Monetary Policy Changes

This chart tells you why the Fed is still behind the curve. This week's 50 bps cut was initially celebrated by markets: after all, if the Fed proceeds with such a sizable cut what's not to celebrate? The problem with such a simple narrative is that the Fed's monetary policy needs to be measured against the underlying growth conditions. Fed Funds at 4.75% can be: - Still loose: if the US economy is running ultra-hot - Still tight: if the US economy is rapidly weakening In other words: the monetary policy looseness/tightness needs to be measured taking into consideration the ongoing economic conditions. The chart below does just that, and it compares Fed Funds (orange) with the underlying trend of US nominal growth (blue). The US nominal growth proxy is built using core PCE - the Fed's official target for inflation - and the NBER gauge for US real economic growth. Why the NBER gauge and not real GDP? Because the NBER is the body that ultimately determines whether the US is in a recession, and they do so using a broad basket of 7 indicators tracking every sector of the US economy (from consumers to industrial production to the labor market). The outcome of this analysis is straightforward. There is nothing to celebrate. The Fed's policy is still dangerously tight. As you can see, it only rarely happens that Fed Funds (orange) sit close or even above US nominal growth (blue) for a prolonged period of time. And when that happens, it's never good news for the economy. The Fed needs to do more. Or it risks falling further behind the curve. Agree or disagree? If you liked this post, you'll love my macro research! Want to try it out FOR FREE? Join thousands of institutional investors and get your FREE trial using the link below 👇 https://lnkd.in/dEVXZw-N

In light of the recent news on tariffs, below are a few updated insights from our prior Compass newsletter: https://lnkd.in/efTDy33r ➡️ The “consensus” expectation was that the average effective tariff rate would rise by ~10 percentage points, imposing a cost on the economy equal to about $300bn. We believed that would probably be sufficient to result in one or two quarters of negative growth. ➡️ The tariffs announced this week were far larger than that so no surprise to see the market sell-off on the news. ➡️ How much larger? While it’s difficult to estimate what the average effective tariff rate will be after yesterday’s announcement given (1) exemptions on products and trading partners (Canada and Mexico), (2) potential interactions with other product-specific tariffs, and (3) potential expenditure switching, it looks to be in the 13 to 17 percentage point range, or ~50% larger than expected. That would mean the economy has to absorb an economic hit closer to $500bn. ➡️ Most of the impact is likely to manifest as increased consumer prices. We had expected consumer prices to rise roughly 1% in response to the tariffs; this would suggest an increase in the price level closer to 1.5%. But the response is nonlinear: the larger the shock relative to household income, the greater the risk to corporate margins due to a larger decline in real sales volumes. ➡️ Despite this inflationary impact, the Fed is more likely to cut rates in 2025 as a result of the new tariff rates. The Fed distinguishes between (1) endogenous inflation, arising naturally from supply and demand factors that can be influenced by policy rates, and (2) exogenous inflation produced by a supply shock or sudden policy change. If the economy deteriorates and unemployment rises, the Fed will likely respond with a rate cut by September. ➡️ The situation is most analogous to the 2014 consumption tax increase in Japan, which caused the consumer price level to jump by 3% in a single month. The economic fallout from the tax increase was so great that the Bank of Japan eased its policy stance in response. Real consumption turned negative and prices increased at a 30% slower rate in the three years after the tax increase than they had in the three-years prior. ➡️ The Fed will need to see clear evidence of economic deterioration over multiple months and will be very cautious with the pace and magnitude of cuts. The Fed will be focused on signs that there are no second-order effects (price increases beyond that which could be explained by tariffs) and will closely monitor inflation breakevens from TIPS markets to ensure inflation expectations remain well-anchored. A rate cut will become more likely if core services inflation decelerates as consumers cut back on spending in response to the negative income shock.

This chart serves as a compelling illustration that we have not yet experienced the impact of tighter financial conditions filtering through the system. Despite the recent increase in mortgage rates, effective interest rates for most individuals remain at historically low levels. Corporations are in a similar position, but bear in mind: We are on the verge of witnessing a substantial surge in the cost of debt as we brace for a significant wave of debt refinancing in the next 12 to 24 months. Sovereign institutions are also facing a comparable scenario. The US federal debt, in particular, will need to refinance nearly 50% of its total debt in the next three years at substantially higher interest rates.

With fixed interest rates up ~70 bps over the last two months, it's important to understand how higher rates impact loan proceeds. I pulled together a chart illustrating that for every 25-bp increase in interest rate, your loan proceeds decrease by approximately 2.6%. Have rates gone up 50 basis points since you last updated your model? Then your loan amount will be ~5.2% lower. The example in the chart uses a $2M NOI, but the same relationship exists regardless of NOI. For people reading this who may be unfamiliar with the terminology: Loan Constant = Your annual debt service divided by the loan amount. It takes into account the amortization, so if a loan is interest-only, then your interest rate and your loan constant are the same. DSCR = Debt Service Coverage Ratio. This is your NOI divided by debt service. Most lenders typically want the NOI to be at least 1.25x the annual debt service. If this explanation may be helpful for any of your connections, please Like and Repost. Thank you!

Interest Rate Risk: Why It Matters Even When Rates Are Stable Interest rate risk often hides in plain sight. When rates are volatile, it is top of mind. But when they stabilise — or appear to — many assume the worst is over. This assumption can be costly. Understanding interest rate risk requires more than tracking central bank decisions. It requires recognising that repricing mismatches on the balance sheet do not disappear just because the market quietens. In fact, those mismatches often deepen during calm periods, masked by stable net interest margins or temporary accounting gains. There are two main types of interest rate risk that every bank must manage: Repricing Risk (or Gap Risk): This arises when assets and liabilities reprice at different times or on different terms. For example, fixed-rate mortgages funded by short-term customer deposits create exposure if rates rise — the funding cost increases, but the asset yield does not. Basis Risk: This emerges when two instruments reprice from different benchmarks. For instance, a bank might hedge SONIA-based assets with 3M LIBOR derivatives (historically) or hedge variable-rate loans using swaps indexed to a different benchmark than the underlying cashflows. These risks are rarely symmetrical. A bank might be positioned to benefit in one scenario but be significantly exposed in another. And while earnings-at-risk models can show the short-term impact, economic value measures often reveal the longer-term story — particularly for banks with large maturity mismatches. So why does this matter today? Because balance sheet positioning over the past five years has shifted dramatically. In the ultra-low rate environment, many institutions leaned into fixed-rate lending, chasing margin through duration. Now, as central banks hold at higher levels or begin to ease, the embedded rate sensitivity in those positions becomes more apparent. Here are three reasons interest rate risk still deserves attention: 1. Lagged Effects: Interest rate risk is often slow to materialise. Hedging costs roll off, floors expire, and behavioural assumptions (like early repayments) shift when rates stay high for longer than expected. 2. Policy Uncertainty: Central banks are not done yet. Rate cuts may not come as quickly or deeply as markets expect. Any surprises — especially on inflation or employment — can quickly change the path and catch institutions off guard. 3. Capital and Liquidity Impact: Earnings volatility affects capital. Rate risk also interacts with liquidity risk, as seen in 2023 when deposit outflows coincided with unrealised losses on securities portfolios. These are not isolated risks. They compound. Managing interest rate risk is not about predicting rates. It is about being prepared for multiple scenarios. This includes regularly stress testing key assumptions, assessing both short-term and long-term exposures, and ensuring risk appetite aligns with strategy, even when rates are steady.

What exactly is the #digitaleuro and do we really need it? What would it mean for our day-to-day and for the entire financial system? Let’s take a look.   The #digital Euro is a Central Bank Digital Currency or a CBDC. A CBDC is the digital form of a fiat currency (in this case the Euro). It is essentially e-money issued by a central bank that can be used to make #payments in the same way we use cash.   Why does the ECB want to issue a digital Euro?   -   It would offer benefits such as lower costs, greater accessibility and increased financial inclusion -   To accelerate the transition to a digital #economy  -   Payments’ autonomy away from US players and rails (Visa, Mastercard, Apple, Paypal, etc) is a strategic goal for Europe -   To offer a pan-European payment solution currently missing (there is no interoperability across local A2A schemes today) -   It’s a way to modernize the european payments infrastructure and cement ECB’s role as the gate-keeper -   Because everybody else does: 93% of central banks globally are exploring CBDCs -   It provides an alternative in a world of cryptocurrencies and stablecoins -   It will help strengthen Euro’s international role   Main features:   -   It is practically a digital version of the Euro with cash-like features -   Any place that accepts debit or credit cards would accept the digital Euro -   Real time payments both online and offline in shops and between individuals -   No personal data or transaction information captured or shared -   Available at all ATMs across #Europe -   Accessible by anyone with access to a digital device (i.e. mobile phones, smartwatches, computers, etc) -   Accessible even to those without a bank account   How it would work:   -   Via a digital wallet or app provided directly by the ECB and linked to an account -   Via other digital wallets or apps (i.e. of commercial banks or PSPs) -   Via a payments’ card that can be topped up at public agencies such as post offices (i.e. for those without an account)   The mechanism:   -   The digital Euro is a so-called retail CBDC following a 2-tier set-up, meaning that it will be distributed by commercial banks -   Direct claim of the funds to the ECB and not to the commercial banks. Because of this (deposits could migrate from commercial banks to the digital euro for safety reasons, endangering the entire financial system), a limit per account will be introduced (€3k most likely)   Roadmap:   -   A 2-year investigation phase has finished with the decision to go ahead with the preparation phase, which will last also 2 years -   The preparation phase will finalize the rulebook and select platform and infrastructure providers   Important clarifications:   -   The digital euro will not replace cash, they will co-exist and it will rather complement cash -   Despite all the progress so far, a final decision to launch the digital Euro has not been taken   Opinions: my own, Graphic sources: ECB, Accenture, Rise

Some have asked me to elaborate on my earlier post on the Federal Reserve, so let me start with two hypotheses. The first, and I feel very strongly about this, is that central bank independence is critical for better economic outcomes. It is a core principle that guides my thinking on this issue. Second, and likely to be more of a reality than a hypothesis (as was demonstrated again just now in a White House briefing), is that the Administration’s attacks on Chair Powell are likely to escalate in the days and months ahead. Moreover, these won’t just target him personally but will increasingly involve broader aspects of the institution itself, as is already happening. Taken together, these two place us firmly in the realm of "second-best" options. The first best – Chair Powell serving out his term and there being no attacks on the independence and reputation of the Fed – is highly unlikely, if not entirely so. If the principal objective is to protect the Fed’s independence—which I deeply believe in—we need to ask: what path best serves that goal? Option one: Chair Powell remains in office, but the Fed becomes an even bigger magnet for political attacks and investigations—including a focus on recent policy errors and bad forecasts (including that of “transitory” inflation), “mission creep,” a costly renovation, insider trading allegations, lapses in the supervision of certain California-based banks, and more. Meanwhile, his term is widely expected not to be renewed in May, and well before then, markets and policymakers alike will view him as a lame duck with limited forward guidance power as a new Fed chair is nominated (probably within the next few weeks). Option two: Chair Powell voluntarily steps down. The political attacks on the Fed will probably moderate significantly, and a credible successor is appointed from q shortlist that already includes candidates committed to preserving the Fed’s autonomy and, in the case of some, strengthening it for the future. Again, I realize this isn’t the consensus view. Most still favor the “first-best” option of Chair Powell staying on and without political interference. But I fear that’s no longer attainable. Were it viable, I would be fully aligned with it. And a final note: whoever follows Chair Powell will inevitably have to pursue reforms within the Fed. For what some of those reforms might look like, and why they matter, I’d point you to the G30 report (link below--Full disclosure: I was a member of the working group for that report). As always, I welcome your feedback. https://group30.org/ #economy #FederalReserve #Markets

US stocks may already be pricing easier monetary policy emerging while other areas of the world still have room to rerate. Our comparative analysis based on the Taylor Rule suggests that most major central banks are employing easy monetary policy, but valuations do not clearly reflect this support. The euro zone has the most accommodative stance, but trades just below its pre-pandemic average, suggesting there may be room for valuations to expand. Australia, the US and India are the only markets trading above their 2015-19 averages, and all have valuations out of the range justified by monetary policies. China, Brazil and Mexico are the only major economies with restrictive policy. Considering current policy levels across markets, Chinese equities may be overvalued while Brazil's may be too cheap.

Consumer Credit Crossroads: Spending, Saving, or Sitting Out? One year ago, Consumer Products bonds in the US HY Index traded 38bps (OAS) TIGHTER than the US HY Yield Master Index. The Consumer Products sector now trades 132bps WIDER vs. the index (note: both maintain the same B1 rating) or +160bps deterioration in spreads vs. the index. Investors and traders banking on the almighty consumer are feeling the pinch—ouch! The 90-day tariff pause has provided relief to this sector over the past 2 trading days. What comes next is critical. When spreads were tight over the past months, there was little dispersion. Dispersion is critical to judge, as there will be a growing delta between the winners vs. losers over the course of 2025—this will be critically important for investment performance. The elasticity of demand will differentiate the winners vs. losers since increased tariff costs will either be passed through to consumers, or NOT; the result will be important part of the formula that determines operating margins/profits. Wider spreads will present a buying opportunity of select issuers that have a strong moat and essential product selection—however, issuers with non-essential products, narrower margins and more susceptible supply chains will find a more challenging path ahead. In other words, these are the days when your credit investment manager is worth their weight (management fee). Consumer Products high-yield (HY) companies weakened as consumer sentiment declined and inflationary expectations rose; tariffs serve as the equivalent of corporate tax increase. Consumers now expect everyday essentials to become more expensive, leaving less room for discretionary spending, while tightening consumer credit and high financing costs provide limited access to finance big-ticket purchases. The net effect reduces demand for non-essential products. These factors collectively create a challenging environment for some HY companies reliant on robust consumer spending. With credit card APRs at record highs (around 20-25%), delinquency rates are rising for prime and non-prime customers. Consumer product companies will look to cut costs, solidify their supply chains that allow them to remain competitive (i.e., renegotiate supplier contracts) and/or localize production to offset tariff/inflation pressures. Notable names in this sector with meaningful China exposure include Newell Rubbermaid with ~15%, Spectrum Brands with ~45%, and Scott’s with up to 10% of their COGS, respectively. Late yesterday, Moody’s downgraded Newell Rubbermaid one notch (now Ba3 /Negative Watch) noting the company's ability to implement pricing actions to improve margins will be limited given the discretionary nature of most of its products and weaker consumer demand. During times of stress: up in quality, is my recommendation. As dispersion separates winners from losers, credit selection will be critical to performance as correlations remain wide.

It’s a good day for Canada. After nearly a year of holding at the 5% peak, the Bank of Canada finally dropped the policy rate by 25 basis points on June 5. This is the first rate change since July 2023 and the first rate cut in over 4 years, since the pandemic began. The Bank had all the ingredients for a rate cut: headline and core inflation measures have fallen below 3%, growth has been flat, and unemployment is rising. And they did the sensible thing. Given the Bank’s dovish statement that acknowledges monetary policy’s sizeable progress on inflation, another rate cut is in the book for July. As long as inflation continues its downward trend, we expect a total of three more rate cuts, bringing the policy rate to 4% by the end of 2024. At 4.75%, the policy rate remains more than sufficiently restrictive. Our modified Taylor rule indicates that based on a decrease in potential growth and the realignment of the labour market, a policy rate of less than 4% would be appropriate until the economy gets back on its feet. While a single rate cut will not revive the economy overnight, it signals to consumers and businesses the beginning of a gradual and orderly rate cut cycle that will unfold over the next year and a half. Recovery can begin now and hit full force in 2025. The Bank of Canada led the G7 in the rate hike cycle back in 2022, now they are once again leading the rate cut cycle. The Bank of England, the Federal Reserve, and the Reserve Bank of Australia are expected to all follow suit and begin cutting rates in the next few months. The divergence from the Federal Reserve will lead the Canadian dollar to weaken, but the effect will be temporary until the Fed begins their rate cut cycle, and it will be worthwhile to help the economy get going again. #interestrates #inflation