Send this article to a friend:

December
18
2023

Seaing Red
Benjamin Picton

The NASDAQ closed at a record high on Friday evening. This came as the US 10-year yield fell another basis point to settle at 3.91%, and Brent crude remained mostly unchanged after sharp gains on Thursday to end the week at 76.55/bbl.

Markets have been in jubilation mode since the proverbial Fed pivot arrived last week. Last Monday I pointed out that for the market to be right on the future path of the Fed Funds rate, the dot plot forecasts of every FOMC member would have to be wrong. Well, that problem was momentarily solved by FOMC members moving their forecasts lower, which prompted the market to then price in more cuts, meaning that the Fed still needs to be wrong for the market to be right.

Lost in the hubbub of 3 implied rate cuts is that the 2024 year-end rate projected by the median of the dot plot is exactly the same as it was in the June update (4.625%). So the Fed has really just pivoted back to thinking that the path of Fed Funds next year is going to be pretty much exactly the same as they thought it would be in June.

This demonstrates that beauty is in the eye of the beholder, and what is important to markets is not the absolute level that rates will reach, but the fact that the latest accounting revises the future path downwards rather than upwards. Markets tend to overreact in both directions (i.e. they are not strong-form efficient), so the shift in direction of travel encourages overreaction on the side of optimism. This makes the Fed’s timing curious, given that market measures of financial conditions are now at their most accommodative since the middle of 2022. Do they know something that we don’t?

To be fair, Powell’s festive spiking of the punchbowl last week wasn’t totally devoid of nuance, but nuance is not rewarded by markets addicted to binary narratives of ‘financial crisis and crushing recession/deflation’ or ‘time to lever-up and YOLO into infinite-duration monkey JPEGs’. Maybe when it comes to central bank transparency it really is a case of less is more?

The nuance arrived in the Q&A session when Powell tried to contort himself into not contradicting his claims at the November press conference that FOMC members were “not talking about rate cuts”. According to Powell, members weren’t talking about rate cuts in December either (kind of). They simply stuck the rate cuts in their SEP projections, showed them to each other, and then shunted that particular elephant off to the corner of the room while they focused on whether or not rates had yet reached a sufficiently restrictive level to get inflation back to target.

So, markets must have been hearing things when they latched onto promises of imminent cuts!

Perhaps having sensed a misfire of forward guidance, John Williams (the economist, not the guy who composed the ‘Home Alone’ soundtrack) was deployed over the weekend to bolster the Fed’s plausible deniability on the rate cut discussion. “We aren’t REALLY talking about rate cuts”Williams claimed, in a triumph of short-term thinking. “As Chair Powell said, the question is have we gotten monetary policy to a sufficiently restrictive stance?”.

This sounds an awful lot like Christine Lagarde, who assured us last week that ECB members aren’t discussing rate cuts either, before her claim was given extra punch by shadowy “officials familiar with their thinking” giving an anonymous drop to media on Friday that the ECB is expecting cuts to come later than those strong-form inefficient markets are currently pricing. The macho talk from unnamed officials coincided with the release of dire PMI figures for France on Friday that seem to suggest Europe’s second largest economy is following Germany into recession. So, that means earlier cuts, right?

While central banks wrestle with the fallout of their own forward guidance, the real economy faces the potential for further shocks from the conflict in the Middle East. Australia is reportedly in talks with the Pentagon over a US request to send an Australian warship to the Red Sea to assist in dealing with Iran-backed Houthi rebels, who have been disrupting commercial shipping in the region and launching missile and drone strikes against US targets and their allies.

This request comes just days after Congress passed laws enabling the sale of Virginia class submarines to Australia under the terms of the AUKUS pact. The agreement marks just the second time that the United States has shared nuclear secrets with another country (on purpose, at least), so it appears that there is an element of “I scratch your back, you scratch mine” going on here.

This is not without its complications, as many members of Australia’s political establishment (particularly within the ruling Labor Party) still cling to dreams of ‘strategic autonomy’ of the kind that doesn’t even work for Europe. Their fear is that AUKUS, and an Australian warship shooting down drones in the Red Sea, further locks Australia in as an organ of US foreign policy, which it probably does. But really, this is par for the course and probably just the modern incarnation of Australia’s long-running policy of having ‘great and powerful friends’.

Quite aside from the diplomatic horse-trading that accompanies it, disruption of shipping in the Red Sea is a big problem, and Europe has the most to lose. 150 years of supply chain improvement risks being unwound as major shipping companies redirect vessels around the Cape of Good Hope to avoid traversing the region to pass through the Suez Canal into the Mediterranean.

This could have major implications for the durability of goods disinflation that we have recently witnessed (bolstered by strong Chinese industrial production figures last week), which in turn has implications for aggressive forecasts of interest rate cuts. Again, this perhaps highlights the inefficiencies of markets that are quick to price in shifts in the central bank reaction function, but slow to recognise structure shifts in the real economy. What happens to goods inflation if the United States is becoming more selective in its orderly policing of global shipping lanes? How much more selective might they be under a Trump Presidency?

For the ECB, it’s a prospect that could leave you Seaing Red.

 Ben Picton is Senior Macro Strategist for the RaboResearch Global Economics & Markets team in Sydney. He is responsible for providing strategic economic research for Australia and New Zealand including interest rates and economic projections. Ben also works closely with the Australian and New Zealand RaboResearch Food & Agribusiness team.

Before taking up the role as Senior Macro Strategist in 2023, Ben worked for more than seven years on the Sydney Markets desk. Here he has held a number of positions in derivative sales and trading, covering both the Wholesale and Country Banking client portfolios.

Ben holds a combined Bachelor of Business and Bachelor of Commerce from the University of Newcastle, and a Master of Economics from the University of Sydney.

research.rabobank.com