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Still Addicted to Dove

Updated: Jun 27

As widely expected, the FOMC left the policy rate unchanged at the June meeting. Much of the market focus in the communication was on the 2024 dot plot projection. The median expected rate cuts were adjusted from three to one 25 basis point reductions by December. Of course, these projections remain hostage to the incoming data. On that front, the May consumer price index was a genuine dovish surprise. The underlying downside miss on headline and core inflation was an abrupt reversal in the recent super-core (services excluding housing) dynamics. That measure fell slightly on the month for the first time since September 2021. The way price responded to the was impulsive and understandable given the abrupt change in the direction of key measures. The odds of a September rate cut have increased; however, it will remain dependent of the macro news flow on growth, inflation, and employment over the next few months.  


On very short time horizons the Fed’s reaction function and the range of possible outcomes is not linear. Moreover, as we have noted in the past, human beings (including the Fed Committee Members) are not particularly good at non-linear thinking. What really matters for markets is that today’s prevailing bias on the “soft-landing” narrative has probably peaked. That might contribute to a peak in equity prices sometime over the northern hemisphere summer.


From our perch, this cycle has been a series of policy errors. When inflation was staring them in the face in 2021, their informed view was not to think about hiking rates. When inflation set on its largest and potentially structural surge of the last half century, they labelled it transitory and carried on with unholy QE while driving real rates into deep negative territory. When inflation was about to get sticky and re-accelerate, they claimed victory in the December 2023 dovish pivot. The Federal Reserve seems to be hanging on the asymmetric directive that they are not going to hike rates further in this cycle. Rather, they still expect to cut rates, but are going to wait for the data. To be fair, the recent data have been more favourable as noted above.  


Looking beyond the near-term reaction function, a key big picture question is on the neutral rate. Former New York Fed President Bill Dudley noted earlier last week that the neutral rate might be closer to 5%. That would suggest policy is only modestly restrictive at current levels. The policy rate has only recently matched nominal GDP (chart 1). Moreover, broad financial conditions also suggest that policy is not particularly restrictive.


Chart 1

Historically central banks have been willing to ease policy rates with inflation above target if growth indicators are falling. However, for now, inflation remains above target and growth conditions remain resilient. Indeed, equity prices and corporate earnings revisions are even consistent with a reacceleration in growth momentum back toward expansion. Irresponsibly loose fiscal conditions might become even more accommodative following the US election in November. If that occurs the path of future short rates and long end yields might still be higher, not lower, despite the positive shift in the May inflation data. In that context, equity, credit risk premiums and implied volatility is probably too narrow. Our other fear is that a higher path for interest rates will amplify pressure in commercial real estate and private assets where there have been visible signs of funding stress.


Rather than concentrate on the linguistics of the short- and long-term projections on what the Fed might do, we prefer to focus on where we are compensated to take risk. Given the news flow on growth, the labour market and inflation, odds are that the path of rates is likely to remain higher-for-longer. It is still plausible that the Fed might even need to hike rates further in this cycle. In that context, the equity, credit risk premium is inadequate and implied volatility is too low. A higher path for short rates will also likely reinforce dollar strength and remain a challenge for emerging markets.

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