Old Habits…

By Elwin de Groot, head of macro strategy at Rabobank

Old Habits…

… die hard, as the saying goes. And central bankers who – perhaps – may be getting some fears of height, after having talked tough for such a long time, are not immune to it. Take Minneapolis Fed President Neel Kashkari – who on Tuesday argued in a paper that he expected one more rate hike and attached a 40% probability to a scenario in which the Fed will have to increase rates by more than 25 basis points. Then on Wednesday he seemed to be more receptive to the ‘negative supply shock’ thinking, cautioning in a CNN interview that “higher oil prices won’t alone warrant more rate hikes” and warning that a materialization of downside risks to the economy, such as a government shutdown or an “extended strike” at US car manufacturers could imply that the Fed would have “to do less with [its] monetary policy to bring inflation back down”. But, doesn’t an extended strike in the auto sector simply mean that workers will not agree with anything less than a 40% wage hike? And in which country has a government shutdown ever led to (structurally) lower inflation?

In any case, US 10y yields reached a fresh post-2007 high yesterday and Asian markets are taking their cues this morning from a suspension of trading in China’s Evergrande and Japan’s 20y bond yield reaching its highest level since 2014, whilst European market participants may be having their eyes on the most recent inflation data from Germany, which will benefit from a sizeable ‘base effect’.

That – closer to the (probable) peak in rates – things would become more wobbly and uncertain was always to be expected. It could be one reason why term premiums have been on the up off late. But should central banks pay closer attention to the downside risks to the economy now and give less priority to the upside risks to inflation? I would argue that such a slippage from recent practice and, thus, a return to the pre-2020 practice could perhaps be defended if

• i) there was a tangible decline in the perceived supply risks and/or
• ii) a tangible easing of labor market pressures.

Unfortunately, we cannot say with any confidence yet that there has been any significant improvement on any of those fronts.

On the first prerequisite I would actually say “to the contrary”. That is not only motivated by the recent tensions between the EU/US and China (whether that is over high-tech, phones or cars) but also by renewed pressures on commodity prices, oil in particular. This morning sees the nearest future for Brent rise above the $97 mark, that’s up 6% in less than 48 hours. At Cushing, Oklahoma, which is the key delivery point for the US WTI benchmark, inventories fell below 22 million barrels, the lowest since July 2022 and, according to Bloomberg, close to operational minimums. Meanwhile, the Dutch TTF natural gas benchmark has been trading at around EUR40/MWh recently, despite the wage agreement between Chevron and labour unions at the Australian Wheatstone and Gorgon facilities that has brought strikes to an end there.

As our own Joe DeLaura points out: “front-month TTF gas now trades around €41/MWh, firmly within our forecasted band for the rest of the year between €32-€50/MWh. Henry Hub futures are also rangebound between $2.48- $3.00/MMBtu, we do not expect $3 to be breached until the first wave of cold hits in November. There is upside potential for Henry Hub to $4 and TTF to the low €60s if there are extended periods of cold and the macroeconomic outlook improves.“ But Joe expects upward pressure on oil and distillates to be sustained. He believes that “Brent has the momentum to touch $100”, but sees “more strength in Q1 2024 to stay above the $100/bbl mark.”

On the second condition I would add that the observation that not only unemployment rates are still close to record-lows on both sides of the Atlantic and that even (more cyclical) vacancy rates (Eurozone) or voluntary quits (US) haven’t yet returned to their historical averages would still put serious question marks behind that second point. And, remember, strikes are taking place for a reason and with considerable public and political backing. Even President Biden has thrown in his support for the autoworkers. Assuming that significant layoffs are not the immediate response by automakers after any agreement, the other options would either be a cut in profit margins or – again – higher prices. On that front, the jury is still out. Slowing global demand may make the second route more difficult, but the recent experience with the energy shock suggests that such dynamics were not as strong as many (including ourselves) had expected. In her last press conference ECB President Lagarde acknowledged that she saw some “very early” signs that businesses’ profit margins are starting to come back down. So perhaps we are at the beginning of more serious profit pain for businesses, but it’s still early days.

There is less uncertainty about the near-term economic pain. Indeed, this thinking is being ‘fed’ by the most recent Eurozone money supply figures that were released yesterday. M1 growth fell into double digit contraction (-10.4%), for the first time since (at least) the 1960s. This largely reflects ‘portfolio shifts’ out of low-interest paying current accounts into deposits with fixed maturities. However, broad money growth also fell further into negative territory, with a -1.3% y/y. Looking at the counterparts, there was a notable decline in the volume of loans provision to non-financial corporations. In y/y terms, growth (adjusted for sales/securitizations) fell back to 0.6% from 2.2%; the net-flow was EUR -22bn in August, the sharpest decline since April 2021. The bulk of this decline took place in the ‘up to 1 year’ segment and as such could reflect things like repayment of (TLTRO-funded) pandemic support loans to businesses and lower demand for working capital. And with EUR 6bn in August, the net flow of credit to households has basically ground to a halt.

So although there are also ‘technical’ explanations for the sharpness of the decline in money supply growth, the data do suggest that the pain of higher interest rates is increasingly being felt in the credit chain and is now contributing to the (mild) contraction in overall economic activity. Whether that is, in turn, sufficient to bring inflation back down in a sustainable manner, hinges on supply developments, how businesses handle those and the labor market. Rinse and repeat.