated the Bank’s patience with easy policy, as the long-term inflation outlook remains uncertain.
Having taken another step to enhance the flexibility and sustainability of the current YCC framework, the BOJ nevertheless stays very close to a dovish stance. Though July’s YCC tweak paves the way for normalisation in Japan’s monetary policy, we believe a more meaningful change in policy will only happen when the BOJ expresses more confidence in the underlying inflation trend coming closer to target. Next year’s wage negotiation dynamics will be key in this regard.
Still cautious on risk
Despite recent consensus adopting the soft landing narrative, we still believe that recession in developed markets remains the more likely end point in this cycle. Even though the policy transmission mechanism does look different from previous cycles, we expect the lags to be longer, not shorter, meaning that the full impact of higher rates is yet to be felt. Tighter credit conditions are starting to weigh on fundamentals in Europe and, to some extent, in the UK, confirming transmission is alive and well. It might take a little longer in the US, but the economy is unlikely to come out of this tightening cycle – now amounting to 525bp – unscathed.
In this environment, it is prudent to adopt a defensive approach to asset allocation. Market sentiment has swung upwards following the release of recent data showing that inflation might be falling faster than expected in the US, Europe and the UK. Investors have returned to risk assets with gusto, but, positioning is no longer light and, in some instances, technical overbought signals are flashing red.
We remain underweight credit and equities, given the economic headwinds and the fact that valuations do not represent attractive risk-reward at the moment. High yield bond spreads, in particular, are priced for a benign outcome that does not give investors a safety net if conditions worsen. With many emerging markets (EMs) offering more attractive fundamentals, we like EM debt and EM FX carry. Within equities, we also favour EM as well as the UK, but are more cautious on Europe. We are overweight government bonds as we believe they should offer some downside protection once fundamentals deteriorate, and we expect yields to fall soon now the Fed is close to its terminal rate. Within government bonds, we prefer US treasuries and US TIPS over Japan government bonds.