Government bonds could have paused for breath after their sharp November rally on market expectations of rate cuts early in 2024. But they didn’t. At the beginning of December, central banker comments contributed to a further fall in yields throughout the curve.
The next US Federal Reserve (Fed) and European Central Bank (ECB) monetary policy decisions are due on 13 and 14 December, respectively. This week, just before the traditional black-out period for their committee members ahead of these meetings, comments from two senior figures caught investors’ attention.
Were Jerome Powell’s remarks overinterpreted?
While the Fed Chair took a cautious approach and repeated on 1 December that the Federal Open Market Committee (FOMC) would still hike rates if necessary, his diagnosis of the state of the US economy bolstered investor assumptions of cuts in policy rates not too far into 2024.
In Powell’s view, the ‘policy rate is well into restrictive territory, meaning that tight monetary policy is putting downward pressure on economic activity and inflation. Monetary policy is thought to affect economic conditions with a lag, and the full effects of our tightening have likely not yet been felt’.
The disappointing manufacturing US purchasing managers’ survey (PMI) published a few hours earlier may have led investors to interpret the Fed chair’s comments as being dovish. The main points he made, however, had already been addressed by other members of the FOMC a few days earlier.
Is Isabel Schnabel becoming a dove?
ECB Executive Board Member Isabel Schnabel’s interview with Reuters on 5 December raised eyebrows. Normally regarded as a hawk, Schnabel seemed to have dramatically altered her assessment of inflation and future monetary policy decisions. Indeed, in a speech just one month earlier (The last mile), she had argued that the ‘last mile of disinflation’ is likely the hardest and that ‘premature celebrations’ should be avoided.
On 5 December, she acknowledged that November inflation data for the eurozone had been a ‘very pleasant’ surprise, but stressed that victory had not yet been achieved.
More important, perhaps, was her answer to the question of whether she was ‘not ruling out a rate cut before mid-2024′. Schnabel simply said that the ECB remains data dependent and that it is crucial to see what happens in the coming months. In response, European government bond yields fell significantly.
Will there be ‘colomba’ (dove) for Christmas?
As our Italian readers (and gourmets around the world) know, la colomba is a sumptuous brioche eaten at Easter, while at Christmas we indulge in panettone (a brioche laced with dried fruit).
So far in December, central bank meetings (in Australia and Canada) have seen key rates unchanged. While the Bank of Canada issued mildly dovish monetary policy guidance, the Reserve Bank of Australia maintained its hawkish tone, articulating the view that inflation may slow less quickly than expected.
For next week’s Fed and ECB meetings, market observers are in suspense – not about the (very likely) status quo in policy rates, but rather about what the banks may say on growth and, more importantly, inflation forecasts.
At a recent hearing before the European Parliament, ECB President Christine Lagarde caused a stir by saying that an earlier end to the Pandemic Emergency Purchase Programme (PEPP) is ‘a matter which will probably come up for discussion and consideration within the governing council in the not-too-distant future.’
Central bank communications may continue to surprise investors. This may be a deliberate tactic or simply a reflection of a significant point highlighted by the OECD in its latest report, namely, that: “The relationship between inflation, activity and labour markets has changed, making the full impact of monetary policy tightening hard to judge.”
This perceptive summary of the analytical challenges faced by central banks, governments and investors may explain why economic narratives have fluctuated so much this year – and may continue to do so in 2024.
Will 2024 see a prolongation of the soft landing scenario?
The ideal scenario of a ‘soft landing’ (gently slowing growth, but no recession) has again come to the fore as the year-end approaches. However, taking a rosy view of 2024 may be too optimistic. The cautious tone of the OECD’s latest report sounds more appropriate: ‘Inflation is easing but growth is slowing.’
In the face of a slower pace of price increases, central bankers have gradually wound down their inflation rhetoric. They also recognise that restrictive monetary policies have started to weigh on activity and see these effects as likely to persist. This was a major change of tone, which has reinforced investor expectations that with tightening very much over, a pivot may be on the horizon. It has boosted valuations of both equities and bonds since the start of November.
It is tempting to conclude that everything is now playing out nicely, and that 2024 will see these favourable trends persist as policy rates are cut on a regular basis.
For government bonds, such a scenario is possible, but the speed of falling yields in recent weeks and the resulting extreme investor positioning may lead to short-term volatility.
As for equities, the earnings outlook still does not seem to us to sufficiently incorporate the likely slowdown in economic activity. That leads us to maintain a cautious stance while taking into account the short-term opportunities that may arise in certain sectors or markets.
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