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Central banks and governments are on autopilot. If this statement surprises you, it shouldn’t. Market participants have become accustomed to the communication drills on both sides of the monetary and fiscal isle. This notwithstanding, the quality of the US response handsomely beats European policies.
Everyone should well understand, by now, the incapacity of central banks to address supply-side malfunctioning. The inflation overshoot will take US policy rates well above neutral. The market expects and pencils in a terminal rate around 3.75% by Q1 2023. Fair enough. The 2-year US Treasury rate at 3.4% provides decent bond-technical protection as the FED tightens policy over a one-year horizon. The drop from near 5% market-based two-year inflation expectations on March 25 to 2.75% last Friday speaks volumes. Even as the narrative in the financial press calls for inflation unanchoring, the signal from short, medium and long-term US inflation expectations is not alarming. US bond markets are getting comfortable and accustomed to a flat yield curve with some inversion at the shorter end, given credible FED policy. The brief and unambiguous message from chair Powell last Friday in Jackson Hole might lower negative or upside US rate volatility into year-end. The US FED’s sole focus is on breaking the inflation trend and it counts on an accelerated return towards target. As financial conditions for households (and to a lesser extent companies) tighten, an aggregate demand slow-down becomes base case. Moreover, a labour market cool-down is hoped for sooner than later. The fear of second-round wage-inflation pressures requires job openings to retreat or, cynically, for companies to start reducing headcount. The former, less skill mismatch, can go along with an unemployment rate that fluctuates around a low 4% versus 3.6% today. Such a scenario would see the terminal rate stable for longer. The latter scenario, companies actively laying off people, carries a lower probability, as companies do fear a higher rehiring cost next to longer lead times in seeking replacement workers once the cycle becomes more promising. Such a scenario would entail a return towards 5% or 6% unemployment, triggering policy rate cuts.
Expect US fiscal policy to remain supportive over the last two years of the Biden administration. During August, the US executive passed two strategic pieces of legislation. The signing of the executive order to implement the CHIPS and Science Act 2022 (a USD 50 billion package supporting the US-based semi-conductor sector) next to the Inflation Reduction Act does reflect an engaged (even bipartisan) executive. The Inflation Reduction Act of 2022 (IRA) aims to curb inflation by reducing the deficit, lowering prescription drug prices, and investing into domestic energy production while promoting clean energy. The IRA is ground-breaking, as it addresses both inequality (no tax impact for lower- and middle-class incomes), whilst simultaneously promoting an energy transition to fight climate change. If one should have to score US monetary and fiscal policy, they get away with a solid A. Over the first half of 2022, US equity markets got rid of the valuation froth accumulated over 2021. The second half will further separate the wheat from the chaff. Old (predictable and profitable) technology leaders will behave resiliently against (unproven) new technology companies (less visibility and less or not profitable) that require further rerating. The soft versus hard landing debate will become less important in retrospect as monetary and fiscal policy has taken back control.
When we gauge the monetary and fiscal challenges that Europe faces, we are left with a lack of visibility and predictability. The outlook is sobering. Indeed, the complexity that the ECB is facing gets worse by the quarter. With the announcement on July 21 of the TPI, Transmission Protection Instrument, the toolkit got bigger. The TPI aims to improve the effective transmission of monetary policy across the soon-to-be 20-member club, with Croatia joining on January 1, 2023. The difference with the FED is stark. The ECB tries to improve the monetary transmission mechanism. You can read this as follows: “If the ECB makes a policy mistake in the tightening pace, in order to deliver on its main mandate trying to bring inflation back to 2.00%, there is a genuine risk of blowing up the EMU construct”. That is what happens when transmission mechanisms fail. A similar visit to 2-year inflation expectations sees Germany at 7.07%, France at 4.92% and Italy at 4.41%…fragmentation is present in short-term inflation expectations. 5-year and 10-year inflation expectations across the above leading EMU economies are more aligned around 3.00% and 2.50% respectively. A small silver lining. Expect the ECB to opt for a careful tightening path. The well-flagged September 8 50bp policy rate hike is base case. Expect further adjustments of 25bp to reach 1.25% over Q1 2023. The market has pencilled in this ECB reaction function. The current fragmentation is built on that premise as well. The main 10-year German Bund – Italian BTP spread closed at 2.30% on Friday. The lack of knowledge and details on trigger points or trigger events embedded within the TPI instrument should deter speculative behaviour against Italian rates and provide enough comfort to institutional investor to remain neutral on Italian government bond positions.
That leaves everyone focused on the path of the European energy crisis. A self-sufficient USA is well isolated in that respect. The European winter heating season starts on October 1. The EU will need to refill its gas storage facilities to above 90% of their capacity to get through the winter. The immediate action is to limit gas consumption today and store saved gas. The International Energy Agency called for a harmonised introduction of the following initiatives:
The nature of the REPowerEU Plan is geared too much towards long-term ambitions. It lacks immediate impact across companies and households that will face hardship over the next 6 months. The EU commission should apply direct measures of use across Eurozone members.
In the meantime, gas price dislocation takes center stage today and makes for scary news headlines. It is not only spot 1-month gas prices that are reaching new highs. The complete gas curve over 2023 and beyond is adjusting higher. The way forward is an accelerated substitution away from (Russian) gas towards other sources of energy. Substitution works. If we extrapolate the 1-month Dutch natural gas contract at EUR 307 per megawatt hour to the crude oil brent front contract, we arrive at a price around EUR 392 …Brent closed at USD 101 Friday. The current set of cards clearly reads that the impact on EU growth will be higher compared to the USA. That reality also predicts that proof of business cycle recovery from the tightening of monetary policy will appear first in the US.
The US-EU monetary and fiscal policy divergences will increase over the next 6 to 12 months. The EURUSD downward trend will not reverse anytime soon.