‘What If The Future Isn’t So Tidy?’ McElligott Asks

Reduced to the basics, market participants harbor a somewhat binary outlook on inflation and monetary policy in the US.

Notwithstanding Jerome Powell’s steadfast contention that he’s not trying to “induce” a recession, policymakers are operating on what amounts to a single mandate, where the inflation fight takes precedence over growth. Higher unemployment isn’t just “acceptable collateral damage,” it’s a wholly necessary and desirable outcome — at least up to, say, 4.5%.

At the same time, headline inflation is widely expected to recede as the commodity rally proves unsustainable. So, while inflation might settle higher than target, the combination of a Fed-engineered recession and retreating commodities (sans European natural gas, which will continue to oscillate commensurate with Vladimir Putin’s level of spite) likely means terminal rate achievement is closer than policymakers are currently willing to concede. The same goes for the first rate cut.

That’s one side of the binary outlook. The other side is just that commodity prices stay elevated and supply chains fractured. Oil spirals to $200 (or higher). Putin cuts off all gas flows to Germany triggering an existential surge and cascading credit events and defaults across the world’s fourth largest economy. Xi Jinping sticks to “COVID zero” in perpetuity at whatever cost, precipitating rolling lockdowns and prolonging supply chain disruptions. Food export bans become a feature of the global economy. And so on, leaving inflation permanently higher and rendering central banks totally impotent in the face of structural supply factors over which they have little, if any, control.

As ever, the likely outcome is probably somewhere in the middle. In this case, that’s not necessarily a good thing, even if the middle ground is far preferable to a scenario where everything humans need remains unaffordable for most humans, and no amount of demand destruction short of a literal depression (with a “d”) proves sufficient to ameliorate the situation.

Nomura’s Charlie McElligott addressed that middle ground in his first note back from what he described as “two weeks of blissful ignorance at the New Jersey shore, aka the American Saint-Tropez.”

“What if the ‘inflation peaking, then lower’ outcome alongside the now base case of a Fed-‘engineered’ and ‘short-and-shallow’ recession isn’t so black and white or ‘tidy’?” he asked, noting that the “generally expected Fed policy pivot from tightening to easing as soon as Q1 2023” hinges on the notion that the first outcome (as described above) is all but a foregone conclusion.

“It’s increasingly my view that despite the widely anticipated easing in inflation seen in coming months from recent backward-looking energy price ‘shock’ levels, it will remain structurally ‘sticky’ and higher-for-longer, tying central banks’ hands versus expectations born of the market’s recency bias,” McElligott wrote.

That’s a crucial point, and in many ways, it’s the mirror image of the discussion from “‘Very Unusual’ Times” and “Game Over,” in which I asked what might happen in the event markets (and the economy) simply refuse to countenance the amount of Fed tightening necessary to control inflation.

Pervasive macro ambiguity aside, we all expect this to be fairly straightforward. As McElligott put it Monday, “the muscle memory from the prior decade’s ‘Goldilocks’ regime [says] any idiosyncratic growth scare or ‘crisis'” will prompt “the Fed or other global central banks to ‘cut to ZIRP’ while resuming balance sheet expansion into the anticipated economic hard-stop.” That assumption may be “greatly overstated,” Charlie said, adding that,

Instead of a prior conditioning that says the perception of a ‘Fed pivot’ is unambiguously ‘risk-on’ (and of course it will initially trade that way), I think the longer-term challenge [is] that markets instead see a grueling sideways ‘chop’ with persistently tighter financial conditions, due to an inflection in future central bank policy that’s hamstrung relative to prior ‘full-tilt’ easing dynamics during the era of sub-2.0% inflation.

Welcome back from Saint-Tropez.