Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets, the Markets and Financing Division of State Street. I'm your host, Tim Graf, European Head of Macro Strategy. Each week, we bring you the latest insights and thought leadership from our award-winning suite of research, as well as the current thinking from our strategists, our traders, our business leaders, and a wide array of external experts in the markets.

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For better or worse, markets continue to hang on to the words and expected actions from global central banks and fiscal authorities. Two weeks ago, the US Federal Reserve kicked off an easing cycle with a larger than expected 50 basis point cut to short-term interest rates. Last week, the Chinese Central Bank and government unveiled a raft of monetary and fiscal measures to support a Chinese economy that has never really bounced back from the pandemic, and where demand is strained by over-levered household and corporate balance sheets.

Policymakers in general had talked a very hawkish game until around the middle of this year, but the tone is now almost universally quite easy and potentially getting easier. Have markets then already caught up to this pivot with equity markets at all-time highs, bonds returning to profitability and the dollar week?

Well, that's what we're going to talk about this week with my guest Michael Metcalfe, who runs the Macro Strategy team globally for State Street Global Markets, and who has a new paper out that looks ahead to some of the opportunities that might still be on the table as well as the challenges that might lie in store.

Michael Metcalfe (MM): Hey, morning, Tim.

TG: Hey, how's it going?

MM: Yeah, all good, thanks.

TG: So this week, I wanted to talk to you about this paper you've written, which is titled, Easing Won't Make It Easy, which is specifically about what the start of the Fed easing cycle means for markets. But in a way, we can probably extrapolate beyond the Fed because the ECB has cut rates a couple of times, probably will again soon. Last week, of course, China announced a huge program of measures to stimulate the economy. The Bank of England's cut rates, the Bank of Japan is maybe starting to sound a bit dovish again. So really, we're talking about an easy policy environment generally here.

And I want to start with the roots of why this is happening, which is this refocus on the risks from above target inflation to risks to growth or the labor market. The first question for you is, do you think that shift in focus and especially the timing are justified?

MM: Yeah, the evidence on inflation has become increasingly convincing, and that's particularly true in the US in recent months. And look, as a nice demonstration of that, the price that's annual inflation rate is at 1.5 percent there, which is a new cyclical low. And even if you go back over the last year, the annual inflation rate, according to price stats, has been just above 2 percent.

So as Alberto Cavallo pointed out on this podcast a couple of episodes ago, of course, some of that gap relates to shelter inflation. But if you take shelter inflation out, then actually the official data is saying the same thing. You know, obviously, if you look at the inflation rate of new rental data, that's also pretty benign. So I think we can be confident that shelter inflation is coming back, and inflation ex-shelter looks pretty good. So yeah, I think that balance of risk has shifted away from inflation quite decisively in the United States.

TG: I can't believe it's going to be me that brings this up, but inflation expectations, which you and I have talked about, and in fact, the last episode we talked about.

MM: Hey, does that mean I win the argument?

TG: No, no, no, come on.

MM: Fair enough, okay, okay.

TG: No, but actually, they have repriced high, market-based inflation expectations, the important one.

MM: Ah, there we go, okay, yeah, yeah, yeah, yeah.

TG: The one that's worth paying attention to, they have repriced higher, and curves have bearishly steepened as a result of the Fed and others becoming more easy. Let's go back to that discussion a little bit.

Do you have any concern that this might get out of hand if market pricing for rates does go a lot easier and therefore pushes inflation expectations up further?

MM: It is a really important trend to watch. It's a question of whether the Fed easing cycle is going to be viewed as credible or not because if the market, if interest markets price in a lot of easing and long term inflation expectations rise, then that might suggest that there's too much easing discounted. You're going to enjoy this. But it's as important to my mind, thinking about the inflation anchor, to look at the expectations of consumers and to look at the expectations of economists as well.

And well, actually, to be fair, of the three, if we take markets, consumers, and economists, actually, there are groups within the Michigan survey that have forecast inflation far better than any of the other two.

Anyway, I'm belaboring that point, I guess. But what I would say is I think you have to look at all three. And right now, the market is showing some concern, as you note, but consumers and economists aren't. Their inflation expectations are still well contained. And I think that will give the Fed some comfort that it's okay to ease reasonably aggressively from here for now.

TG: Yeah. And I think as well, the market-based expectations, as well as all the others, have remained pretty range-bound since they've come off their highs a couple of years ago. So no real de-anchoring risk yet. But there is a potential de-anchoring risk that is being talked about, which is the labor market. And there is this concept now, people talking about labor market expectations, which so far the US labor market has been relatively healthy. There's been clear slowing, it's balanced. The Eurozone labor market, again, relatively healthy and no signs of softness. I think you could see a little bit of softness in the United Kingdom (UK) maybe.

But let's speak a little bit about labor market expectations just to kind of finish the back story, because this episode is coming out the day before we get the US payroll report for September. The expectation is pretty benign. I think it's around 145,000 growth in headline jobs, which is basically labor force growth. So again, balanced.

I mean, beyond that set of data, is there anything you look at in particular in the labor market that gives you maybe a more timely sense in either direction as to how central banks might respond to, if not deteriorating labor market expectations, at least softening or a balanced labor market?

MM: Unfortunately, we don't have a price stats for the labor market. But I think that the data set that we've seen that comes closest to it, probably be the one from Indeed, the job postings website. And they do a very nice job of collating their data. What they're doing right now is they're benchmarking it to kind of pre-pandemic levels. They're looking at the trend in new job postings, which would seem to be a very reasonable guide of whether the labor market is in balance right now.

And what that's shown is that the level of new job postings has come down quite significantly in the last 18 months really. But I think from the point of view of thinking about the latest payrolls report and actually what we've seen over the summer, it's interesting is that we haven't seen a marked deterioration. So you kind of think that if the US economy were about to tip into recession, you'd think that job postings would be falling very rapidly. And they're not. It's just a gradual correction.

But the interesting thing on that, so that's the US, but there are some really, you noted that the UK labor market is softening. And so their job postings, for instance, on the data are below their pre-pandemic average. But here's the thing in the UK, which is, I know this is puzzled as both, Tim, is that actually the wage growth that is appearing in these job postings in the UK is still above 6 percent.

And so it shows that there's still an inflation risk in the UK from the labor market, even though the labor market is softening. And that isn't true in the States. So the wage growth emanating from new postings in the US is, again, it's stable, but it's back at 3 percent. So it's back at where it was pre-pandemic. So no threat there.

TG: One of the aspects in the paper you talk about is how markets have started to respond to this pivot that the Fed, in particular, but other central banks as well, have made. And pricing becoming more easy than, you know, the Fed themselves release projections, of course, the dots, where they see policy rates in, you know, by the end of this year, by the end of next year, another year, and then the long term dot kind of where neutral is. And the pricing for rates in the kind of very short run is more aggressive than what the Fed is saying. But the pricing overall is just to kind of get to where the Fed says rates will go, which is neutral.

Do you think that gap that has opened up between where the market and the Fed are in the more short to medium term, do you think that is meaningful? And does that then mean you start to think about rates potentially going the other way? Or are there other factors you have in mind when thinking about where rates go from here?

MM: I think it matters, to be honest, in a similar way to the earlier conversation we had about inflation expectations, that if the market is a long way from the Fed in terms of projections, in this case for rates, then it begins to become a little bit of a question about credibility. And you have this debate about who's going to be right and who's going to be wrong. I think on balance, there isn't a clean winner. It's not that the market is always right, it's not that the Fed is always wrong. But I think it does show you potentially where the risks are, or it gives you one gauge of where the risks are.

Also, if the market is below the Fed, as it still currently is, even after the dots moved a long way, it might suggest that short-term rate markets are going to be a little bit more vulnerable to stronger rather than weaker data right now. So I think it's helpful in showing you potentially where the balance of risks are.

TG: On that note, do you think there's any risk in any economy, whether it's the US or Europe or UK, for rates which are mostly priced, as I say, and those three that I've just mentioned, US, Europe and UK, rates are priced to be neutral or even higher when it comes to the UK. Policy is priced to be tight.

Do you think there is a case to be made, especially in the US, where the growth story actually looks the best of those three, for policy rates to ever be priced to be easy? In other words, that we have a harder landing than what is currently priced.

MM: I think the other point to note in terms of the projections is obviously that the Fed also releases some economic projections. This obviously shows how uncertain the current outlook actually is because market interest rates are below where the Fed projects interest rates to be. You look at the Fed's unemployment forecast in particular and think, well, actually, that looks really quite optimistic. They have unemployment rising a little bit just in the near term, but then falling back the rest of the forecast period, which as good as US growth has been right now, it really does look to be quite an optimistic scenario on the soft landing, which I mean, that might be the landing, but history would suggest that when the economy slows, it lands a little bit harder than that.

So I think you put all of that together and the outlook still looks really quite uncertain, even though we've begun the easing cycle that we've all been waiting for.

TG: Yeah, and I think that gets to the whole point of your paper, which the thesis or the title is easing doesn't necessarily mean easy. It becomes a little bit more tricky. And I think that's especially the case when we start to think about how markets respond to this, because you have the Fed at least telling you they want to get rates to neutral and do so relatively quickly. You have all of the stimulus out of China, which over the last week, that's really all anybody has been talking about or thinking about. And you're doing this with equity markets globally at all-time highs, with bond markets having done relatively well as a consequence of easier policy being priced in.

The obvious response to all this, especially given seasonals are now favorable as well, is that you just dial risk up into year end. And I've been asked this question a lot the last couple of weeks.

Does this automatically mean, this easier policy setting mean, that you take that allocation you have to equities and you ramp it up? Is there scope to do that further?

MM: I think the key point here is we've been waiting for the start of the Fed easing cycle for some time. And while it started with a bigger move, you've got to assume that markets have discounted some of this. And I think when we dig into the measures of investment, the most top-down measure we've got is the spread of allocation between equity and bond.

If you take that data back to 1998, it's kind of fun. The long-term average of the gap between equity allocation and fixed income allocations is, guess what, 20 percent. It's like the perfect 60-40 analogy. And look, right now, that gap is 25 percent. So it's above average. Investors are over what equities by a substantial margin. Could it get higher, to your question? I mean, yes. Curiously, the historical analogy for this would be the run up to the dot-com bust when that spread got as high as 35 percent. So it has been a lot higher than it is today. And obviously, there's also a lot of focus on tech right now, funny enough. So there is an analogy there.

But I think the one thing I would just sort of observe and typically, what happens to that spread of allocation between equities and bonds during fed easing cycles, is that during fed easing cycles, the allocation to bonds relative to equities usually rises by at least 10 percent . So you have a situation here where the allocation to equities is already quite stretched, and we've just started an easing cycle. And the historical analogies of all the easing cycles we've seen in the last 25 years has seen allocations to bonds go up.

So there is a very compelling case, as you say, for like a Santa rally and risk to do nicely in the year end. But positioning just looks a little stretched. During easing cycles, it usually goes the other way. And so I think it's just a point of caution, I would say.

TG: Yeah. So this is really interesting because that, I don't think I can go more than about four or five episodes without asking someone about stock bond correlation. It's been kind of my thing the last 18, 24 months. And this, I think, plays into that very nicely because if that's the case, you're talking about potentially a return to the negative correlation of returns between bonds and equities that really prevailed for about 25, 30 years before we had a return to inflation. So with that in mind, let's assume that happens.

I mean, do you think that is a lasting effect that stocks and bonds return to that kind of beautiful diversification they gave each other for a sustained period?

MM: Look, I think, and I'm sure this would have come up on prior episodes as well. There's a really nice paper. Actually, it was published in the middle of last year by Will Kinlaw Law, Dave Turkington and Mark Kritzman called Co-occurrence, A New Perspective on Portfolio Diversification. And that uses a lot, you know, that's a really long run paper.

What it finds in their conclusion is that, you know, as we know, the stock bond correlation does vary, but it's very regime dependent. And it turns out that when you're in lower inflation, or obviously it goes together, lower inflation or lower interest rate regimes, you do tend to get more diversification between stocks and bonds.

And so I think, and to your earlier question, if it's that rates get to neutral or lower, then in that kind of environment, then you would definitely expect the diversification properties to come back. Oh, and then of course, by the way, those same authors, their recession likelihood index for the US is still stuck at 90 percent.

So if you get the recession on top of that, then all of that points to the vulnerability for equities for one, because equities haven't discounted the recession for sure, but also this idea that you get diversification back.

TG: You bring up the recession probability indicator, and we've talked a little bit about this on the podcast, but for those listening for the first time, we have a prediction indicator that uses things like change in non-farm payrolls, the shape of the yield curve, the health of the manufacturing sector.

I think inflation might be the other variable? Mike can fill that in when I actually ask the question, but it has been heavily pointing to recession because of the inversion of the yield curve. Is that still the main contributing factor?

MM: The indicator is neat in the sense that it's built off just four variables. It's the yield curve shape, it's the equity market return over the past year, it's the annual growth and employment, as well as the health of manufacturing. And look, of those three, the one thing I would just kind of note on the curve to your question, yes, the curve is still a contributor because it uses a slow moving average. So it looks at a 12-month rolling average of the shape of the curve.

So it's not the kind of the immediacy. As soon as the curve inverts, you get a recession or as soon as the curve dis-inverts, recession risk goes down. And I think that slow moving component is important to note because also, as we said at the top of this, you were beginning finally to see weakness in the labor market and weakness in manufacturing. But the curve is still the main part of the signal for now. But you can see manufacturing and employment potentially taking over and keeping recession risk high. So I just think it's worth highlighting as a risk that the market is just so anti-consensus right now. I think it's just an interesting indicator to highlight.

TG: Yeah, very much so. It was the equity market, not inflation, the equity market. I don't have my own indicators straight, Will is going to be very upset with me.
So let's talk about what this means for risk assets generally just to finish here, because we've talked about the allocation to stocks versus bonds.

But is this an environment as well where all risk markets get lifted in a universal everything rally? The last couple of weeks, we've had big moves in stocks, in gold, in crypto, everything really except oil within the commodity complex.

Thinking about correlations, not just across markets, bonds versus equities, but within risk markets in particular, is this a rising tide market, or do you think there are divergences to play up in asset markets or in currency markets as well as this risk rally continues, if the risk rally continues?

MM: Yeah, I mean, it's always good to start with a big if. But if it does continue, I do think divergence is worth noting because your positioning across different axes is quite stretched. So the US exceptionalism story in terms of the overweight in US equities, that's very, very well positioned for, same in US tech.

Right now, there are quite significant underweights still in emerging market assets, whether it be equities or fixed income even. It's interesting to see how investors react to the China news because that is a policy step up that we've made, like you said, right at the top of the podcast. So if risk is going to rally, it will be remarkable. If everything rallies together because positioning is so uneven, you think there'll be a little bit of a rebalancing, maybe out of the US and into tech, from tech, and into emerging market assets which are more under owned and in some cases much better valued.

And by far and away, the best demonstration is, I think, actually is in the currency market, where at the start of the summer, and all through the first half of this year, Carry was the place to be, that the trade got very crowded, and then we had the vol shock, the combination of the BOJ and the disappointing payrolls number. And remarkably in our indicators, it completely cleaned out the Carry trade.

I mean, that does happen, but now we're getting into a position where, if risk does, if, there's that if again, if risk does come back and vol is a little contained, then there is huge amounts of room for investors to gradually go back into Carry strategies in the FX market in particular. So from that point of view, I think that the risk value will be much more uneven this time if we get it.

TG: Well, the final question on that then is, where does the dollar sit in all of this? Because of course, a lot of the rally in risk is being predicated, as we've talked about, on easier US policy, and the dollar has seen some unwinds, but I would note our positions in the dollar that we track from institutions are still modestly overweight. The hedging of US assets is still very, very low, so room to lift those hedge ratios, and yet the US is still kind of the cleanest dirty shirt, or the best growth story, and relative to the Eurozone, relative to the UK, maybe has the best growth outlook for getting about the best growth performance.

So taking all of that into account as well, oh yeah, we’ve got an election coming up. I mean, how would you play the dollar for the rest of this year with all of that in mind?

MM: So I think the key question here is the point you made at the end, and how to invest this position for the upcoming election in the US around the dollar. And look, one of the things that we've observed with our media sentiment analysis is that when the media seems to be leaning towards Trump, then the beater on the dollar is positive. When the media leans towards Harris, it tends to be a little more negative. But here's the challenge is, of course, that the election is still too close to call.

And I think that's partly reflected in current dollar positioning, is that where it's close to neutral on dollar positioning, that you're right, it's a little bit of an overweight. But in general, where it's close to neutral on the dollar, it would be in two and a half years. And in that two and a half year period, of course, investors have never been negative on the dollar.

So I think, unfortunately, this is a bit of a cop out here, is that you absolutely need to wait and see until November. And until you get there, there are plenty of different ways to play. Carry, for instance, and FX that don't involve the dollar. And so I think that's what our data is showing, actually, is that investors are, they're kind of neutral on the dollar for now. It's a wait and see, but risk could come back on in the merchant market currencies or other high-yielders.

TG: It's certainly not going to be easy. In fact, that is the paper. To bring us full circle, the paper is easing won't make it easy, especially for US portfolios, and especially those with dollar risk in them. It's by Michael Metcalfe, my guest this week. Mike, thank you so much, as always.

MM: Pleasure, Tim.

TG: Thanks for listening to this week's edition of Street Signals from the research team at State Street Global Markets. This podcast and all of our research can be found at our web portal, Insights. There you'll be able to find all of our latest thinking on macroeconomics and markets where we leverage our deep experience in research on investor behavior, inflation, risk, and media sentiment, all of which goes into building an award-winning strategy product. If you're a client of State Street, hit us up there at globalmarkets.statestreet.com. And again, if you like what you've heard, subscribe and leave a review.