“We don’t have a dominant economic view.”
We were struck by Mde. Lagarde’s comment that the downward trajectory for European interest rates was “pretty obvious”. Some of us have spent quite a few years of our lives trading rates, and the trajectory seldom seemed that obvious at the time. The Euro deposit rate was lowered by 25bps, but beyond her statement of the obvious, Lagarde gave precious little you could describe as guidance. We are “data dependent”, which prompted traders to reduce the odds of further cuts at the October meeting.
Is data dependency a good thing? Well, that depends: Mo El Erian took the view that we have “excessive data point dependence”. He inferred this from the extreme volatility of 2-year yields after the CPI data. El Erian rightly suggested the 0.1% miss in core (shelter again!) really wasn’t enough to justify a 20bps swing in 2-year yields. However, he went on to suggest the culprit was the lack of a “dominant economic view” from JPowell. Consider us unconvinced. SOFR pricing is far from suggesting an ambivalent Fed. Rather, the price action is indicative of poor liquidity (hmmmm) and a market which isn’t sure it understands the Fed’s reaction function. Where the ECB prefers to wait for fear inflation might get out of hand, the Fed looks much more concerned that labour market conditions might be rapidly deteriorating and is perfectly happy to ignore the resilience in core inflation readings. It’s not like today’s PPI offered any consolation, but markets managed to look right through it.
Perhaps the Fed’s confidence is misplaced. Perhaps it isn’t. But what seems to be true given the Fed’s recent communications suggests they are happier taking risks with inflation than employment, and that messaging strategy has only challenged short rate pricing in terms of extent rather than direction. We can’t really reverse engineer the Fed’s shift in stance from the data. The closest we can get is to focus on the recent rather sharp deterioration in the Beige Book.
But reaction functions don’t just reflect data: risk preferences are just as important. Dominic Konstam’s observations (which we share) on US inflation, point to the political sensitivity of the surge in inflation even as it wanes. Which brings us to the other big event of the week: the Trump-Harris debate, where the consensus was that Harris had bested Trump. Betting and financial markets seem to confirm a Harris win, and there were other subtle signs. We don’t have a dog in this fight (forgive the terrible pun), but we do recognize the political sensitivity of the economy for a near incumbent. In these circumstances, we would suggest keeping an eye on the Longshoremen’s Union, who have displayed a keen appreciation of tactical opportunities in the past. Would be a shame if anything happened to the Biden administration’s inflation-fighting credentials right now.
