RBC BlueBay AM: Central bankers left looking irrelevant

February 3, 2023

Mark Dowding, BlueBay CIO, RBC BlueBay Asset Management, looks at the recent decisions by the Bank of England, Fed, and ECB.

Treasury yields moved lower in the wake of this week’s FOMC meeting, with risk assets performing robustly. Broadly speaking, Powell’s message has not really changed. The Fed continues to signal that a further couple of 25bp hikes are to be expected in March and May, taking the effective Funds rate just north of 5%, before policy goes on hold. Thereafter, the Fed currently appears committed to maintaining rates at this level for an extended period, in line with its last dot plot in December.

However, Powell seemed to open the door to a more dovish path, if inflation comes in lower than the Fed’s anticipated trajectory. In doing so, he highlighted inflation risks relative to the Committee’s assessment, now on the downside, without making much mention of upside risks.

In this sense, Powell did relatively little to lean against the market and an ongoing easing in financial conditions. Yet, it is clear that the central bank is in data-dependent mode and there is scope for views to shift materially before the March meeting, with two payrolls prints and two sets of inflation data to be released before then.

With the focus switching back to data, so today’s US jobs report will be interesting to digest. Generally speaking, data from the labour market remains healthy, with weekly claims and Jolts data both pointing to a solid report, notwithstanding anecdotal stories of job losses, in areas such as tech. This week’s ADP jobs report was a bit softer than consensus, but perhaps more eye catching was the narrative showing that workers, who had stayed in their jobs since last January, had experienced a 7.3% pay rise.

Meanwhile, the ADP report went on to highlight that for those workers who had moved jobs, the median pay increase accelerated to 14.5%. This data stands in contrast to a more benign wage picture of average hourly earnings in last month’s labour report in the Household Survey. This difference may reflect job composition. However, to us, this may also be a reason why it may be wrong to dismiss second round inflation effects with a tight labour market.

As things stand, we are inclined to believe that the Fed won’t look to alter its trajectory for rates over the next several months. In this context, the yield curve is already very inverted and we are doubtful that it will invert much more, in the absence of much weaker information with respect to growth, or a much softer inflation outlook.

Meanwhile, a sudden slump in growth seems to appear unlikely. Credit card spending seems to have rebounded solidly over the past month and with financial conditions continuing to ease, we see this supporting both business and consumer sentiment.

On this basis, we continue to think there won’t be room for Treasuries to rally much further and are happy to retain a short rates position, as we see risk skewed to the upside in yields, especially with investor surveys now highlighting extensive net long duration positioning.

Meanwhile in Europe, the European Central Bank (ECB) also delivered higher rates as expected, hiking by 50bp in line with market expectations. Further tightening is expected and the hawks on the Governing Council will push for a further 50bp when the ECB next gathers, with rates likely to peak above 3.5% in the spring.

In this regard, the ECB is playing catch-up with the Fed and with many commentators now projecting the Eurozone to outgrow the US in 2023 at a time when inflation remains more elevated, it is understandable that Lagarde can remain hawkish for the time being. With respect to euro fixed income, we also look for yields to rise and think that supply is going to be a prevalent source of pressure on bonds in 2023.

A desire to increase fixed income allocations has seen robust demand for fixed income at the start of the year and this has created a supportive technical dynamic. However, once this demand is sated, elevated deficits across the Continent and an ECB selling bonds to shrink its balance sheet, are both risks that could pressure yields higher.

Elsewhere, the Bank of England (BoE) also delivered a 50bp rate hike this week. However, Bailey’s comments were relatively dovish and with the UK economy underperforming, this prompted some discussion as to whether rates may now have peaked at 4%. UK data has lagged the improvement in activity seen in other developed economies over the past several months.

In light of this, the IMF has downgraded its outlook, with Britain now projected to perform worse than all of its peers in the year ahead, even including war-ravaged Russia. House prices are now falling and mortgage approvals have slowed sharply. With UK interest rates continuing to increase and inflation crushing real incomes, it appears that the macro backdrop is weak and unlikely to improve any time soon.

Labour market data have shown the UK has lost nearly 4% of its labour force since 2016 compared to the pre-pandemic trend. This ensures that the labour market remains tight, even as growth slumps, putting upward pressure on wages, where private sector pay is now running above 7% growth.

Ordinarily speaking, this would mean that the BoE would want to be more hawkish. Yet we think that taking rates beyond 4% risks a housing market slump turning into a collapse, which could have systemic implications for the UK. On this basis, we think that Bailey will need to be dovish in the months to come and allow inflation to overshoot higher and longer than the Bank would otherwise have liked to see.

Yet more persistent inflation will only make unions angrier and until there is a change of government in 2024, it is difficult to see how these trends can change. Against this backdrop, we think it remains correct to adopt a cautious stance on UK assets and we remain bearish on our long-term outlook for the pound, as we think the currency will inevitably end up taking the strain.

Away from central banks, lower government bond yields have seen a further push into risk assets with credit and equities rallying strongly. Performance data from surveys suggests that this has been something of a pain trade for a number of investors, who had been hoping to add exposure at more attractive levels.

Index spreads are now back to where they were last March and it seems that fears of recession and a default cycle are quickly being dismissed. Goldilocks is the short-term narrative in play, yet we would advocate caution as central banks are not yet done and with labour markets tight and growth still robust, there could be scope for renewed disappointment on inflation at a time when many investors appear to assume that it is no longer an issue.

Looking ahead

Data will be key, as we look ahead. We know that monetary policy tightening works with lags and so expect growth globally to slow as we move through the year ahead. However, in the short term, improving sentiment could lead to an outcome where it appears that higher interest rates are having relatively little bearing on the economy, away from certain interest rate-sensitive sectors. Yet if the economy remains upbeat for now, we think that central banks will be very wary of sending dovish signals on monetary policy, no matter how much the market will want to push for them.

Paradoxically we might observe that the stronger the economy and markets at the start of the year, then the weaker the outlook for both will be later in 2023. Conversely, if things looked materially weaker now, then this could be more of a harbinger of a stronger second half of the year.

Meanwhile, data coming out of Netflix also caught our attention this week. Historically speaking, peak streaming times for the Netflix service have typically been on Sunday evenings. However, this appears to have shifted, with peak viewership now occurring on weekday afternoons. Perhaps there is some telling information here with respect to workers ‘quietly quitting’ or becoming distracted or demotivated, in a work-from-home environment.

It is certainly tempting to suggest that productivity is being lost and it is tempting to wonder whether too many of us will allow ourselves to grow lazy, given half a chance. If Netflix from Home (NFH) is the new WFH, then this would be a troubling sign, with negative economic consequence for economies over the medium term. If that is the case, then the Netflix effect could lead to a chill in asset prices.