Macro, geopolitical pressures hold risks as central bank warnings fall on deaf ears

The market is pricing in early rate cuts in Europe and the US, apparently ignoring pointed comments from central bankers and a minefield of geopolitical tensions throughout 2024, meaning the risk of a sharp repricing is real, according to Valentin Giust, global macro strategist, Crédit Agricole CIB, and Louis Harreau, head of developed markets macro and strategy, Crédit Agricole CIB.

You can download a pdf version of this article in the full BIHC Briefing alongside further coverage.

Neil Day, Bank+Insurance Hybrid Capital: The market seems quite bullish regarding rate cuts, and this has driven primary market activity at the start of the year, but we have had mixed signals from data and central banks lately. What are the key risks on this front?

Valentin Giust, Crédit Agricole CIB: Looking back at the past year, expectations regarding 2023 were revised substantially. A year ago, the consensus for 2023 US GDP growth was about 0%, but now we expect something around about 2%-2.5%, which is an outstandingly large and positive revision. And the US economy is still quite hot — it is slowing down, but only very gradually.

There are two main forces compelling the Fed to remain quite hawkish — indeed, we were quite surprised by the Fed in December, with Powell’s rather dovish tone. The first is the fiscal deficit, which is still quite significant, with the deficit to GDP ratio above 6% over the last 12 months — this is akin to a recovery plan on the still overheating economy. At the same time, the household saving rate is very low, which helps the US consumer continue its very strong pace of consumption and the very positive retail sales we’ve had since the summer, as evidenced by last week’s print.

Consequently, we are not convinced that inflation will return to 2% very easily in the US. The first mile has been achieved quite easily, but the second one will be much harsher. We mainly believe that we are in a “no landing” scenario. The labour market is still too tight. It is slowing down, but the imbalances — mainly excess demand over supply on the labour market — are still significant, so we still expect some wage pressures, above 4%-5% per year this year as well as in 2025. That’s why we expect US inflation to remain at an annualised rate of around 3% this year, and why we expect the Fed to remain quite hawkish this year, at least until summer. We currently expect just two rate cuts this year, in July and November. We are discussing this call and whether we will add an additional cut, but we clearly lean towards the hawkish side of the market as far as the US is concerned.

Day, BIHC: So would you expect a repricing at some point?

Giust, Crédit Agricole CIB: We need to see some repricing across the whole curve, and especially the short term part, because some of the cuts that are currently priced in have to be de-priced. A first cut in March or April as anticipated by the market is completely out of touch with macro reality. There would need to be a huge downward revision of growth for the central bank to be in a position to deliver such a cut, and we do not expect that, which is why we rather expect the first cut of the easing cycle to occur in the summer. The picture is not dissimilar for the ECB, but I will let Louis comment on that.

Louis Harreau, Crédit Agricole CIB: Indeed, this parallel between the Eurozone and the US can be drawn. The repricing in relation to both central banks seemed to occur in one go and to have been something of a self-fulfilling phenomenon. As far as the ECB is concerned, markets are way too optimistic about rate cuts. The pricing in of a rate cut in April is very unlikely to be proven right.

The Eurozone economy may be in a different situation than the US, but core inflation is much stickier than what the market is currently pricing. Even if you can have volatility in terms of headline inflation — due to energy prices, etc — core inflation should remain sticky. Wage pressures in the Eurozone are continuing to build due to the tightness of the labour market, and this will be transmitted into price rises. Consequently, we expect inflation, and especially core inflation to remain above the ECB’s target permanently, if you will, or at least until 2026. In this context, we expect — as for the Fed — the ECB to keep its rate at the current level for significantly longer than what the market is expecting.

This means that at some point in time there will be a repricing of the market. What we find surprising is that the ECB’s pushback against current market pricing over recent days and weeks is not being listened to by the market. Most ECB members have explained more or less clearly that they do not intend to cut before this summer, at least — so we could discuss if it will be June or July, but certainly not April. On the way down, markets have been very eager to price in rate cuts when there were any dovish comments — for example, Isabel Schnabel’s interview with Reuters on 5 December surprised on the dovish side — but now ECB members can be as hawkish as they want and the market is not listening to them. So the risk is that you could have a significant repricing at some point in time — although it is not yet clear what could spur this repricing.

Day, BIHC: What impact might geopolitical developments have, for example and perhaps most topically, the attacks on Red Sea shipping?

Giust, Crédit Agricole CIB: There are many geopolitical risks — regarding Taiwan, regarding Iran and the Red Sea with the Houthis, as well as the Ukraine conflict, which has not gone away. So we are facing a very difficult geopolitical environment and this is a source of inflationary risk, with the risk of a negative supply shock. We believe that the current market pricing of inflationary risk coming from an exogenous supply shock is very low, and that some repricing shall be needed.

There is a second part to this story, namely the US election. We believe Trump could also be considered as an exogenous negative supply shock risk potentially bringing inflationary pressures. A victory for Trump would be positive for US demand — we could see a new recovery plan, a new tax cut scheme, or something like that.

So there are many inflationary risks around the corner and market pricing is nowhere near reflecting these.

Harreau, Crédit Agricole CIB: The Eurozone is particularly exposed to geopolitical factors, such as the Red Sea tensions, and obviously the Russian invasion of Ukraine due to its proximity. So unfortunately the Eurozone is likely to be more exposed than the US if there is a worsening of geopolitical issues.

When it comes to elections, the outlook is better. Since the beginning of the pandemic, the Eurozone is no longer a geopolitical or political problem per se. The Eurozone is not the source of the problem. There will be important European Parliament elections in the middle of this year, but if you look at projections, there’s no reason to be especially worried about them: even if the number of populist MEPs may increase, they should remain in the minority. So again, the EU and the Eurozone should not be an issue; it will rather face exogenous issues.

Day, BIHC: Apart from the rate cut question, should we be watching out for any other significant moves from the ECB, in terms of TLTROs or QT, for example?

Harreau, Crédit Agricole CIB: Let’s be clear: we don’t expect QT or any acceleration of QT with PEPP in the second half of the year to have any meaningful impact on anything. The reduction of the ECB’s portfolio is extremely slow, possibly too slow — we could discuss that, but this means it will have probably no impact on the market whatever happens.

On the contrary, the end of TLTROs still holds some uncertainties. We have to acknowledge that the repayments of TLTROs have been extremely smooth so far: it has had no market impact and banks have faced no difficulties in getting the liquidity they have needed. But there’s still the possibility that repayment of the last €400bn of TLTRO monies that will have to be repaid in 2024 could be more complicated. The banks who have not yet repaid their TLTROs are probably those who most need the ECB’s refinancing operations, and that’s why it could be more complicated for them to replace the ECB’s term funding by market funding. So you could have some limited tensions from specific banks when they have to repay their TLTROs and when their TLTROs will no longer be NSFR-eligible, i.e. when the longest one falls below six months. I’m by no means talking about a banking crisis or whatever, but there could be some idiosyncratic issues for specific banking institutions.

Day, BIHC: Taking a longer term view, perhaps into 2025, do you have any thoughts on the prospect of a comeback for QE at some point, given the ballooning supply and possible question over how this will be absorbed without a significant repricing?

Harreau, Crédit Agricole CIB: There are several dimensions to this very interesting question. The first is the market’s absorption capacity.

The second touches on the question of the neutral rate for central banks. Indeed, we have the feeling that neutral rates have to be significantly higher than prior to the pandemic due to structural changes in the economy. So market rates will have to adapt to the new supply-demand imbalance in the bond market overall.

And the third point is related to the issue of the US election and specifically the funding of US debt, and Valentin can cover that together with the first point.

Giust, Crédit Agricole CIB: Here, our assessment for the US is quite different than for the Eurozone. In the US, there is a clear issue when it comes to stabilisation of public debt and its long term trend. Issuance is rising and at the same time there is no clear political platform to deliver consolidation in the public finances. That’s why we expect public debt issuance to continue rising year over year.

Meanwhile, we can discuss whether or not the capacity for this to be financed externally remains as it was pre-Covid. The US current account balance is substantially negative, about $1 trillion per year, and the US has to find this externally. The main three financers are Germany, Japan and China, and it is reasonable to doubt both the capacity and the willingness of those suppliers of excess savings to continue financing the fiscal deficit and the external deficit of the US. So while the funding needs of the US are projected to grow over the next 20 years, there is a question mark over the capacity of savings globally to absorb this, resulting in a funding gap. In theory, this could lead to the emergence of some term premia on the US dollar curve.

But at the same time, the Fed’s approach to QT normalisation is very different from the ECB’s. While in the Eurozone space, as Louis said, the ECB is willing to keep up with QT, the Fed is willing to slow down its QT — we expect the Fed to reduce its QT in the second part of 2024, and then stop its QT and just sterilise its balance sheet from some time in 2025. This will not mark the return of QE, but we can therefore expect some kind of end to QT, and this will help offset the effect of term premia in the US. So while we can be cautious about the US long end, you have this Fed support.

In the Eurozone, we don’t have this pessimistic outlook, but at the same time we don’t have the ECB to sustain the market.

So at the end of the day the situation on balance will be quite similar, but the reasons across the pond are very different.

Main image copyright ECB/Felix Schmitt