Goldman Talks Geopolitics and Equity Cycles...
The BoE blindsides, Goldman's oil frustrations continue, and the optimism phase of this equity cycle may be too optimistic...
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Part 1 / 4: Bank of England Blindsides
In last week’s newsletter we discussed how UK inflation came in last Wednesday far hotter than expected, with core CPI of 7.1% YoY vs. consensus estimates of 6.8%. But rate hike expectations for last Thursday’s meeting didn’t change too much with most anticipating that the BoE would maintain the same relatively apathetic posture they’ve had all cycle.
This sentiment - that the BoE wouldn’t suddenly be responsive to, once again, underestimating the strength and resilience of inflationary pressures - was a view shared across the vast majority of rates desks. The only real division was over if the BoE’s failure to respond to the latest inflation overshoot would be the final nail in their credibility coffin or not.
Here’s a snippet of what Jha, the head of UK inflation trading at GS, had to say in a desk note after the inflation print but before the BoE’s meeting (if you’re curious, the full quote is in last week’s newsletter).
Credibility is key–and whilst the market may not have much in the BoE’s forward looking inflation projections–it does at least assign some credibility when it comes to them delivering hikes in response to spot inflation realising well above their forecasts.
…Any hesitance to hike, in the absence of a clear signal that inflation is meaningfully slowing down, could potentially reignite concerns around their credibility.
But it appears market participants had become slightly too jaded and cynical (not for the first time!) because the BoE raised rates by 50bps to 5.00% vs. the 25bps that was expected. Perhaps more surprisingly, given how dovish many members of the Monetary Policy Committee (MPC) have been lately, the vote was 7-2 (the two dissenters favored not raising rates at all).
In the aftermath of the hike, Governor Bailey signaled that he got the message that markets were sending as he said he felt it was “absolutely imperative” to raise rates by 50bps at this meeting.
But old habits die hard and in the monetary policy summary the BoE couldn’t help but chide markets for overreacting to one CPI print. It seems that it still hasn’t dawned on the BoE that the outsized vol in the front-end has been a direct reflection of their consistent underestimation of inflation and their continual undershooting of market expectations for rate hikes. Markets overreact, sure. But when they are always overreacting in the same direction, and overreacting more in the UK than in other developed markets when similar situations occur, that should maybe tell you something.
There was some evidence that market pricing had been more sensitive to economic data outturns than had been usual over the past decade. Recent data releases had been accompanied by larger movements in the OIS curve than surprises of a similar magnitude had generated previously, notably in response to the material upside surprises in recent UK data releases on CPI inflation and the labour market.
Note: The BoE also maintained its strategy for most of this cycle of declining the opportunity to prejudge how much they’d hike (if at all) in future meetings.
Today, the terminal rate is sitting around 6.1% with some strategists believing the BoE will get to 6.0% but most (i.e., JPM, Barclays, and GS) believe they’ll pause at 5.75%.
The monetary policy summary stated that the 50bps hike was warranted “at this particular meeting” implying that the MPC is not committing to a series of 50bp hikes moving forward until inflationary pressures cool.
But beggars can’t be choosers, and the mere fact that seven members could be corralled, coerced, or cajoled into raising by 50bps was enough to accomplish something important: lowering front-end vol.
Because in recent weeks, in a redux of what happened last year during the gilt crisis, rates vol began to pickup steam — a natural consensus of credibility waning and the belief that the BoE won’t do enough today, so will have to do more tomorrow.
Here’s how Barclays puts it…
The important point from the committee’s perspective is that the immediate path of rates over 2023’s remaining meetings has been re-anchored to the view of the MPC, rather than being at the mercy of near-term data flow.
This is reflected in both declining volatility in the immediate MPC meeting pricing compared with the further out meetings, as what has been continually repriced is the path to the terminal rate and the expectations of easing thereafter (Figure 5). From a more macro perspective this is shown in Figure 6 where we see that realised vol has been higher in the GBP 1y1y-1y2y space.
And here’s how the market repriced meetings moving forward: more hikes in the near-term and more cuts thereafter…
Barclays believes that with front-end vol easing and with the MPC reasserting control, it’ll take out some of premium built up in longer-dated gilts (similar to what we saw after the gilt crisis was tamed last year). In other words, the curve should flatten further.
Therefore, given that the turbulence in the front end over the past few months as inflation has proved far stickier than in other developed markets, they’re pitching a long 10y Gilt/Bund spread premised on the spread reverting back to the 160bps range now that the MPC has got the message and is taking action more inline with market expectations.
Given that many, myself included, think the market nearly fully pricing in a 50bps hike for the next meeting is a bit rich - and that the MPC may view going 50bps in August as setting a precedence that’ll bake in 50bps for the Sept meeting too - it strikes me that Goldman is directionally right in arguing that vol should moderate some but is liable to remerge quickly and unpredictably.
Below is a great table from JPM that tries to game out the BoE’s reaction function through the latter half of this year. They’re expecting the labor market to remain red hot; with wage growth settling at around 6% by year end, core at 6% by year end, and no recession occurring (although it’s difficult to look at the market pricing for upcoming meetings and think it shouldn’t be higher if this all eventuates).
Interestingly, JPM takes an outright view on 10y gilt yields going lower regardless of how the economy evolves through the end of the year: believing a recession would lead to the 10y getting back to a more normalized level, as most would agree with, but also that the economy running hot would result in further curve inversion based on an increased hard landing probability in 2024.
Note: Monday saw shop price inflation in the UK come in at the weakest (i.e., slowest) level since January of 2022. Reinvigorating arguments among some that the BoE is poised to over-tighten by focusing on backwards looking data and are being bullied by markets into rate hikes that are unwarranted based on more real-time data.
However, against a backdrop of over 6% wage inflation and core inflation that’s remained sticky at extremely elevated levels for an increasingly prolonged period, putting too much stock in monthly quasi-real-time measures is a dangerous game to play — especially with credibility concerns rising.
Based on the view that the BoE will raise rates to 575bps, Bloomberg Economics now believes that a shallow recession will begin in Q4 2022 and will last for around a year — something that, although it won’t be said by BoE members, is the surest way to cool the labor market, reset wage inflation to levels compatible with target, and ensure that inflation doesn’t revive.
The BoE, to their credit, understand fully that the root of the intransigence of inflation begins and ends with wage inflation — but it’s politically difficult, to put it mildly, to tell people to turn down raises as they see their purchasing power erode. However, Governor Bailey once again stepped into the fray saying that he hoped workers would stop seeking higher wages. I somehow doubt many will take his advice.
Part 2 / 4: Goldman and Geopolitical Gyrations…
Several weeks ago we discussed Jeff Currie, Goldman’s head of commodities research, and his latest note that (yet again) had him lowering his year end Brent forecast — this time to $86/bbl from $95/bbl previously.
It’s been a tough year for Currie: back in June 6 of 2022 he nearly perfectly top-ticked the oil market by calling for Brent to average $135/bbl over the next twelve months due to a belief that a mix of underlying underinvestment, stronger than anticipated growth, and geopolitics would keep oil elevated.