Macroeconomics: The Day Ahead for 26 August

Today is all about Powell’s Jackson Hole speech, even if there is a good volume of data to peruse, with Tokyo CPI (higher than expected), German (new record low) & French (better than expected but still very close to 2013 low) Consumer Confidence surveys to digest ahead of Italy’s monthly confidence surveys, and US Personal Income & PCE, Goods Trade Balance, Wholesale Inventories and final Michigan Sentiment. Today also brings the UK utilities regulator Ofgem’s decision on the level to which the ‘price cap’ will be raised as of 1 October, with the announced £3,549 well above the expected £3,000, from the current cap at a already unaffordable for many £1,971, i.e. 80%. Next week brings month end, which in the aftermath of Powell’s speech today could prompt some quite sharp rebalancing flows from equities to bonds. It also has Eurozone provisional August CPI readings, the US labour report and Consumer Confidence, Manufacturing PMIs and a further array of surveys, along with the usual run of month end Japan readings.

** U.S.A. – Jul Personal Income/PCE **

Personal Income and PCE are forecast to largely echo Retail Sales and Average Hourly Earnings with gains of 0.6% and 0.4% m/m respectively, rather more poignantly “real” PCE is also seen up 0.4% m/m, which would be the best m/m out-turn since January’s distorted 1.3% m/m. While one swallow does not a summer make, it points to spending volumes holding up well, doubtless assisted by the fall in gasoline prices since their mid-June peak. Meanwhile PCE deflators are likely to echo the flat m/m headline and modest core 0.3% m/m CPI gains, pushing down headline y/y to 6.4% from 6.8%, and edging core to 4.7% y/y from 4.8%.

** U.S.A. – Powell Jackson Hole speech **

This is a Q&A with a journalist from yesterday previewing Powell’s speech:

Q: The advanced nations’ long bond yields are breaking higher from multi-decade downtrends. Does it indicate high rates are the new normal and the liquidity lottery is gone at least for a few years? 

A: To a degree yes, but it is a very grudging acknowledgement, and the summer rally in risk assets underscores two points: a) the habits of the past QE dominated decade die hard, one might call that a case of Pavlovian conditioning, or that even with higher rates and yields, the returns are still low, above all driven by the fact that many funds were very defensive during H1, weathering the risk downturn, and with yields on govts and credit a lot higher, equity and crypto valuations much better than at end 2021, there was a strong case for putting some of the accumulated cash “to work” – it is in other words an RV trade.

Q: Perhaps the breakout in yields hints that stagflation is here and central banks will maintain restrictive rates for some time, as opposed to expectations that the tightening cycle will be quickly followed by a rate cut cycle.

A: This has been and will continue to be the big battle ground. On the one hand markets remain very much conditioned by the near 25 years of Greenspan, Bernanke & Yellen ‘puts’, on the other hand inflation is out of control in most countries around the world, due to the brutal exposure of supply side deficiencies due to under and mal-investment (capital misallocation). It was also exacerbated by central banks who have demonstrated a colossal ignorance about supply chains, and its impact on price formation, and along with reactive rather than proactive monetary, and the accompanying belief that inflation would be transitory leaves us with  rates higher than they would be. To be fair, raising rates to curb supply side inflation is a very blunt instrument, and fiscal and legislative measures are/would be far more effective, but as politicians are “fiddling while Rome burns”, and central banks all have a primary inflation mandate, central banks do not have much choice other than to raise rates and destroy demand. Markets understandably think that with all the world’s accumulated debt, a sharp downturn will force central banks to reverse course, as they have done on each occasion since LTCM & Asian Debt crisis in 1997/98. The peak of the tightening cycle is likely to be less than what would theoretically be required to curb inflation, but a rate cut cycle will equally be much further away than markets would expect.

Q: Are rising rates a cause for concern or risk assets, including crypto?

A: Without a doubt. However, the critical point over the next 6 months is less about the aggressive rate hike cycles, and far more about central bank balance sheet reduction. QT has barely started, (the Fed only gets to $95 Bln per month reduction in September) and  if the 2016-2019 Fed QT cycle is any guide, it is only after 3-6 months that markets start to feel the pinch of the liquidity withdrawal. But as vastly inflated housing markets (due to a decade of QE) in developed countries are demonstrating, the reality of that liquidity will start to bite. At the end of the day, the key equation is about ‘opportunity cost’, in a low rate, low return environment reaching for yield/risk makes good senses, but as rates/returns improve, and defensive assets start to offer acceptable returns (above all in an uncertain demand environment), the attractions of risk assets is reduced. So rates and liquidity matter, as does the consideration that when private sector money / savings has to step in to fill the gap left by the lack of central bank purchases of “safe assets”, then there is less money for riskier assets, and risk premiums rise.

Q: Lastly, do you expect Powell to say anything dovish to stall the ascent in yields?

A: To be honest, this is not about what Powell actually says, it’s about how markets perceive what he says. What he is likely to say is a) rates will continue to need to rise, as inflation remains way too high, and the labour market far too tight. b) if a (mild) recession is what it takes to drag inflation down, and loosen the labour market significantly, then that is what will have to be done. But is market reaction to the next point which will be key: c) a slower pace of rate hikes does not signal that an end to the rate hike cycle is close at hand. But rather that with rates moving beyond neutral into restrictive territory, the Fed needs to have more flexibility and will be “data dependent” (as they have said). He will stress that even if the Fed gets to the point that it is satisfied that inflation is on a clear bath back to 2.0%, and stops hiking, rates will nevertheless remain at higher levels for a protracted period. Markets will be looking for signals on what sort of economic data readings would stay the Fed’s hand, but Powell and the FOMC should know all too well that offering specifics would only be a rod for markets to be the Fed’s back. So it will really boil down to whether there is an acknowledgement that demand is weakening, any concerns voiced about the housing market slide, and any comments suggesting some optimism that core and headline price pressures are starting to ease.

Last but not least there is that very clear message from KC Fed’s George yesterday “We have to get interest rates higher to slow down demand and bring inflation back to our target”. When asked about holding rates and where, she said: “I think we will have to hold — it could be over 4%. I don’t think that’s out of the question. You won’t know that, I think, until you begin to watch the data signs.” It should be remembered that George dissented in July, voting for a 50 bps rather than 75 bps move, and that makes it abundantly clear, that the dissent was about a steadier, more predictable trajectory, and not about signalling a peak.