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Sentiment Improves as Fed Rhetoric Remains Balanced

The dollar is softer and Treasury yields are subsiding after the chair of the Federal Reserve avoided walking back last week’s observation that signs of “disinflation” were beginning to appear – something that many saw as a communications error at the time. 

Jerome Powell essentially repeated last week’s message in a question and answer session at the Economic Club in Washington yesterday. Speaking with David Rubenstein, Powell noted that Friday’s jobs data was “certainly strong – stronger than anyone I know expected,” warning that the process involved in getting inflation down to target would be “bumpy”. “The reality is we’re going to react to the data,” Powell said. “So if we continue to get, for example, strong labor market reports or higher inflation reports, it may well be the case that we have do more and raise rates more than is priced in”. He noted “The disinflationary process, the process of getting inflation down, has begun and it’s begun in the goods sector, which is about a quarter of our economy. But it has a long way to go. These are the very early stages.”

Market expectations have risen over the last week, with overnight swaps suggesting central bankers will raise the Fed funds rate to 5.1 percent, up from 4.75 today. 

President Biden’s second State of the Union address left markets unmoved. The president largely focused on domestic issues, with pledges to avoid a debt default and to continue pursuing an industrial policy-focused agenda – both of which are unlikely to gain much traction in a divided Congress (the Democrats hold a minority, and the Republicans are essentially split into separate wings). He declined to take direct aim at China on economic issues, but seemed to reflect a growing belief among experts that the country’s economic model has fundamentally broken down, saying: “Name me a world leader who’d change places with Xi Jinping – name me one, name me one”. 

The euro is trading on a slightly stronger footing after two German European Central Bank officials delivered characteristically hawkish statements. In an interview with the Boersen-Zeitung newspaper, Joachim Nagel warned “From where I stand today we need further, significant rate hikes”, and his colleague Isabel Schnabel said “It is not yet clear that monetary policy is actually working so much that we can hope for inflation to return to our inflation target of 2 percent in the medium term.”

Today’s agenda is dominated by Fed speakers. New York’s John Williams is up first at 9:20, followed by governor Lisa Cook at 9:30. Minneapolis’s Neel Kashkari and governor Christopher Waller will provide economic updates at 12:30 and 1:45, respectively. 

The Bank of Canada will release minutes from its last policy meeting today. The Bank has previously only released a record of its deliberations under unusual circumstances, so we can’t be entirely sure how markets will react – but we don’t expect significant moves, given that policy settings are largely on hold at the moment. 

In a speech yesterday, Governor Tiff Macklem warned that growth is expected to flatline through to the fourth quarter of 2023 as rising borrowing costs hit highly-indebted households hard. “We need to pause rate hikes before we slow the economy and inflation too much,” he said, noting that monetary policy lags can extend to between 18 and 24 months. With the Bank of Canada expected to begin cutting rates before the Fed, yield differentials remain heavily tilted against the loonie – the Canadian two year bond yields 48 basis points less than its US equivalent, and the ten year is almost 60 points lower. 

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