We have entered into a phase shift in global monetary policy. Central banks ex US are blinking, delivering dovish surprises even as inflation remains stubbornly high. This increases the probability of a regime shift to a much more divergent policy and market backdrop.
Last week saw significant volatility continue in global markets driven by increased divergence in policy and some signals of growth positive policy changes from China. Asian equities lead global equities higher, rising by 2.5-3 weekly stdevs as hopes rose for an exit from China's zero covid policy. In conjunction with this, industrial base metals rallied, Iron Ore rising by 1.9 weekly stdevs. Hawkish commentary from the FOMC resulted in US yields rising by another 25bps over the week with the terminal rate for this cycle making new highs.
However the major macro theme we saw last week was continued divergence from developed market central banks.
October 2021 was the beginning of the end of the transitory inflation narrative, as global developed market central banks pivoted away from growth centric, maximally stimulative monetary policy stances.
A year later, we are seeing the opposite. Over the last number of weeks, there has been a clear shift in the global monetary policy reaction function. Notably, we have seen a number of dovish surprises (BOE, Norges) with the early movers of 2021 (Canada, Australia and Poland) having all delivered dovish surprises by slowing the pace of rate hikes. There are clear signs of a phase shifting the global policy backdrop.
For countries like Australia and Canada, there are good reasons for this shift. In both countries, the domestic housing market shows significant signs of weakness. Australian home prices declined for the ninth straight month in Sydney, and the national housing price index fell again by 1.2% in October. In Canada, there are clear risks of a housing market shock, with rising Non Performing Loans among property developers, falling prices, falling confidence and a sharp slowdown in activity.
Broadly, the global economy is slowing. In October, the global all-industry PMI fell to 49, which, as JP Morgan notes, is a record low outside of a recession. The slowdown is most pronounced in manufacturing, which has been hit by weakening demand at a time of sharply higher input costs.
The US is not immune to the impact of tighter financial conditions. This is especially true in the housing market, where real residential investment fell 26% SAAR in 3Q, on top of the 18% 2Q drop, and pending home sales fell by 10% in September.
However, this loss of momentum in the US still places the US economy in a far better place than the rest of the world. The US labor market remains remarkably resilient. While Friday's employment report was more mixed than prior reports, with noted weakness in the household survey and the slowest pace of job gains since 2020. However, unless we see a sudden stop, we are still some ways away (to borrow a phrase from Chair Powell) from the extreme tightness in US employment easing.
Hence, the Fed continues to signal a prolonged period of tight monetary policy. Chair Powell took great pains to state that a shift in the pace of hikes is not signaling a pause, but rather that the terminal rate will need to be higher than they had expected. He went on to say that the risk of doing too little outweighed overtightening. This ran almost directly contrary to the tone of the rest of the world’s central bankers over the last two weeks.
The challenge for policy makers is that inflation shows very few signs of easing. Global inflation surprised to the upside in October, with core inflation becoming an increasing driver of inflation readings.
Policy makers find themselves in an uncomfortable place. However, what was revealed in October is that growth and financial stability risks are now back at the forefront of some policymakers' minds. This reaction function, developed over the course of the post GFC era, is supported by increased noise from politicians. The pendulum is swinging from one where central banks had significant political air cover to tighten policy to one where they have to justify focusing on inflation over growth.
Together, with some signs (although tentative and early) of a shift in China's zero Covid policy, risk assets have seen sharp rallies with Friday's 3.5x daily stdev rally in commodity currencies the largest since Covid. This rise in volatility across assets is consistent with the market on a cross asset basis, pricing regime shift.
However, the nature of what is to come, is less certain. While there are clear signs of bearish exhaustion across assets, the fact that inflation has not fallen yet does not support the idea of a shift to a benign liquidity environment in the near future. Further, if China reopens, this would likely add to the global inflation mix.
To us, the major theme that is building is one of divergence. For countries with worsening growth outlooks and rising financial stability risks, the asymmetry is for continued dovish surprises. If inflation shows signs of falling, we expect this to accelerate. If it doesn't, the persistence of negative real rates is likely to continue, and that will over time undermine currencies.
In contrast, the US is still a “ways off” from a meaningful pivot, which we believe will only come after a sharp contraction in economic activity and rising unemployment. We therefore expect the trend of widening spreads US vs ROW to continue to play out over the coming months especially vs Australia and Canada.
However, we would highlight one clear risk: If inflation does not fall, but growth continues to deteriorate, then a global stagflation scenario is here, and that is not likely to be a positive environment for risk assets.