The September FOMC meeting kick-started the Fed’s easing cycle with a significant 50bps cut in the Federal Funds Target Rate, leaving it at +4.75% - +5.0%. Unusually, this large step was taken even as the US economy remains strong, and explicitly with a view to keeping it so. Effectively, macroeconomic conditions having induced a shift in the Fed’s priorities towards the ‘maximum employment’ component of its dual mandate, while still not declaring mission accomplished on the inflation side
We expect September 17-18 FOMC Meeting to result in a 25bps decrease in the Federal Funds Target Rate to 5.0% - 5.25% - barring a huge surprise. This move will launch the beginning of an easing cycle for monetary policy. The combination of improved data and outlook for inflation and the ‘unmistakable’ softening of the labour market leads to a shift in the Fed’s priorities, paving the way for rate cuts. A few thoughts beyond the direction change:
In 2019, the European Union (EU) adopted a very ambitious Green Deal, setting a 2050 climate neutrality target for the 27 member states. Since then, the Fit for 55 legislative package (in 2021) has been introduced, followed by the series of REPowerEU directives (in 2023) detailing the process to speed up reducing greenhouse-gas emissions (to at least twice the current pace). The main focus has been on developing renewable energies, whose share is set to double within six years, accounting for 42.5% of end-energy use by 2030.
Since the start of the year, growth in emerging countries has held up quite well. This is reflected not only in business and household confidence, but also in the confidence of foreign investors in the local bond and stock markets. The tightening of US monetary policy from early 2022 to mid-2023 did have a major negative impact on portfolio investment flows. However, this impact was largely offset by the attractiveness of emerging markets for both private and institutional investors, whether for purely financial reasons (carry trade strategies) or as part of a diversification strategy
Speaking at a joint press conference in Germany on Tuesday, 28 May 2024, the French President and German Chancellor expressed their desire to create a “European savings product” to “bolster Europe’s competitiveness and growth”. This political will follows on from the Letta[1] and Noyer[2] reports and statements made by the French Minister of the Economy. It’s a new approach to getting Capital Markets Union back on the rails.
News about growth, inflation and monetary policy influences bond and equity markets. For bonds, the relationship is straightforward but for equities, the relationship is more complex. Therefore, the correlation between bond prices and equity prices fluctuates over time. Since 2000 it has been predominantly negative, thereby creating a diversification effect. It underpins the demand for bonds, even when yields are very low. Unsurprisingly, during the recent Federal Reserve tightening cycle, the correlation has turned positive again. Based on past experience, one would expect that, as the Federal Reserve starts cutting rates later this year, the bond-equity correlation would turn negative again.
An analysis of the latest PMI indicators, by Tarik Rharrab.
The data dependent nature of monetary policy has intensified the mutual influence between economic data, financial markets and central banks. Inflation releases play a dominant role given that central banks pursue an inflation target. In the United States, when CPI numbers are published, the change in the financial futures contracts on the federal funds rate has the highest correlation with the monthly change in core inflation. Going forward, Fed watching will consist of monitoring the inflation surprises -the difference between the published number and the consensus forecast- as well as the ensuing market reaction
The US 2-10s yield curve has been inverted since mid-2022, with no clear signs of an impending recession in the US economy. Thanks to the current risk-on mood, this looks like a “false positive”, as it did in the mid-1990s.
According to the World Bank’s report published last week, the external debt stock of all low- and middle-income countries (LMICs) contracted in 2022, for the first time since 2015. However, this observation does not apply to sub-Saharan Africa (consisting exclusively of LMICs with the exception of the Seychelles): the region’s external debt continued to rise in 2022, reaching USD 832.8 bn, a figure up 2.1% compared to 2021.
The latest communication from the Federal Reserve -the new projections of the FOMC members for the federal funds rate and the comments of Fed Chair Powell during his press conference- reinforce the view that the US economy should experience a soft landing, which should allay potential worries about the outlook for corporate cash flows and household income. Bond and equity prices rallied, reflecting a feeling amongst investors of ‘Santa Claus is coming to town’. The focus will now shift to the trickier part of the soft landing scenario: how fast and far will rates be cut? Another important question is when will bond markets start to anticipate the risk that the pick-up in growth that should follow from further disinflation and lower interest rates would quickly lead to new bottlenecks.
Updated data on GDP growth, inflation, interest and exchange rates.
The net short position of hedge funds in the US Treasury futures market has expanded considerably over the course of the year. At the end of November, it stood at an unprecedented level of almost USD 800 billion. Asset managers, eager to hedge against interest-rate risk, increased their net long positions.
In a recent speech, ECB President Christine Lagarde said that when the financing needs of an economic transformation exceed the capacities of fragmented financial markets, developing a capital markets union becomes crucial. This is the point at which the EU has arrived. According to European Commission estimates, financing the energy and digital transition will require more than EUR 700 billion annually. One way of reducing capital market fragmentation is by lowering the cost of information gathering for investors, e.g. through the harmonisation and, where possible, simplification of standards and regulations. This would increase the risk bearing capacity of investors and lower the cost of financing for issuers
GDP growth, inflation, interest rates and exchange rates
Rising long-term yields in the US are causing waves in the region : they have reverted FX gains seen earlier in the year, redirected portfolio flows and are complicating plans to issue debt to fund the energy transition.
In Central Europe, capital flows (foreign direct investments, portfolio flows and bank lending flows) have resisted rather well despite geopolitical uncertainties. Similarly, they do not seem to be affected, for the time being, by the weakening of economic activity in the region.
In the US and several European countries, gross public sector borrowing requirements are expected to remain sizeable and the reduction in the size of central banks’ balance sheets -quantitative tightening- complicates matters. The impact on bond yields will depend on the risk-bearing capacity of investors. Their ability and willingness to increase their exposure to duration risk depends on several factors: the existence or absence of strict duration risk limits in portfolios of institutional investors, risk aversion in reaction to recent bond yield volatility, uncertainty about the outlook for official interest rates, the correlation between bonds and equities, the balance sheet capacity of financial intermediaries
US Treasury yields have increased significantly since the end of July and this movement has accelerated in the past three weeks. It seems that the increase in the term premium has been a key driver although there is ambiguity about the underlying causes. There is no ambiguity however on the economic consequences: they are negative. A key channel of transmission is the housing market. Credit demand in general should suffer and another factor to monitor is the equity market considering that the earnings yield of the S&P500 is now lower than 10-year Treasury yields. All these factors represent a headwind to growth and may convince the FOMC that an additional rate hike before the end of the year is not warranted
Since its publication last May by France Stratégie, the "Pisani-Mahfouz" report on the cost of ecological transition in France has been the subject of numerous, sometimes imprecise comments. For example, the main quoted figure of EUR 66 billion does not refer to the investment required for decarbonization, but to a net additional financing requirement. Explanation.
GDP growth, inflation, interest and exchange rates.
Stylised facts are recurring patterns between economic variables and between economic variables and financial markets. They are conditioned by the economic environment and shape expectations of households, companies and investors. They are also used when producing economic forecasts. In the current cycle, there is doubt whether certain stylised facts still apply. In the US, the economy is still growing despite a significant yield curve inversion and aggressive rate hikes. In the Eurozone, the labour market thus far has been resilient notwithstanding the actions of the ECB. Moreover, financial market investors are undeterred by the talk by economists about recession risks. Several factors help to put these, at first glance puzzling observations, into perspective
