“Ready or not, here I come“
Fugees, Ready or Not
Last week, we discussed the recent important macro developments in the US, from the employment report and JOLTS, to the June FOMC. We outlined our view that the US labour market continues to normalise as the supply and demand shocks attributable to COVID continue to normalise. Indeed, it is notable there has been a narrowing of the jobs gap (the gap between job openings and unemployed workers) to levels equivalent to those before February 2020, such that we can expect to see not only any further weakness in labour demand play out in job losses (higher unemployment rate) but also likely a further weakening in aggregate demand.
The second factor we discussed was the sharper-than-expected decline in the pace of US CPI - the May core CPI rose just 0.16% m/m, the lowest since August 2021 and substantially below expectations. We argued that we see Q1 as the outlier (not the lower May print) and that this more disinflationary view has significant implications for markets and pricing. Lastly, we discussed the FOMC meeting and the updated SEP’s and dots, where we argued that the context of the higher median dot for 2024 is very important (Powell arguing that the decision between one and two cuts in 2024 by many participants was a close call, the fact that the low CPI print was not factored into the projections and the fact that the dots were lowered for both 2025 and 2026) - all skew dovish
Thus, we argued that confidence in the inflation rate not accelerating (i.e. monthly readings of 0.2 or below) will bring rate cuts. Any further weakness in the labour market (the Unemployment Rate has risen 6-tenths from the low point already, and data from the labour market now suggests the jobs workers gap is now back to its pre-covid level), likely brings about earlier and/or more aggressive rate cuts. In short, we maintain our view that the reaction function of the Fed is asymmetrically dovish.
Update from Threadneedle Street
This week, the Bank of England was in focus. The MPC voted (by a 7-2 majority) to leave rates unchanged at 5.25% (As expected), with two members (Dhingra and Ramsden) maintaining their preference for an immediate 25bp rate cut. The Bank stated that while they expect inflation to risemoderately through the remainder of 2024 (due to the positive base effects of energy price declines in H2 2023), CPI fell to its 2.0% target in May from 3.2% in March, and indicators of short term inflation expectations have also continued to moderate, particularly for households.
On the labour market, the Bank highlighted the “considerable uncertainty around estimates derived from the ONS Labour Force Survey means that it is very difficult to gauge the evolution of labour market activity”. The MPC judges that the labour market continues to loosen but remains relatively tight by historical standards, and aggregate pay growth has continued to ease - both factors that we see as facilitating rate cuts as the labour market continues to cool.
Interestingly, on the subject of services inflation, which remains at a level above that projected in the May Monetary Policy Report, the minutes played down services inflation persistence concerns, suggesting “this strength in part reflected prices that are index-linked or regulated, which are typically changed only annually, and volatile components”. This is another very important point as it argues against excess demand for services, keeping prices high and thus policy rates high - another clearly dovish statement.
An August Cut?
Furthermore, the Bank were clear that “the restrictive stance of monetary policy is weighing on activity in the real economy, is leading to a looser labour market and is bearing down on inflationary pressures”. While the narrative around near-term growth was more positive than at the May MPR (estimates for Q2 GDP revised higher to 0.5% from 0.2%), there remain some concerns at the consumer level, noting that retail sales fell sharply in April and that households remained sceptical about making major purchases and instead favoured saving. For us, this remains consistent with (if not yet fully recognising) our view that the consumer, or underlying demand in the UK, is weaker than the headline data suggest, and thus, rate cuts are likely needed sooner.
The two dissenters (Dhingra and Ramsden) held firm in their rate cut view this month, with the dovish tone at the MPC increasing, with the decision not to cut rates being “finely balanced” for ‘some’ further measures. For us, unless there is a concern over the fiscal trajectory of the incoming UK government at the next meeting (August 1st), it is likely that the decision to cut rates is very close - if ‘some’ equates to three members and they are convinced by August, then there is a majority for a cut on the MPC. With only modest changes to the growth trajectory, it is likely that the inflation projections (conditioned on the market rate path) remain significantly below target at the forecast horizon. This, too, continues to argue in favour of rate cuts.
The MPC are now in a blackout until after the election, so markets will have to judge the incoming data for themselves - alongside, of course, the election results.
The Long & Short of it...
Ultimately, the Bank of England is moving more clearly towards a series of rate cuts. Reference to the normalisation of the labour market and underlying factors, other than excess demand driving services inflation are significant dovish iterations from our perspective, and do not yet make reference to the growth weakness that we see more anecdotally in the UK economy. To paraphrase the Fugees - Ready or not, rates cuts are coming, you can't hide. Indeed, the intention will clearly be “to take it slowly” at first… faster, or deeper rate cuts may well prove necessary as we move towards or into 2025.
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