Summer is done, and stress has begun. Lectures, internship processes, IB days, exams and the like are all back to torment us. And as if that was not enough, the Week at the Close is back as well. The intrigues and developments of the financial markets are back to Tra i Leoni. To all new students and readers, you probably won’t find a more stressful way to spend your free time than by reading this column. But that’s not my fault. It’s the markets that always find new creative ways to spread bad news to everyone. My commitment here is to try to make it, at least, understandable and somewhat funnier. So, let’s get to it.
After a turbulent beginning to the year, the financial markets faced a quiet period as Tra i Leoni went on summer break. The concerns that were rising due to potential problems with the stability of the system didn’t materialize. The path of monetary tightening softened as we put forward on the final Week at the Close of the last academic year. The Fed was on its wait to finally pause with the rate increases, while the ECB was some steps behind, so more consecutive hikes were predicted. And that is exactly what happened.
The Federal Reserve, which had been – in a provocative basketball reference – the “world champion” of hiking since mid-2022, paused its 500-basis-points-long tightening cycle in the June FOMC meeting. The main argument put forward was the uncertainty of the timing and power with which all the previous tightening was and would be transmitted into the real economy. Nonetheless, the room for further rate increases was left open. Actually, further hikes were being priced by the market back then.
In the very last committee meeting, that extra step was indeed taken. 25 basis points upwards was again the Fed’s decision. The stickiness of inflation was the main argument behind it. But in the August all-star meeting of central bankers in Jackson Hole, Wyoming, the Chair of the Fed went more in-depth into this justification. An in-depth explanation that set the tone of the Fed’s chair as hawkish.
Jerome Powell’s direct references to above-trend growth in GDP, the robustness of consumer spending, and the slight pick-up of the housing market were an alert to the possibility that public enemy number 1, inflation, still has some fight to give back. Not only that, but these economic developments also called for a possible reassessment of where the neutral rate of interest stands – i.e., the level of rates at which the economy is neither expanding nor contracting – and hence more tightening might be needed in such conditions.
The market got the message and yields rose straight after. Most notably, the 5-year real yield reached its highest level since 2008 at 2.26% soon after the comments.
Next week, we’ll have another FOMC meeting. After the release of the CPI report this Wednesday which was pretty much aligned with expectations, futures traders are pricing in another pause to come on the 20th with quite some certainty. Much less certain, though, is the projection for the November meeting. Currently, traders are implying a 30% probability that November will have another rate increase.
Still at Jackson Hole, the ECB was also under the spotlight. And even though President Lagarde made the effort to try not to comment too much and refrained from giving indications on the path of future policies, her co-counsellors did the work for her. As usual, governors of the different central banks had different tones to their rhetoric.
The more fragile Portugal – and it hurts for a Portuguese to write this – had the dovishness sense coming out of its central bank governor. The risks of a general economic slump and the fast retreat of inflation (faster than its rise) were the core of Centeno’s remarks.
A somewhat neutral intervention came out of the central banker of the latest addition to the eurozone Croatia. Boris Vujčić focused on data dependency to have a better grasp on whether we are currently in restrictive territory.
The hawkishness, as usual, came from the representatives of the (traditionally) stronger countries. Why the parenthesis? Well, despite the call for further tightening by the block’s powerhouse Germany, things there are not shining that bright. The country is now being called the “sick man” of Europe. After three straight quarters of economic contraction and – in the very last for which there is data – stagnation, the projections are now indicating another quarter of GDP contraction: at -0.1%. The influence of Germany in the eurozone figures made the case for a downward revision in the area as well.
But after a 425-bip hiking campaign over the last year, was the ECB done or ready to push it one step further? The answer came out this Thursday. The market didn’t quite appreciate it.
Prior to this week’s governing council meeting, some buzz was already being developed because of an overall market division. For the first time in the cycle, there was a 50-50 chance that the ECB would hike or pause, as priced in on the swap market. And that surely didn’t mean good news in inflation more than it reflected the danger of all this tightening in terms of economic performance.
But the ECB followed its stance. The rigorous commitment to the fight against inflation has been characterizing the committee’s performance, without overthinking the second-round effects of it. Thursday was no exception to this. The ECB increased its three key policy rates by 25 basis points.
The aftermath of the decision was not the brightest. The hiking-into-weakness narrative took over and the euro immediately fell against the dollar, so the usual rates-up-currency-up relationship didn’t hold. (The Bundesbank governor) Nagle’s Jackson Hole remarks were not agreed upon by market participants. The economy is already weak enough to risk it further.
After three months, this is where we are. In all honesty, not much changed. Sentiment, expectations, and the economy per se remain relatively in the same spot as when Tra i Leoni left them without weekly reporting. But now we’re back, and judging by last academic year’s events, maybe we just needed to return to bring the storm back to the markets. Hope it’s not the case this time, but if it is, you’ll find everything here broken down. Enjoy!