Last week, we discussed the continued focus of Developed Markets Central Banks on the prospect of continued above trend inflation, how we feel that the downside risks to both growth and inflation are understated by the Fed and markets, and more broadly, how the recent events in the banking sector are likely to add to the monetary tightening required to restrain such inflation. We also highlighted our view that there is likely too much emphasis on the relative evolution of prices, fiscal impulse, and financial conditions and not enough on the absolute level of prices, interest rates and even taxes.

While it remains unclear what the magnitude of the banking sector concerns will be on the real economy, it is clear that the seriousness of the issue (and the remaining opacity over federal deposit guarantee) likely leads to a new wave of bank or asset regulation, and or tighter banking discipline (internally or externally driven), and thus slower credit creation and slower growth over coming quarters.

By extension, markets will need to consider how the tighter credit standards will restrict growth, how will it limit inflation by reducing the money supply and the financial multiplier, and ultimately how will the events, in conjunction with the absolute level of prices, interest rates and taxes, impact the most influential factor for consumer demand – confidence – especially when set against falling asset prices (equities last year and housing now).

Ultimately, this is the non-linear downside risk factor that we have been discussing for the past couple of months. Indeed, in discussion with DB US economics this week, they highlighted a further two points to such downside risks to consumption through 2023: (i) the prospect for an end to the suspension of student debt repayments in the US and (ii) the debt ceiling debate in the US. Both are likely to be contractionary for spending at the consumer and local government levels, and thus a further downside risk for demand and for inflation... and for policy.

This week, ahead of the long Easter weekend, we have seen a couple of events that are relevant to this discussion.

Firstly, on the monetary policy front. The RBA held the OCR unchanged at 3.60% this week, against a market that was almost evenly split between zero and +25bps. What is perhaps the most interesting part of the RBA decision process, appears to be the emphasis of downside risks to growth over the continued above trend inflation and tight labour market. The RBA stated that it sees “evidence of substantial slowing in household spending”, despite “wages growth continuing to increase” and a “very tight” labour market. Australia also has a very elevated (interest rate sensitive) property market, which in itself, likely explains the RBA’s desire for “time to assess the state of the economy”.

However, while the RBA paused policy on the basis of greater caution in relation to growth risks, given a restrictive policy setting and the yet to be felt impact of past cumulative rate hikes, the RBNZ surprised markets with a 50bp rate hike, taking its OCR to 5.25% - - despite the sharp downside surprise to Q4’22 GDP -- as it focussed its attentions of recent stubborn inflation pressure. Despite this, the yield curve flattened further as markets doubt the ability of the RBNZ to maintain higher rates.

In Europe, the RBA narrative was echoed by an MPC external member Silvana Tenreyro, who this week stated that “looser monetary policy [is] needed” to meet the BoE CPI goal and that “high rates now will lead to a faster reversal”. We have discussed our views in previous pieces - that the BoE inflation projections forecast inflation at just 0.37% at the forecast horizon - a level that would imply significant rate cut expectations, not the continued hikes that the market expects. We are firmly in the Tenreyro camp (and not just for the UK).

Interestingly, the Reserve Bank of India reached a similar conclusion, as it paused its rate hikes (or withdrawal of accommodation as the RBI prefers to describe it) as the “global economy sees renewed turbulence” and “unprecedented uncertainty in geopolitics”. Essentially, the RBI pause is focussed on the “need to evaluate the cumulative impact of past rate hikes”. And while the Governor of the Reserve Bank of India stated that the move was a “pause and not a pivot” we believe that inflation is driven predominantly by global factors, and there are some emerging global themes in its evolution - lower.

Secondly, we have had some very interesting data from the US this week: (i) JOLTS job openings came in significantly lower than expected, with downward revisions to previous months - suggesting that the tightness in the labour market may be easing (likely from both supply and demand sides), (ii) a lower than expected ADP payroll print suggests there may be some downside risk to the NFP print on Good Friday and (iii) Services ISM data this week suggests that we may be seeing some slowing in the service sector. Sub-indices for new orders and prices were particularly soft, with disappointing momentum drop in the employment component also.

Taken together, this week’s data appears to be more in keeping with our structural macroeconomic views. Essentially, the absolute level of rates, prices and even taxes are likely to weigh on consumption, and by extension prices (perhaps fairly rapidly), over the rest of the year, and that ultimately policy has done enough. In short, we would be more in the Tenreyro, RBA, RBI camp.

What is perhaps more interesting going forward is how the market interprets the slowing of growth and inflation in the US - a more sustainable rebalancing of demands and supply or something more sinister or recessionary. From our perspective, we would err towards the former. Output gaps are still negative, there is significant room for monetary policy easing to counteract the demand decline as inflation normalises and pricing of risk assets is not stretched.

As growth slows, it is possible that we encounter periods where slowing US growth will be seen by markets as a risk off backdrop, and thus supportive of the USD. From our perspective, however, overvaluation and continued narrowing of rate differentials can continue to weigh on the USD - particularly relative to EUR and JPY. Risk assets - notably tech stocks (long duration) should be supported by the repricing lower of rate curves and notably also by a declining USD.

As far as rate hikes are concerned, we continue to be of the view - to paraphrase Queen - that while the dominant narrative from central banks is ‘don’t stop me now’ further rate hikes set policy on a ‘collision course’ and the cumulative impact of past rate hikes and falling inflation push real rates beyond sufficiently restrictive. For us this means that ‘defying the laws of gravity’ on rates is likely a very temporary phenomenon.