Market narratives have been shifting rapidly. We have gone from speculation that rate hikes by US Federal Reserve had begun to ‘break’ the financial system, to imminent recession and imminent rate cuts, to a resilient US economy, to weak domestic demand and deflation in China, and slumping growth in the eurozone amid continued central bank policy tightening.
Stubborn services inflation has so far kept central banks from pivoting towards an easier policy stance. With concerns over regional banks having faded, the path for US policy rates has now been revised higher and the Fed has reaffirmed its hiking bias. The European Central Bank (ECB) has stated that ‘there is more work to do’. The Bank of England (BoE) has felt it has had to take tough measures.
The question of where policy rates might peak remains unresolved – but it is clear to us that all the major central banks will likely be taking rates higher than had been anticipated a few weeks ago.
Despite the resilience of US economic growth, there are reasons to be cautious about the outlook. Regional banks still face a rise in the cost of funding that will hit earnings. Higher deposit rates, required to prevent outflows to money market funds or Treasury bills, will severely constrain regional bank earnings, and reduce their capacity to provide credit to small businesses and commercial real estate.
This contraction in credit will be a significant headwind to growth and commercial real estate asset performance, and we will need to closely monitor the quarterly Senior Loan Officers’ Survey and small business surveys for the impact on credit conditions, and pass-through to the real economy.
The economy has been supported by strong household spending resulting from rapid growth in earned incomes (in a hot labour market) and the tapping of excess savings. Growth has likely also been supported by the passing of legislation that have incentivised a surge in business investment in key technologies, clean energy and infrastructure.
Simultaneously, Treasury tax receipts – a real-time measure of activity – have slowed. Business confidence surveys have slid lower – with the manufacturing index in contraction territory (see Exhibit 1). Services are operating near trend. We conclude the much-anticipated recession has not yet arrived.
Since the Fed is trying to constrain demand, it is natural to focus on interest-rate-sensitive sectors. Looking at the US residential construction sector, it is notable that both homebuilder sentiment and construction activity continued to improve in the second quarter. The reluctance of many homeowners to move and abandon their low-rate mortgages has seemingly sharply reduced existing home transaction volumes, and hence the supply that would come from households that are downsizing.
Limited supply and rising household (nominal) incomes have thus pushed prices back up, triggering a revival in new construction. There are also indications that new lease rent growth may correspondingly be reaccelerating, with implications for inflation.
The resilience of US housing to higher mortgage rates demonstrates that monetary policy transmission may be more limited when higher policy rates are applied to a fixed-rate mortgage market that has recently gone through a refinancing wave.
The labour market suggests that output has not yet slowed sufficiently. Employment gains remained robust in the second quarter. The prime-age labour force participation rate rose to above the pre-pandemic peak of 83.1%, and payrolls increased by a monthly average of 244 000 (to June) – well above the theoretical 100 000 needed to absorb population growth (see Exhibit 2).
Nevertheless, there have been signs of tentative easing in labour market strain. For example, average hourly earnings and the Atlanta Fed wage tracker appear to have peaked. Indicators suggest that even though the pace of hiring has remained robust, the labour market is slowly rebalancing.
A key question for both investors and policymakers is whether wages can really normalise via a reduction in openings alone, or whether a rise in unemployment will be necessary to sufficiently cool wage pressures. This will determine how far and for how long the Fed will need to tighten policy.
Our view is that some proportion of the rebalancing can occur without raising unemployment, but ultimately the unemployment rate will need to rise to bring wage growth to a level compatible with the inflation target.
On the inflation front, shelter costs finally showed signs of moderation as price gains on new leases slowed. But the non-shelter services ‘supercore’ measure – which is driven by wages and is the focus of the Fed’s attention – remained at levels inconsistent with the Fed’s 2% inflation target.
Over coming months, we anticipate there will be further softening in core non-shelter services (some pullback in items such as hotels, auto repair and auto insurance. Eventually, this means we will see a retreat in core and supercore PCE – allowing the Fed to pause its hiking cycle (see Exhibit 3).
Mortgage-backed security (MBS) index performance has been strong of late thanks to improved investor demand, falling volatility and limited new origination supply (an anaemic USD 2 billion per day).
Despite the recent tightening, current coupon spreads still look attractive to us. Prepayments have been well-behaved as refinancing activity is virtually non-existent. Housing turnover has been subdued due to lock-in effects stemming from high origination rates, high home prices, and limited homes available for sale.
Fixed income fund flows have been positive, and the supply/demand dynamic is a positive tailwind for MBS that could lead to a further rotation from money managers into MBS out of credit sectors as tighter financial conditions cool the economy. The challenges for the sector have been limited bank demand, the further inversion in the yield curve and still high volatility, even as this has declined.
Economic data continues to paint a mixed picture, which both limits our conviction and leads to rapid shifts in market narratives. However, everything pivots around the answers to two key questions:
- Is labour market rebalancing possible without a significant rise in the unemployment rate?
- Is the US economy proving to be less responsive to monetary tightening than anticipated?
To the first question, we acknowledge that wage gains and other signs of labour market strain have eased over the last year, without the unemployment rate having risen. However, there is a limit to how far this can go: On the supply side, labour force participation among prime-age workers probably has little room left to rise, and on the demand side, employers will at some point be looking to fire workers in addition to closing unfilled positions.
Hence, we remain of the view that some period of below-trend growth and an accompanying rise in unemployment will be needed to bring wage growth closer to 3.5%.
On the second question, the answer has to be ‘yes’. The Fed has tightened monetary policy at a rate unprecedented since the early 1980s. But the headline economic activity numbers on spending and hiring are yet to show much evidence of a slowdown. Most notably, the jobs market is still strong and the number of unfilled vacancies is large. While there are pockets of weakness, they do not suggest the economy is about to tip into a major slowdown in the next six months given the resilience of most of the services sector.
One possible explanation for the surprising buoyancy of the economy is the buffers built up in the corporate and household sectors during the pandemic, coupled to an almost unprecedented federal fiscal deficit for a period of full employment. However, these buffers won’t last, so we expect growth and hiring to slow. While we are expecting stagnation, recession is not completely off the table.
The implication is that the central bank will need to maintain restrictive policy for longer to achieve the effect it wants. This means rates will probably not be much higher because leading indicators show a moderation in growth is coming, supercore inflation is no longer rising, and the labour market is indicating some rebalancing.
Additionally, we are mindful that the student loan moratorium is set to expire in October, which could put additional strain on household finances.
To fully return inflation to target, we think the Fed will need to raise rates at least once more in July to 5.25-5.50%, and then keep rates on hold until the third quarter of 2024. By then, there should be sufficient evidence that supercore PCE inflation is declining amid a mild recession, permitting the Fed to begin gently lowering rates. By the end of 2024, the rate is likely to still be at around 4.50-4.75%. By the end of 2025, the fed funds rate could be at 3.00-3.25%, which we consider to be broadly neutral.
The eurozone is in a technical recession, although the mild contraction is a sign of resilience in the face of an energy shock, high inflation and tightening monetary policy. Looking ahead, headwinds from the energy shock should ease further thanks to the decline in energy prices, high natural gas storage levels, and the associated moderation in inflation amid a strong labour market. However, the manufacturing sector remains weak and growth in the services sector seems to be dissipating (see Exhibit 4).
While underlying price pressures remain strong, there are early signs of them levelling off. However, the ‘supercore’ indicator and domestic inflation indicator were still rising in the latest readings. This pointed to the prevalence of persistent domestic price measures, as cost pressures from the energy shock and supply chain bottlenecks receded (see Exhibit 5).
We expect growth to stagnate over the next few quarters after significant monetary policy tightening and the rolling back of fiscal support. Yet, the mild slowdown in demand is unlikely to cause a significant increase in unemployment as structural factors such as demographics and sectoral mismatch will likely keep the labour market tight. This, alongside sticky core inflation, suggests that the ECB will maintain a hawkish bias until more evidence of sustained disinflation emerges.
The impact of the inflationary squeeze on consumers and businesses was not as severe as it could have been. Falling headline inflation, a resilient labour market, and strong nominal wage growth point to increases in households’ real disposable income, which in turn should support consumption.
However, credit conditions in the eurozone had already tightened meaningfully, and the effects of higher interest rates continued to weigh on credit demand from both corporates and households. Business and housing investment will bear the brunt of monetary tightening and that will weigh on economic growth.
We expect fiscal aids to be gradually rolled back and the focus to shift to restoring medium-term fiscal sustainability. That said, public investment expenditures will likely be protected, with contributions from the NextGenerationEU fund and other EU budgets.
We believe the ECB is now in the last stretch of the hiking cycle. Near-term persistence in core price pressures is likely balanced by considerations of cumulative effects of past monetary tightening and rising economic uncertainty. Another 25bp rate hike by the ECB in July is almost certain, and the odds that deposit rate reaches 4.00% by September – the consensus view – are high.
Beyond that, falling headline inflation, tighter financial conditions and declining loan demand imply that policymakers would see the trade-offs between not tightening enough and over-tightening as more balanced.
As headline inflation has peaked, and with the end of this policy tightening cycle in sight, investors may want to reallocate into euro government bonds. The issuance hiatus in euro government bond markets over the summer has typically helped their performance as well.
However, the overall issuance needs from eurozone economies are at historical highs, and continued strength in the labour market and wage inflation also pose upside risks to government bond yields. We expect German 10-year Bund yields to settle at between 2.25% to 3.00% in the coming months. We intend to establish a long duration position should Bund yields reach the higher end of the range.
As for ‘peripheral’ bond spreads, political risk in Italy has receded, and cheap loans and grants from the NextGenerationEU programme should help Italy’s debt sustainability outlook at least in the near term. In the near term, we see no clear catalyst for ‘peripheral’ spreads to widen.
We believe the combination of continued ECB tightening and slower growth will likely bode poorly for euro breakeven inflation rates. We believe the risk of a wage-price spiral is low, and the ECB’s strong focus on real-time inflation outcomes increases the risk of over-tightening as credit conditions tighten.
Headline inflation is expected to fall sharply. Energy prices will continue to detract from headline inflation, given the decline in utility bills set by the price cap in July, and a likely further 5% decline in October. Food inflation has likely peaked, but the path lower could be gradual.
Core goods prices could decline further on the back of plummeting wholesale costs. Core services inflation is unlikely to recede quickly in the near term as upward wage adjustments after rounds of (still ongoing) strikes will take time to show up in the data. However, forward-looking data points to an easing labour market and moderating wage growth.
Interestingly, business and consumer surveys showed falls in inflation expectations despite the rise in realised core inflation, suggesting the risks of a further wage-price spiral may not be as high as feared (see Exhibit 6).
Overall, the strength in wage growth and the slow easing of the labour market is consistent with the expectation that the Bank of England will have to raise rates further to brake harder against inflation.
Growth has been at best flatlining. Manufacturing has remained mired in contraction, growth momentum in services has waned. The pass-through of higher interest rates to the mortgage market has been slow. For households re-fixing their mortgage loans this year and next, the higher cost will weigh heavily on consumption. Business investment will be at risk given the tighter credit conditions.
Wage growth will likely remain strong in the near future, but moderate through the second half of the year as the labour market continues to loosen. Labour inactivity continues to fall as workers re-enter the job market. Vacancies have fallen and the redundancy rate has ticked up, albeit slowly.
On the fiscal side, the government recognises the need for fiscal discipline as well as the danger that any further loosening would probably be met with an adverse market reaction. The long-awaited loosening in policy before the next general election is unlikely to materialise in the near future.
While there is still a chance for Prime Minister Sunak to achieve his goal of halving inflation by the end of the year, the BoE’s work in bringing inflation back to target is not yet over. We see a 50bp move in August followed by a further 25bp hike in September, taking the bank rate to 5.75%.
Given the recent developments in inflation and the labour market, more decisive hikes are urgently warranted to keep the wage-price spiral from worsening further. Further ahead, we believe the BoE could under-deliver versus the 6.2% terminal rate priced by markets at the end of June.