June and the “Draghi Effect”

June was progressing according to expectations. A rate hike at the June 14 FOMC meeting was a given, so it should not have much of an effect on anything. In effect, the 10-2 spread was falling on those expectations, as was the 5yr-5yr forward inflation expectations.

The big move at the closing of the month reflected Draghi´s unexpected hawkish comments on the 27th, which helped lift rates around the world. Suddenly we hear hawkish comments from the major central banks, including the Fed, ECB, BoE, BoC and the RBA.

Important to note that the last time the major central banks “coordinated”, the outcome was not at all pleasant. In late 2007, they were all “coordinating” on the higher headline rates of inflation due the 2007-08 oil shock.

A few years later, the ECB led by Trichet went on alone to tighten policy again due to a rise in headline inflation from the oil price recovery. Later, Draghi came to the rescue.

What are they “coordinating” on now? Certainly not on inflation, which has surprised everyone on the downside. Just three days after Draghi´s bullish outlook for the economy, accompanied by a forecast that inflation is still on track to rise, the Eurozone’s annual rate of inflation fell for the second straight month to its lowest level in 2017. They are, therefore, likely “coordinating” on the desire to put an end to “unconventional” policies.

The end-of-moth market moves are more likely a quirk, being premature to conclude, for example, that the recent flattening of the yield curve, a bearish signal, has run its course.

Regarding only the US, one of the factors that is narrowing spreads is expectations that economic growth will be softer than previously assumed. The IMF, for example, cut its forecasts for growth to 2.1% for 2017 and 2018 (from 2.3% and 2.5%, respectively). A key reason for the downsized outlook is rising uncertainty about the viability of the Trump administration’s economic policies. In other words, confidence is fading that the White House will be successful in rolling out a pro-growth legislative agenda.

Note that recent estimates of US GDP growth have been sliding. The Atlanta Fed’s GDPNow model, for instance, is currently projecting second-quarter growth at 2.7% (as of June 30). That may be an encouraging rebound following Q1’s sluggish 1.4% rise, but only two months ago, (May 1) the model was forecasting a 4.3% rise in Q2.

Based on the flattening of the yield curve (assuming the recent reversal is just a temporary quirk), the Treasury market sees a softer outlook for the US economy. The Fed´s policy outlook, however, sees rates rising. However, with each “lackluster” inflation release, the policy consensus among Fed members seems to be eroding. Recent speeches by Bullard, Evans and Kaplan clearly show this divergence from consensus.

Will this consensus divergence move the Fed away from its “Phillips Curve mode”? That´s hard to envisage, especially because many on the outside still think it´s relevant.

On Europe:

“The relationship between growth and inflation may have been loosened somewhat by a number of structural changes—technological advances, globalization and the impact of structural reforms—but it has not been eliminated,” said BNP Paribas economist Luigi Speranza.

“If, as the ECB expects, the output gap continues to close over time, inflation should converge gradually toward 2%—in other words, the current period of subdued inflation is temporary,” he added.

On the US:

Having achieved both its mandates of low inflation and full employment, should the Fed declare mission accomplished and rest on its laurels? Of course not! As can be seen in figure 3, the natural unemployment rate does not act as a lower bound to unemployment, and the US economy has regularly undershot this objective. A further decline in unemployment could put pressure on wage inflation and subsequently on price inflation. In this scenario, the Fed would be forced to tighten monetary conditions further in order to achieve its price stability objective.

The top half of the chart below is shown as “proof” of the Phillips Curve relation. The bottom half, however, indicates that inflation is not an “unemployment phenomenon” but a “monetary phenomenon”.

Until the Fed changes its view, danger will continue to lurk.


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