Risk Asymmetry
- 08 January 2024 (10 min read)
- Markets don’t budge on their aggressive pricing of the policy trajectory for the Fed and the ECB despite the absence of “lights flashing red” which would call for a quick reversal of the policy stance.
- While a “soft landing “ is the baseline for the US and the Euro area when controlling for the difference in potential growth rates, the most plausible alternative scenario around this baseline is not the same in the two regions.
While so far in the new year the equity market has not kept up with its pre-Christmas exuberant mood, forward contracts suggest investors still believe that the ECB and the Fed will deliver quick and massive accommodation in 2024. We maintain our more cautious approach. The minutes of the December FOMC meeting strengthen our view that Jay Powell’s very dovish statements on 13 December should be taken with more than a pinch of salt, while the labour market softening continues to proceed by minuscule increments in the US. In the Euro area, headline inflation has rebounded in December, as expected. At the current juncture no light is flashing red and forcing the Fed and the ECB to engage in cuts as early as March.
The fixed income market is resolutely positioned for a “soft landing” on both sides of the Atlantic and, when controlling for the difference in potential GDP growth between the US and the Euro area, it is also our baseline. However, when it comes to risks around such baseline, we feel there is too little thought given by the market on the possibility of some significant transatlantic divergence this year. The most obvious alternative scenarios revolve around the two classical policy mistakes: central banks may already have gone too far and engineered a “proper recession” which would ultimately take inflation below target. Conversely, they may have stopped their tightening too early making it impossible to bring inflation fully back to 2%. In our view, the Euro area is more at risk of falling in the first scenario, and the US in the second. Beyond the fact that the economy has recently been much more resilient in the US, a fundamental difference between the US and the euro zone is that in the latter the maximum effect of the tightening of monetary conditions, given the usual transmission lags, will coincide with the start of budgetary restriction. The asymmetric materialisation of these alternative scenarios would be quite damaging to the euro exchange rate and make the policymakers’ choices even more delicate.
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