This week's FOMC meeting followed by the statement and press conference on 1 May 2024 are eagerly awaited considering the change in tone from the Fed in recent weeks, which has signaled that rate cuts will come later than expected.
According to the IMF’s latest Fiscal Monitor, between 2023 and 2029, many advanced economies are projected to see an increase in their public sector debt to GDP ratio. The US ranks second in terms of increase of the public debt ratio (+ 11.7 percentage points of GDP). Administration and Congress will have no other option than to structurally reduce the budget deficit. However, the challenge will be huge given the unpopularity of tax increases, the difficulty of cutting expenditures and the major headwinds of rising interest charges and, in the medium run, slower GDP growth. Whether the US manages to bring its public finances under control also matters for the rest of the world, given the central role of the US Treasury market and the US dollar in the global financial system
The debate on monetary sovereignty in emerging countries is resurfacing with, on the one hand, the plan of Argentinian President Javier Milei to dollarise his economy, and on the other, the temptation of several West African country leaders to abandon the CFA franc. The abandonment of the CFA franc with the aim of recovering the flexibility of an unpegged exchange rate regime and greater autonomy of monetary policy, is an argument that is either weak in theory or unconvincing in practice.
Downward pressure on Asian currencies increased slightly last week, with the geopolitical and monetary climate becoming less favourable. This recent pressure has been fuelled by fears of rising international oil prices as a result of the conflict in the Middle East, on the one hand, and the shifting stance of the US Federal Reserve on the other. However, the Indian rupee has held up better than other Asian currencies so far.
Historically there is a very close correlation between changes in US Treasury yields and German Bund yields. This is relevant at the current juncture, considering that the recent hawkish twist in the tone of the Federal Reserve might continue to push US long-term interest rates higher and put upward pressure on bond yields in the Eurozone. However, since the start of the year, the increase in Bund yields is lower than expected based on the past statistical relationship. This probably reflects a conviction by investors that the ECB will start cutting its policy rate earlier than the Federal Reserve. This monetary desynchronisation is linked to a notable difference in terms of inflation with the US
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.
2024 should be the year of the start of the easing cycle by the Federal Reserve, the ECB, and the Bank of England, primarily to accompany the easing of inflation. However, the timing of the first cut remains uncertain, as does the number of expected cuts. Conditions for a first rate cut in June seem to be in place for the ECB, which, according to our forecasts, would thus act before the Fed, whose first rate cut is expected in July (instead of June previously). The possibility is rising that the Fed will not cut rates at all this year because of the resilience of growth and inflation. Such a prolonged Fed monetary status quo could have more negative than positive consequences.
US inflation March figure, again higher than expected, put an end to our scenario of a simultaneous first rate cut by the Fed, the ECB, and the BoE in June. We now expect only two rate cuts by the Fed this year, the first in July and the second one in December. The possibility is even rising that the Fed will not cut rates at all this year. On the ECB’s side, we maintain our expectation that the first cut will occur in June, but we have ruled out our back-to-back cuts forecast (i.e. June, July and September), favouring a more gradual easing of one cut per quarter (in June, September and December). The ECB would end up cutting rates before the Fed.
GDP growth, inflation, exchange and interest rates.
The Federal Reserve releases the Summary of Economic Projections (SEP) following the last meeting of the quarter. These forecasts are closely scrutinized as they include the “dot plots”, i.e. the median trajectory of the medium-term policy rate by the members of the Committee. The Q4 2023 projections included three rate cuts (of 25 bps each) in 2024, for a rate target of 4.6% at year-end. At the same time, the Fed Chair, Jerome Powell, noted progress on the inflation front (CPI at +3.2% y/y in Q4 2023, v. +7.1% y/y a year earlier), but refused to declare victory.
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
GDP growth, inflation, exchange and interest rates
Recent communication by the Federal Reserve and the ECB has made it clear that the first cut in official interest rates is coming. Both central banks are saying the same -it depends on the data- but the ECB communication is more opaque than that of the Federal Reserve, which provides interest rate projections of the FOMC members (dot plot). In assessing how fast and how much the ECB might cut policy rates in this cycle, several approaches can be adopted. Based on the credibility of the ECB and plausible estimates of the neutral rate, it makes sense to use an assumption of a range between 2.00% and 2.50% for the ECB deposit rate as the end point of the easing cycle.
In the US, the latest Survey of Professional Forecasters (SPF) of the Federal Reserve Bank of Philadelphia paints a rather upbeat picture of the economic outlook. A similar survey of the ECB points towards a gradual pickup in growth this year. In both cases, the level of disagreement is low. This provides reasons to be hopeful about the economic outlook. However, the alternative scenarios are predominantly negative for growth and inflation, and some have totally different implications for the evolution of bond yields. This would mean that as time goes by and the likelihood of the different alternative scenarios evolves, bond yield volatility could be high.
GDP growth, inflation, interest and exchange rates.
There is a broad consensus amongst forecasters that Eurozone quarterly growth in real GDP will gradually pick up over the year on the back of a further decline of inflation, cuts in official interest rates, investments in the energy transition and those related to NextGeneration EU. Foreign trade may also play a role. Survey data of the European Commission and S&P Global have improved since the autumn of last year but their level remains below the historical average. Based on historical relationships, their positive momentum -recent observations are better than those 3 months ago- increases the likelihood that GDP growth in the first quarter will be better than in the final quarter of 2023.
After a short respite in December, uncertainty about US economic policy, based on media coverage, rose again in January. This resurgence in uncertainty was likely caused by the latest US inflation figures, which proved more persistent than expected: it remained above 3% in January (3.1% year-on-year, according to the BLS Consumer Price Index) and turned out to be higher than consensus expectations (2.9%). During its mid-December meeting, the Federal Open Market Committee (FOMC) made it clear that it would not be appropriate to cut rates in the absence of certainty as to whether inflation was on a sustainable downward path towards its 2% target.
Monetary and exchange rate conditions in emerging economies are more favourable in this early part of the year than they were at the end of 2022 and beginning of 2023. The relaxation of monetary policies made possible by lower inflation and upward revisions of economic growth forecasts has attracted portfolio investment. Despite the increase in geopolitical risk, sovereign risk is likely to reduce except for the most fragile countries, which were already under pressure in 2023. For low-income countries, 2024 will be a high-risk year as governments’ external debt repayments will remain very heavy, just as they were in 2023.
Against a backdrop of rising regional geopolitical pressures, the economic crisis is deepening further in Egypt and now poses a threat to public finances. With no agreement reached with the IMF, the balance of payments crisis is continuing to unfold, and the adjustments needed are being postponed. As a result of the exchange rate depreciating and interest rates rocketing, this crisis has pushed the interest burden on government debt to a level that could quickly become unsustainable. As a matter of fact, it could hit 70% of government revenue this year and remain very high next year
