Wording Is Everything

Week Ending 4th November, 2022

Another eventful week in markets dominated by the Fed’s decision on rates but, more importantly, around the wording of their outlook and how they see the current economic and financial climate. The BoE also saw rate hikes by +0.75% to 3.00%, a decision endorsed by all nine voting members. In the markets, Global Equity funds saw inflows of over £17bn with Healthcare, Tech and Consumer Staples as the main beneficiaries. However, Money Market (MM) funds drew in a whopping $66.82bn.

Continue reading for the full weekly update:

US Rate Announcement:

As expected, the Fed raised rates +0.75% setting the target federal funds range between 3.75% and 4.00%. Initially, markets rallied and the US$ fell on the perception this was the start of rate tempering. However, following Powell’s press conference and a closer examination of the wording in his statement, markets reversed. Here are some of the key aspects of the wording (incorporating both the previous as well as the new to form the current text):

• Recent indicators point to modest growth in spending and production.
• Job gains have been robust in recent months and the unemployment rate has remained low.
• Inflation remains elevated reflecting supply/demand imbalances related to the pandemic, higher food/energy and broader price pressures.
• Russia’s war in Ukraine is causing tremendous human and economic hardship. The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity. The Committee is highly attentive to inflation risks.
• The Committee seeks to achieve maximum employment and inflation of 2% over the longer run.
• The Committee anticipates the ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2% over time.
• In determining the pace of future increases the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation and economic and financial developments.
• The Committee will continue reducing its holdings of Treasury securities and agency debt.
• The Committee remains strongly committed to returning inflation to its 2% objective. In assessing the appropriate stance of monetary policy, the Committee will continue to monitor the implications of incoming information for the economic outlook; it would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of its objective.

To paraphrase the above, we believe what Powell is saying is the following:

“Overall, the economy is doing well and continues to grow - albeit more slowly; the risks are largely external but nevertheless serious enough that we need to be mindful of them. With regard to the latter, despite continuing improvements to the supply side, these external risks make inflation-targeting unpredictable as they are beyond our control and, as a result, we need to be flexible on timelines in achieving these objectives. Therefore, while we will continue to reduce the overall balance sheet, we believe the size of the rate hikes we have implemented thus far means we are no longer behind the curve but we will continue to monitor the situation and adjust policy as and when necessary”

It therefore came as quite a surprise to see how severe the market backlash was. The US$ rallied hard while US bond yields soared, especially along the 2y to 10y portion of the curve. Another 100bp (1.00%) from here is in line with the above narrative putting the Fed Funds Rate at between 4.75% and 5.00% by end-2023….but, critically, the Fed will continue to monitor and assess.

US Employment:

October’s nonfarm payrolls grew +261,000, more than expected (forecast: 205,000). September was revised up by +52,000 while August’s was revised down by -23,000. The unemployment rate however rose to 3.7% (from 3.5%) as more people returned to the labour force. Average hourly earnings grew +0.4% m/m to 4.7% y/y. Healthcare led the way with a gain of +53,000. Professional/Technical gained +43,000 while Manufacturing gained +32,000. Leisure/Hospitality grew +35,000.

The unemployment rate that includes discouraged workers and those holding part-time jobs for economic reasons rose a little to 6.8%. Given that every silver cloud has a dark lining (no, you haven’t misread that!), there are some warning signs ahead e.g. Amazon is pausing hiring, Apple is freezing hiring except for R&D, Lyft is cutting 13% of its workforce while Stripe is cutting 14% of its workforce. The latest official September job openings and labour turnover survey (JOLTS) data showed a sharp rebound in job openings to 10.717mn (August was also revised up to 10.28mn).

UK Rate Announcement:

Also as expected, the BoE hiked rates +0.75% to 3.00%. It was a decision endorsed by all nine, voting members though two did note a smaller increase was more appropriate (one indicated +0.50% and another +0.25%). The market-implied path for rates sees it at 5.25% with GDP falling for eight, successive quarters. Interestingly, even with rates left unchanged at today’s 3% level, GDP would still be expected to fall six, successive quarters. How worried should we be? A couple of points worth noting:

• The latest announcement assumes support for energy prices will continue beyond April 2023. We know this is no longer the case – the new Finance Minister made it clear support, for all, will be for six months (i.e. till April 2023) and thereafter it will effectively be means-tested.
• The BoE has not allowed for the impact of budget announcement which has been delayed to 17th November. Granted, it does not have a crystal ball but, nevertheless, they have followed the status quo in their approach and based everything on what has happened before the recent leadership change.

If the implied rate of 5.25% is correct, inflation should be back to 2% by Q2 2024. However, even if were to stay at 3.00%, inflation would still fall to 2.00% but not till 2025. The Governor strongly emphasised he sees the peak rate at nearer 3.00% than the market-implied 5.25%.

In a nutshell, I think the BoE felt it was in a bind. Ideally, it would liked to have seen the budget announcement first to assess what its impact would be on funding requirements and growth prospects for the economy. However, seeing as it was postponed till the 17th of this month, markets might have felt its “independence” had been compromised had it implemented a soft rate hike together with a wait-and-see approach. It had nothing to lose by hiking an aggressive +0.75% now, and then going softly after that – which is effectively what Governor Bailey has hinted at. Political risk premium has been eliminated. It’s now all down to the quality of the budget!

MARKET SUMMARY

For w/e 4th November, global equity funds saw inflows of $13.76bn (US, Europe, Asia at $10.19bn, $2.42bn and $830mn respectively). Healthcare, Tech and Staples were the main beneficiaries. Global bond funds drew in $655mn with High Yield bonds being the biggest ($4.35bn). However, MM funds drew in a walloping $66.82bn.