Some months are packed with changes and updates that keep us engaged and intrigued, like April. But then there are months like this May, where things seem a bit quieter, and it’s harder to pinpoint what exactly happened, especially if geopolitics isn’t on our radar. So, pardon the brevity of this update—it’s just one of those quieter months.
United States
The data released pretty much confirmed what was already said in previous updates, and there hasn’t been much going on with narratives either. Quoting AlphaPicks, “Economic data out of the US for May was a touch softer for the labour market, with inflation steady. There are no alarm bells for us either that the economy is underperforming or blowing the top off. So the 31bps worth of cuts (1.5 actual cuts) through to year end seems well priced.”
The main issue I’ve noticed in public discourse about policy is the lack of an invalidation point for theses. Many people persist in promoting their views indefinitely, regardless of the economic data. However, this approach is detrimental not only to market analysis but also to any argument in general. Without an invalidation point, how do you know when you’re wrong? How do you differentiate between being early and simply being wrong?
My thesis for the United States this year has been more or less the same since December: I expect the next monetary policy move to be a cut, with disinflation continuing or stalling, and growth being lower but still positive. The anticipated rate cut is a consequence of disinflation and growth trends rather than a standalone point. While we can debate specifics, such as the timing of a rate cut or the exact year-end inflation forecast, and I actually do that on a daily basis with my models, the thesis outlined as above already provides a robust framework for approaching markets and data.
So far, the data has agreed with my view, but that may change in the future, and being right isn’t the goal anyway. The key point is that I won’t change my view unless there is evidence that contradicts it, which is only feasible because my thesis is well-defined.
Consider a vague thesis like “the US will eventually go into recession.” How would you know when to abandon it? It suggests a general direction for growth but lacks specifics on timing or exact figures. This is the kind of broad view that leads to blowing up your portfolio.
You need an invalidation point—something to signal that you’re not just early, but wrong.
That said, let’s review the various narratives that took place this year so far:
- Inflation reacceleration: While it doesn’t take a PhD in Economics to notice that the decline in YoY inflation measures has pretty much stalled, this doesn’t mean it’s about to reaccelerate. Economic data releases for the past four months have been inconsistent with the reacceleration thesis. This may change in the future, of course, but so far, there’s no reasonable evidence showing we’re about to experience a second wave of inflation. Those pointing to specific commodity futures quotes, such as cocoa, and arguing that inflation is about to reaccelerate because of that, demonstrate a lack of fundamental understanding of how inflation measures are actually computed.
- Fed pivoting to hikes again: This never made sense, to be fair. Let’s consider this: after the hikes of 2022-2023, companies had to do strategic planning around their debt covenants and increase their cash flows by hiking prices and improving cost controls as they faced refinancing events down the line. They had to adapt to a 550bps difference, and the ones who weren’t able to do so have already failed. Now the focus has shifted back to growth. Let’s say that, against all odds, the Fed decides to hike by 50bps this year: the change would be totally inconsequential to the businesses that have already successfully adapted.
- Recession in 2024: Growth is declining but still positive. You may argue that this decline will make growth turn negative, but even if that were the case, you would hardly see a recession with historically low unemployment rates as we’re seeing now. Some accounts on Twitter are pointing to the Sahm rule for individual states to forecast a recession, but there is no point in using local data when your focus is only on the aggregate: indeed, because of the very nature of the United States, you’ll have some states’ growth offsetting others’ declines. Regardless, these same people have forecasted ten out of the last two recessions, so there’s little point in paying them any attention anyway.
- Stagflation in 2024: This is my personal favorite, and I touched this topic in greater detail already in the previous update. For stagflation to happen, you need three things: sluggish growth, high inflation, and high unemployment. You can debate whether growth is low, but we surely have neither high inflation nor high unemployment. The only people still talking unironically about stagflation in the United States are either permabears or people who have no idea what they are talking about. In the first case, regardless of the data, they’ll just believe that either the data is fake or they are very early. In the second case, in the age of unlimited access to information available at our fingertips, there’s really no excuse to be ignorant.
This month, there has also been a lot of talk about whether the Fed is in restrictive territory or not, which, in other words, is a discussion on where R* actually is. This theoretical rate, also known as “neutral”, is the level at which borrowing costs are neither slowing nor stimulating the economy, and Fed officials are having a broader discussion about whether it has risen since 2020 or not. The implication is that if R* actually increased, then interest rates may not be as restrictive as previously thought.
However, while I’m somewhat of an economic nerd myself, I don’t think there is much value in the discussion when it comes to practical applications. Indeed, R* is similar to FX fair value in that it’s more important to determine whether it’s going up or down rather than its actual value. But, at the same time, while you can see it yourself in FX by looking at quotes, for R*, you need to wait months on end. Economists love the concept and rightly so, but for traders, it has little use. The only interesting implication for R* being higher is that the likelihood of seeing rates back at zero is even lower than we could have expected back in 2022.
Federal Reserve
While the last PCE data gave some reassurance to the Fed officials that inflation remains on a downward path, albeit bumpy, it’s very unlikely that they will pivot from the message that they need more evidence. Indeed, as said early this year already (see January’s Portfolio Update), they need reasonable evidence of a sustainable path to target to cut, rather than the target itself: as disinflation seems to have stalled, the waiting period will be longer than originally expected. The market is pricing in the first cut to happen no sooner than September, which in my opinion is fair.
Looking at the minutes, they basically said the same thing, revealing that members think recent data means it would take longer than previously thought to gain further confidence in inflation moving sustainably to 2%. They also suggested the disinflation process could take longer than anticipated.
Regardless, ultimately the Fed will be guided by the evolution of the data, and this takes us back to the dilemma outlined back in December: “This brings us an interesting dilemma. If central banks successfully cut interest rates and achieve a soft landing, it could mark one of the most significant moments in the history of central banking. However, should inflation surge again after the rate cuts, they might be perceived as a joke. Therefore, the pivotal question now is: do they aspire to be heroes, staking their reputation, or do they prefer a cautious approach, risking the possibility of tightening monetary policy too much? This dilemma, I believe, will be the crucial factor to consider while interpreting both economic data and market movements in the first two quarters of next year.”
Let’s say the adverse consequences of its past tightening on employment become abundantly clear by September, and that the Fed did indeed wait too long to ease. In that case, we might expect something like a 25bps cut in September, another 25bps cut in November, and another 25bps cut in December. However, this is not my base case. Regardless, it’s arguably too early to tell. One thing is for sure, though: we won’t see the Fed hiking this year.
Europe
Moving to Europe, the second quarter’s economic strength continues, with new orders growing at a healthy rate and a steady hiring pace by companies, reflecting optimism and increased confidence. Furthermore, inflation for both input and output in the service sector has softened as well this time, which supports the cut by the ECB next week.
In general, the European data this month has been quite positive and suggests that the specter of a recession is behind us. Sure, growth is mainly driven by the service sector, but at the same time, manufacturing acts less and less as a stumbling block for the economy, and optimism about future output has increased further in the sector. If the stars align correctly, maybe the Eurozone will have the first digit of 2024 growth different from zero.
Elsewhere, in the first quarter, wages in the Eurozone saw an increase to 4.69% YoY, up from 4.45%. Following this announcement, an ECB blog indicated that “the rise in wages is part of a multi-year adjustment, and wage pressures are expected to ease in 2024.” From an economic growth standpoint, the GDP grew by 0.3% quarter-over-quarter, and the unemployment rate dropped to a record low of 6.4%.
Among the important things to note about Europe this month is that France has been downgraded to AA- by S&P. The credit agency stated that although reforms and a recovery in economic growth will improve the situation, the deficit will remain above 3% of GDP in 2027, and it also updated its forecasts for debt/GDP to 112% by 2027 (versus 109% forecasted last year).
I believe that this downgrade will have negligible economic effects since the reason was the deficit rather than the debt. Therefore, I don’t think it will affect the currency in the slightest; it may impact the CAC40, but even then, this downgrade was widely expected already.
The real effect will be in the political landscape, as the European Parliament elections are next week, and this news is giving Le Pen a good opportunity to leverage against Macron.
European Central Bank
Next week’s ECB meeting is expected to be a cut—the first cut among major central banks. The market is assigning this outcome a roughly 90% chance, and several speeches by ECB officials have long talked about this. However, while the recent inflation data is promising, it’s likely not enough for the central bank to announce that further rate cuts will follow suit, and therefore I stand by what I’ve said in April: “While the Fed is inclined to follow a scenario where rate cuts are followed by further cuts, the ECB may opt for a different approach, where rate cuts could be followed by periods of pause”.
The central bank diverging its policy from its American counterpart will have interesting implications for the exchange rate, especially if the Fed ends up not cutting at all this year.
Reviewing the ECB’s April meeting minutes, I found that there was little new information. Regarding the economic assessment, members concurred that the data broadly aligned with the medium-term inflation trajectory projected in March, which expects headline inflation to return to target by mid-2025. Economic growth in Q1 was assessed as slightly weaker than expected, but the narrative of an improving growth outlook remained intact. From a policy perspective, it was judged that the most recent data confirmed the continued strong transmission of monetary tightening.
United Kingdom
As expected, the BoE left the interest rates unchanged at 5.25%. In its policy statement, the MPC reiterated guidance stating that “policy needs to remain restrictive for an extended period until the risk of inflation surpassing the 2% target diminishes”. It was further emphasized that the committee will continuously review the duration for which the rate should be held at the current level, suggesting that the policy stance might remain restrictive even if a rate cut were to be implemented.
Regarding progress on inflation, the statement acknowledged the encouraging signs observed in key economic indicators. However, the BoE signaled that it is not yet considering interest rate cuts, expressing a preference for observing more evidence of sustained low inflation first. In the accompanying MPR projections, it was forecasted that the CPI would return to target in Q2, with downward adjustments to the inflation outlook for 2024-2026 and upward revisions to growth forecasts for the same period.
During the subsequent press conference, Governor Bailey stated that while the MPC is not currently contemplating rate cuts, the June meeting would benefit from additional data, leaving its outcome a coin-flip. Bailey hinted at future rate reductions, indicating that they may be necessary in the coming quarters and could potentially exceed market expectations. Furthermore, he emphasized that even with a 25bps rate cut, the policy stance would remain restrictive.
Overall, the meeting exhibited a dovish tone, particularly evident in the voting split.
Australia
Unsurprisingly, the RBA decided to keep interest rates unchanged at 4.35%. They reiterated the Board’s commitment to bringing inflation back to target, and emphasized they are open to various policy options. Despite the acknowledgment that inflation remains high and is declining slower than anticipated, the Board remains focused on returning it to target within a reasonable timeframe, considering it their utmost priority.
The bank also adjusted its inflation forecasts for 2024 upwards, but revised down estimates for GDP growth and unemployment. It’s worth keeping in mind that these projections are based on the assumption that interest rates will remain at 4.35% until mid-2025, extending the timeline by nine months compared to previous expectations. The market reaction to the announcement leaned towards a dovish sentiment, as many were expecting a more hawkish stance, particularly given recent stronger-than-expected inflation figures.
Anyway, Governor Bullock, in the post-meeting press conference, cautioned against overanalyzing the technical assumptions regarding rate forecasts, emphasizing the need for vigilance regarding inflation risks and mentioning that the Board discussed the possibility of rate hikes. However, she believes that the current interest rate level is appropriate to achieve the inflation target, and sees no immediate need for further tightening.
The minutes released two weeks after the meeting revealed that the Board deliberated on the possibility of raising rates, but ultimately decided in favor of maintaining the current policy stance: the board acknowledged the heightened risks of inflation persisting above the target range for an extended period, and expressed a limited tolerance for inflation remaining off-target beyond 2026. They also recognized that a rate increase could be warranted if economic forecasts proved overly optimistic, and they assessed the risks around these forecasts to be balanced.
Overall, the language in the minutes did little to prompt significant market movement and indicated a continued lack of urgency to adjust policy. The RBA noted that financial conditions in Australia are considered restrictive, and inflation expectations remain firmly anchored.
Given this backdrop, it’s hardly surprising that the AUD appreciated throughout the entire month.
New Zealand
The RBNZ also chose to maintain its OCR at 5.50%, mirroring the decision of the RBA, and like the latter, this move was perceived as hawkish. The bank revised its OCR projections upwards across the forecast horizon, signaling a potential delay in the first anticipated rate cut, perhaps not materializing until late 2025. Moreover, the RBNZ reaffirmed its hawkish stance, underlining the importance of keeping monetary policy restrictive and reiterating its expectation for inflation to align with the target by the end of 2024.
In the minutes, members expressed confidence in the efficacy of current monetary policy in curbing demand, anticipating further easing of capacity pressure. The committee also acknowledged the likelihood of interest rates needing to stay at restrictive levels for a prolonged period, surpassing initial expectations from February, to ensure the inflation target is met.
Akin to the situation with the AUD, it’s unsurprising that the NZD appreciated throughout the entire month.
During the press conference, Governor Orr’s language maintained a hawkish tone, emphasizing the gradual nature of domestic inflation’s decline and the limited tolerance for inflation surprises. He also mentioned the consideration of a hike during this meeting. However, his stance seemed more dovish the following day, suggesting that another rate hike would only be warranted in the face of uncontrollable inflationary pressures. Orr also hinted at the possibility of the central bank implementing easing measures before inflation reaches the 2% threshold.