In terms of monetary and fiscal policy, the American response is clearly better than that of the European Union.
The inability of central banks to remedy supply-side dysfunctions should now be considered well established. Excess inflation will result in key rates well above the neutral rate, with the market expecting a final rate of around 3.75% in the first quarter of 2023. In the context of the tightening of monetary conditions which will be implemented by the Fed over the coming year, the 3.4% yield on 2-year Treasury bills represents decent technical protection for bonds. In this regard, the fall in inflation expectations, which fell from a level close to 5% on March 25 to 2.75% on August 26, is extremely revealing. And despite the fact that the financial press advocates “unanchoring”, short, medium and long-term inflation forecasts in the United States are not alarming.
Towards a slowdown in demand
Given the credibility of the Fed’s policy, bond markets seem to be comfortable with a relatively flat or slightly inverted curve on the side of the shorter maturities. Furthermore, Jerome Powell’s clear and precise message during his speech on August 26 in Jackson Hole could have the effect of reducing the volatility of US rates, both up and down, until the end of the year. The Fed, which is concentrating all its efforts on the fight against rising prices, expects an accelerated return to its initial target.
Given the tightening of credit conditions for households and, to a lesser extent, for businesses, the slowdown in demand is becoming the central scenario. Moreover, the labor market should relax more quickly than expected. Avoiding a new surge in wage inflation implies either a reduction in job vacancies or a reduction in the workforce in companies. In the first case, the unemployment rate, excluding the mismatch between job supply and demand, could fluctuate around 4% (against 3.6% currently), which remains a low level. If this assumption materializes, the terminal rate would remain stable for longer.
As for the alternative according to which the companies would carry out layoffs, it seems less probable. Companies fear that the cost of new hires will prove to be higher due to the lengthening of recruitment times in the recovery phase of the economic cycle. Nevertheless, in such a scenario the unemployment rate would drop to 5-6% and would imply a reduction in key rates.
Policies that deserve the “A”
During the last two years of Joe Biden’s presidential term, American fiscal policy was to remain generous. In August, the US executive passed two strategically important pieces of legislation. This is on the one hand the signing of the implementing decree for the “CHIPS and Science Act 2022”, which provides for an envelope of 50 billion dollars to support the semiconductor sector, and on the other hand the Inflation Reduction Act (IRA), which seeks to curb inflation while reducing the deficit. This law is very innovative insofar as it tackles inequalities (it will have no fiscal impact for the incomes of the middle and lower classes) while promoting the energy transition. In short, if we had to give a grade to American monetary and fiscal policy, it would very clearly be an “A”.
During the first half of 2022, the American stock exchanges cleaned up the excesses accumulated in 2021 and the second half will make it possible to separate the wheat from the chaff. In the technology sector, the traditional leaders, profitable and with predictable results, should show resilience. On the other hand, companies that offer new technologies, but which enjoy less notoriety and are not or only slightly profitable, should see their valuations subjected to a new test.
Mists and Challenges for Europe
On the other hand, the situation is much less clear in a Europe faced with monetary and fiscal challenges whose outcome is difficult to anticipate. The complexity that the ECB has to deal with seems to be increasing from quarter to quarter and the difference with the Fed’s situation is striking. The creation of a new instrument for purchasing securities, the TPI (Transmission Protection Instrument), on 21 July last, an instrument by which the ECB tries to improve the transmission mechanism of its monetary policy, could be interpreted as following: if the ECB commits a timing error in its policy of tightening financing conditions, in order to honor its main mandate, which is to bring inflation down to 2%, then there is a real risk implosion of EMU. This risk actually materializes when the transmission mechanisms seize up.
If we look at the two-year inflation outlook, the fragmentation is obvious since these expectations are at 7.07% for Germany, 4.92% for France and 4.41% for Italy. The 5- and 10-year expectations for the major EMU economies are around 2.50 and 3.00% respectively, which is closer to the ECB’s targets. So there is a small glimmer of hope.
Italy protected by the TPI
The ECB should opt for cautious tightening. The 50 basis point increase in the key rate announced for September 8 is the base scenario and new adjustments should take place to bring this key rate to 1.25% in the first quarter of 2023. At least that is what is anticipated by the markets and which manifests itself implicitly through the current fragmentation. Ten days ago, the yield spread between the 10-year Bund and the Italian BTP stood at 2.30%. However, the lack of details regarding the factors likely to trigger the activation of the TPI program should discourage speculation against the Italian bond and encourage institutional investors to remain neutral in terms of their exposure to Italian government bonds.
Energy: immediate action required
All the spotlights therefore remain on the energy crisis in Europe (the United States being self-sufficient in energy, they are well “isolated” in this regard). On the old continent, the heating season will start on October 1 and, to get through the winter, the EU will therefore have to fill its gas storage facilities to more than 90% of their capacity. In the immediate future, it is therefore a question of limiting gas consumption and storing the gas thus saved. For its part, the International Energy Agency (IEA) has called for the harmonization of various initiatives aimed at reducing demand, strengthening cooperation between operators and harmonizing emergency plans.
Regarding the European Commission’s “REPowerEU” plan which aims to make Europe independent of Russian fossil fuels well before 2030(1), it is oriented towards the long term and will have little impact on companies and households which will find themselves faced with supply difficulties over the next six months. It would therefore be desirable for the Commission to propose measures applicable immediately in the member countries of the euro zone.
Meanwhile, the new surge in gas prices has made headlines and is fueling uncertainty. However, this rise is not just in the spot price, but it ripples through the entire futures contract expiration curve for 2023 and beyond. One solution would be to accelerate the replacement of Russian gas with other energy sources, a substitution measure that is clearly likely to work. Indeed, if we extrapolate the price of the one-month contract of the Dutch TTF, the benchmark for the European natural gas market, which stood at 307 euros per MWh, on that of Brent at the nearest maturity, we arrive at a price of around 392 euros. However, at the close of Friday August 26, Brent was trading at 101 dollars!
On the basis of current data, the impact of the energy crisis will be much more marked in the EU than in the United States. We can therefore infer that the first signs of the recovery in the economic cycle which will follow the phase of tightening of monetary policy will first appear on the other side of the Atlantic. In terms of fiscal and monetary policies, the divergences between the United States and the EU will increase over the next 6 to 12 months and the downtrend of the EUR/USD pair is therefore not about to end. ‘reverse.