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In December, the Federal Reserve cut interest rates 25 basis points but signaled a slower pace for rate cuts compared to its November meeting. This shift in tone unsettled the markets. The minutes of the FOMC meeting show that inflation hasn’t come down as much or as fast as expected. This has made the Fed wary of increased inflationary risks, including uncertainty relating to proposed changes in trade and immigration policies from now-President Donald Trump. The explicit judgement and change in forecasts based on executive and legislative policy contrasts starkly with their careful dodging of any such commentary during massive deficit spending of the last administration and Congress. The most recent meeting projected a similar concern about inflation’s path. The Fed appears less concerned regarding the health of the job market, which had figured prominently in its aggressive 50 basis point cut, supported by a more dovish inflation outlook in September.
Recent data points suggest a broad-based rise in inflation expectations. 5-year and 10-year inflation swap rates and breakeven inflation rates started rising from their lows following the Fed’s September rate cut and remain well above the Fed’s 2% inflation target. Consumer expectations of inflation have jumped since September. The Fed’s Philadelphia Manufacturing Survey and ISM Services PMI are both showing prices rising at the fastest rate in two years.
The market may have once again overreacted to the short-term direction of the Fed as we’ve seen many times over the past year, forecasting multiple rate cuts and then pricing them out. There’s countervailing evidence that inflation will continue to ease, with the labor market more in balance, productivity staying high, growth in rents slowing, and the continuing base effect, with high inflation months of early 2024 falling out of the year-over-year monthly comparisons.
Source: Bloomberg
Source: Bloomberg
The current level of political upheaval affecting Germany, Canada, South Korea, France and the U.K. is striking, with all in varying degrees of political crisis. Germany is heading toward a snap election after the governing coalition lost a no-confidence vote. South Korea’s president has been impeached and arrested following a failed attempt to impose martial law. France has been unable to form a governing coalition even as the EU deadline for getting its large government budget deficits under control fast approaches. Canada’s prime minister has resigned and will step down once a new party leader is selected. The U.K.’s new Labour government is already under siege with the new prime minister reaching historically low approval ratings after entering office in July of last year.
Political turmoil has hurt investor confidence, shaking markets in these regions. The U.K. has seen significant outflows with the pound weakening and yields on 10-year Gilts nearing a 16-year high. Yields in France have risen, with the divergence between French and German yields widening considerably, reflecting eroding confidence in France’s fiscal deficits relative to Germany, where debt levels are much more manageable. 10-year yields in France are now higher than Spain’s, a dramatic reversal in their relative economic strength and fiscal health.
The onslaught of Eurozone elections points to a shift toward populism reminiscent of the recent U.S. election. This messy political process is occurring coincident with difficult economic conditions exacerbated by still elevated inflation, weakening employment and out of control debt growth. The contrast with the clear political leadership and economic strength of the U.S. will further incentivize capital to flow to the U.S.
Source: Bloomberg
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