Listening to central bankers, not just inflation data

Since the start of the year, the narrative driving markets has changed in an important way. The rally spurred by the soft US inflation report in November 2023 has since gained momentum, notably because of changes in the perception of central-bank policy. 

This week, Simply put considers changes in the tone of central-bank communications, how the market reacted and why data might not be the sole driver for future policy

Looking back to inform the future

Initially, the Fed's policy pivot in December paved the way for excessive rate-cut expectations, before a change in tone led to these extreme cuts being removed from expected scenarios. The ECB faces the same difficulty in moderating the market's enthusiasm for loosening policy while staying the course in the fight against inflation. 

Studying how markets have adjusted to these shifts is essential to prepare for the rest of 2024, and requires monitoring several indicators. We look back at the previous three quarters to try to understand what may arise in the next three.
 

A pivot from hawkish to dovish

Despite their recent efforts to extinguish anticipated rate cuts, it’s clear that major central bankers have changed course. After two years of restrictive monetary policy at full throttle – lest the jumbo hikes of this cycle be forgotten – the Fed's meeting on 13 December changed everything. 

The ‘higher for longer’ rhetoric gave way to when the Fed would consider rate cuts. The ECB may not have said as much, but its March meeting telegraphed a reduction in June 2024. Indeed, the pivot from hawkish to dovish policy is well and truly here. 

Figure 1 shows two indicators that measure this change in tone. The black line shows the analysis of central bankers' speeches in a score ranging from hawk (positive) to dove (negative). Peak hawkishness is reached in the summer of 2022, and the trend is confirmed at the end of September 2023. 

The US inflation report certainly supported market valuations and the way Fed members treated the data – seeing it as a reason to put the brakes on the rise in real rates – played an instrumental role in this process. 

Figure 1 also shows our monetary policy nowcasting indicator, which is comprised entirely of economic data selected for historically triggering monetary-policy decisions. When central bankers' speeches are perfectly in line with the data analysis, the time has come for rate cuts.

As investors, we are interested in how this pivot affects the markets we allocate to. 

FIG 1. Hawk-dove score vs LOIM monetary policy nowcasters

Source: Bloomberg, JP Morgan, LOIM. For illustrative purposes only. As at March 2024.
 

When pivots become discerning

Figure 2 attempts to summarise the situation in a graph, showing changes in the US 10-year Treasury yield compared with changes in investment-grade credit spreads. Four main phases stand out relatively clearly:

• In phase 1, preceding the start of the 2023 summer term, monetary policy was perceived as increasingly restrictive (interest rates were rising) without jeopardising growth prospects (credit spreads were tightening)
• In phase 2, the hawkish tone from central banks sharpened: interest rates continued to rise and credit spreads also widened in their wake. Monetary policy became the enemy of the economy
• November's inflation report marked phase 3, but as the chart clearly shows, rates and spreads began to fall before it was published. October saw the Fed moderate its tone (after the peak in hawkish communications, see figure 1). The markets willingly listened
• Phase 4 covers today. The markets have focused too much on the dovish message surrounding the pivot and anticipated too many rate cuts. The central banks corrected their stance and, as a result, interest rates rose but credit spreads did not

FIG 2. Investment-grade credit spreads and 10-year Treasury yields

Source: Bloomberg, LOIM. As at March 2024. Yields are subject to change. For illustrative purposes only.

Understanding the role these monetary-policy adjustments have played on market perceptions is essential to determining what valuations currently reflect. We have moved away from the perception of central banks being the enemy of the economy to the opposite stance; and if rates are rising today, they are no longer taking credit spreads wider. 

If last year serves as a guide, will the 4.5% threshold on US 10-year Treasuries be a Rubicon that, when crossed, tips the market back into phase two? To find out, we will have to listen to central bankers more than to inflation reports.

 

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Once again this week, the growth indicator declined with the US newsflow deteriorating 
• The inflation indicator continued rising over the week, as inflation pressures are slowly but surely building up
• The monetary policy indicator continues to show the Fed and the People’s Bank of China leaning towards the dovish side

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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