“And I’m joining up the dots“
Little Things, One Direction
Last week, we further discussed our long-held disagreement with the market extrapolation of both US growth and European weakness (US exceptionalism) ‘Convergence not divergence: A Growing Asymmetry'. Arguing that nominal growth rates in the US are not nearly as impressive when considering the recent productivity and migration gains, pushing up the equilibria. This concept has been inferred by Fed Chair Powell in recent press conferences where he coined the phrase ‘bigger, not tighter’ about the relationship between higher-than-expected growth outcomes without a change in the monetary stance - a demonstration of the asymmetric monetary policy reaction function in the US with interest rates “well into restrictive territory”.
Last week we also discussed the evolution of that reaction function with the May FOMC meeting. We argued that going into the FOMC meeting, there was a clear concern (or view) from markets that there would be a shift in the symmetry of the policy reaction function from the Fed following a series of higher inflation and (in some data series’) growth readings. Indeed, interest rate options markets were pricing an effective (approximate) 30% rate hike probability.
This concern proved misplaced, as Powell offered a more balanced narrative, pushing back against the prospect of a rate hike and retaining a disinflationary view through the remainder of the year as “over time policy will be sufficiently restrictive”.
The weaker-than-expected April Employment report at the end of last week all but eradicated rate hike pricing and brought the US rate pricing back into better balance with the rest of the developed markets - convergence, not divergence.
The Lady is for turning
This week, the Bank of England was in the spotlight. Having announced an unchanged policy rate at 5.25%, Governor Bailey began the press conference with the statement that monetary policy is working. However, while global inflation shocks are fading, we are not yet at the point of cutting the base rate. However, from our perspective, this week’s BoE meeting is a clear milestone for the policy trajectory.
The key evolution was the downward revision of the inflation projections across the forecast horizon. With the projections - conditioned on the market-implied rate path - lowered to 1.9% in Q2 ‘26 and just 1.6% in Q2 ‘27. Such a significant downside miss at the forecast horizon is a clear dovish signal for policy. A point emphasised by Governor Bailey in the press conference where he stated that ”rates may fall more sharply than markets expect”.
The case for dissent
Also notable at the May meeting was the dissent of Sir Dave Ramsden, who joined Swati Dhingra in voting for a 25bp rate cut, arguing “Bank Rate needed to become less restrictive now to enable a smooth and gradual transition in the policy stance, and to account for lags in transmission.” and perhaps more pertinently “As the outlook for demand remained subdued, with vacancies continuing to fall and nominal pay growth easing, the risks to inflation returning sustainably to the target in the medium term were to the downside.”
Indeed, the MPR also included a more negative growth narrative - corroborating our long-held view that the UK economy has been significantly weaker than the headline data has suggested for some time now. Perhaps troublingly, the Agents’ update on business conditions (Box E in the MPR) states “Contacts have been surprised by the weakness in consumer spending on goods and services in 2024 Q1 and are revising down their expectations of growth for 2024.Subdued consumer demand is widespread across the retail and service sectors….there is also a sense that underlying demand has weakened, although contacts are unsure as to the reason.”
June Cut: N’est Pas Fait Accompli?
Bailey was clear that the evolution of the data since the last Monetary Policy Report (MPR) in February was broadly in line (with expectations Q4’23 GDP was a little weaker than the Bank expected but the Q1’24 reading a little better), and so too inflation. However, Bailey was clear that the Bank still seek ‘more’ data to help provide sufficient confidence for a withdrawal of restrictiveness. In this regard, direct questions about the likelihood of a cut at the next meeting were met with the response that it is “not ruled out, nor a fait accompli”
Both Bailey and the soon-to-depart Ben Broadbent were very careful not to infer a preference for the date or path of rate cuts - “Bank has no preconceptions about how far or fast to cut but will be driven by evidence at each meeting”.
But now, both direction and intent are very clear. Markets are quite split between the prospect of a rate cut at the June meeting (implied by the reference by Bailey to the amount of data between now and June) or at the August meeting, where the MPC decision will be complimented by the updated economic projections of the MPR.
The Long & Short of it
The Bank of England policy meeting this week was a significant milestone - a first step on the path to rate cuts. Indeed, we see continued disinflation and, thus a clearer path to rate cuts across developed markets. Easing labour market pressures and continued supply chain recovery / improvements also contribute to easing price pressures across DM, which despite some idiosyncratic bumps still seem likely to converge to target across all countries. You could say that inflation and policy rates are now more clearly headed in One Direction!
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