Risk Gets Relief from Fed, ECB + BoE Previewed

Fed Boosts Stocks, Dollar Dips, Gold Rises 

Stocks rallied, the dollar fell to a new low, and gold jumped as US front end rates tumbled after the Federal Reserve appeared to give a more cautiously optimistic outlook. The S&P 500 rallied more than 1%, the Nasdaq jumped 2% and the 2yr Treasury note yield fell to a two-week low. European stocks rose in early trade following the decision but with the European Central Bank and Bank of England later there is no let up. Meta shares leapt in the after-market trade by 20% after earnings beat expectations. 

The Fed hiked 25bp as expected, with chair Jay Powell saying "it would be... very premature to declare victory" on inflation but that "the disinflationary process has started".  

Mixed Fed Signals Keep Markets Guessing 

Truth be told there were mixed signals from the Fed statement. It kept the "ongoing increases" language, added inflation "has eased somewhat", and changed "pace" of future increases with "extent", as it transitions from rate of hikes to duration. That’s the old Waller comment again – pay attention to the end point. Powell also mentioned “a couple more rate hikes”, which gave a bit more detail around the end point – question is whether this is in fact the end point and how long it stays there.  

Powell said that since December they’d covered a lot of ground and financial conditions have tightened “very significantly over the last year” ...but still said a lot of work to do. I find the lack of push back on financial conditions odd. The easing in recent months has been clear and in Dec the Fed seemed keener to push back. Perhaps it’s not that bothered as long as it keeps seeing core inflation come down, but it was odd that journalists in the press conference did not take him to task on those comments. 

The focus on disinflation and easing in financial conditions was noteworthy – he was not pushing back against the recent easing in financial conditions. Powell also focused on 3-month core PCE being ‘quite low now’. And he was apt to point out that the market is still wrong to call for rate cuts this year. "Given our outlook, I don’t see us cutting rates this year, if our outlook comes true".  

I think bulls were too keen to read what the wanted from the comments around disinflation and tighter financial conditions and chose to ignore the fact that the Fed signalled it’s keeping going for now. What matters now is the data - I think we switch now to a more data-dependent Fed henceforth, which is why I think it will keep tightening. The Fed may have declared victory too early and will see wages and inflation accelerate again.  

ECB Not Done Hiking 

A 50bps hike seems like a done deal. The question is whether Christine Lagarde guides for another 50bps in March, and what the market thinks the upcoming staff forecasts – also due March – will mean for the future path of rates. Data out Tuesday merely confirmed 50bps is a certainty as French inflation rose to 6.0% from 5.9% in December. The harmonized index which the ECB looks at rose to 7% from 6.7%.  

And on Wednesday we had some very interesting figures that point to persistent and broadening inflation that does not depend on the energy shock. Eurostat’s flash index showed CPI inflation at 8.5% in January, well down on the 9.2% in December and significantly below market expectations. It marked a sharp deceleration from the record high 10.6% in October. However, core inflation remained unmoved at the all-time high of 5.2%. The ECB will want to see much more evidence of cooling in core inflation before it pauses.  

Lagarde has been pretty steady in her remarks since December, when she outlined 100bps of hikes through to March. There seems little to suggest she would deviate from this, and the GC seems largely on board with the need to hike the front end.   

Where there is doubt is further out along the yield curve (the belly) and this will depend on what the market thinks the ECB will say in its staff forecasts in March.  

Lagarde could surprise to the hawkish side with a firm commitment to another 50bps in March and suggest that there will be further hikes required thereafter, pushing back against rate cut speculation and notion that peak is near.   

Any changes to the statement released ahead of the press conference will hold clues. In its December statement the ECB said interest rates would “still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target”. This was a step-change from the “substantial progress” hailed in the October statement. Lagarde went further in the press conference, effectively outlining at least another 100bps of hikes by March.   

On APP, the base case would be for guidance to be unchanged with the GC aiming to end APP by the end of the year.   

What does it mean for EURUSD? Well, the market seems to have accepted 100bps through to March and this is what’s driven the euro higher. But it’s also Fed week and there is scope for a hawkish surprise from the US central bank.   

As ever, we cannot rule out communication errors from Christine Lagarde. Some of the messaging has been mixed of late and markets may prefer to bet on what’s happening later this year and ignore another 50bps hike in March.   

ECB TLDR  

Base case – with no staff forecasts, I’d anticipate no changes to growth/inflation outlooks, a 50bps hike + indication very likely to do similar in March. QT nod with APP ending this year.  

Hawkish – Lagarde could warn on inflation persistence, sticking firmly to 50bps in March and hinting at more hikes required beyond then.  

Dovish – Inflation slowing/growth contracting more than thought, 50bps but not committed to another, could slow to 25bps in March and stop.   

Bank of England: do the doves change tune?  

Inflation is not coming down fast enough, and the Bank of England is likely to respond with a 50bps hike. Whilst in December the Bank hinted at slowing to 25bps, wage pressures are elevated and inflation is sticky.   

Another split vote seems likely as we continue to see genuine disagreement between members of the Monetary Policy Committee. But the BoE looks likely to prefer to raise rates by 50bps and signal is not done yet. My sense is that the Bank will be able to sound a little more optimistic on the economy given the decline in energy prices and the market pricing for rate hikes; whatever the IMF thinks. But more optimism on the economy doesn’t tame inflation – this goes to the heart of the conundrum facing central banks right now – as soon as they lift their foot off the brake pedal the inflation engine runs away from them.  

As per the ECB, a lot of the market moves we will see will be less about the front end and the immediate hiking cycle, but whether the BoE starts to shift its medium-term inflation outlook on rising wages and more persistent price pressures. That might signal a more hawkish BoE stance longer term.   

If forecasts for constant rate inflation are close to 2%, then the Bank is close to the peak – maybe one more 25bps hike in March. This would take the Bank rate (assuming 50bps today) to 4.25%. Governor Bailey has said that market pricing for the terminal rate around 4.4% was correct. What is less well understood is the extent to which structural labour market tightness pushes up longer-term forecasts for inflation, which would force the Bank into a more hawkish pose.  

BoE TLDR  

Base case - 50bps hike, but a split vote. Reiterates that market pricing is about right and there will be another hike to come. Growth a little better, sees inflation coming down to 2% in the medium term. 

Hawkish – Doves change tune, strongly hints at another 50bps in March, wages drive inflation forecasts higher further out along the time horizon  

Dovish – Still downbeat on growth, thinks inflation is coming down, signals caution about impact of rate hikes on the economy, suggests markets are overpricing tightening.