This is a function of confidence over the avoidance of a recession, a decline in the inflation rate (disinflation) and expectation around the arrival of peak rates. Have markets become overconfident about the delivery of the soft-landing given the recent tightening in financial conditions and the risk that inflation declines become harder to achieve. The hard landing risk is reflected in 2024 forecasts not 2023.
Financial Conditions cover much more than just the Fed funds rate.
Despite market anticipation that the interest rate cycle is close to peak, it is worth remembering that risk appetite is more heavily impacted by the status of aggregate Financial Conditions. Our Financial Conditions Indicator (FCI) encompasses the combined impact of monetary policy shifts, the credit cycle, and the dollar. Exhibit 1 shows that some of the key components of the FCI such as bond yields, Fed balance sheet contraction and interest rate futures have all tightened over the last few months.
Exhibit 1: A tightening in key Financial Conditions components over the last few months
Recent moves have pushed the US FCI back into restrictive territory
Exhibit 2 shows the aggregate FCI scores for the US, UK, Europe, and Japan. It shows that the US and UK have seen there FCI's move back to restrictive levels while Europe and Japan remain in neutral territory. The recovery in risk appetite in the first half of the year was aided by the easing in the US FCI. The risk off move in August could be responding to the upward inflection in the US FCI.
Exhibit 2: The US FCI has moved back to restrictive levels.
The period of favourable base effects for inflation are now behind us
Exhibit 3 plots the Fed's key inflation target (the core PCE deflator). Over the last 12 months or so the inflation rate has been disinflating sequentially. However, this has been helped by favourable base effects (the comparison with prior year inflation levels). The chart shows that the Fed expect the rate of disinflation to continue with a year end 2024 inflation target of 2.6% (dotted blue). To achieve this requires a monthly run rate of 0.24% for the inflation indicator.
The risk is that now that the base effect tailwind is dissipating the monthly inflation run rate could prove stickier than the Fed hope. We show that if the PCE deflator continues to match the monthly run rate we have seen over the last few months year end 2024 PCE of 4.4% (dotted red). This would cause concern for the Fed.
Exhibit 3: The Fed's key inflation target the Core PCE deflator no longer has base effect tailwinds.
The hard-landing forecast is seen as a 2024 not a 2023 event
Exhibit 4 shows the status of consensus 2023 and 2024 regional GDP growth forecasts and the scale of revisions to these forecasts over the last three months. Looking at the US forecast we can observe positive revisions to the 2023 forecast (the genesis of soft-landing confidence) but larger negative revisions to 2024 growth with a 0.6% forecast.
The negative revisions to 2024 growth reflect concern about the delayed impact of restrictive financial conditions. Focus has not yet fully rotated to the 2024 outlook.
Exhibit 4: Latest consensus 2023 and 2024 GDP growth forecasts
Source: Wilshire, Refinitiv, Federal Reserve, BoE and ECB. Data as of August 14, 2023
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