"I Thought I Was Dreaming And I Just Wanna Wake Up"

By Elwin de Groot, Head of Macro Strategy at Rabobank

International diplomatic efforts to ‘control’ the situation in the Middle East are ongoing with French President Macron yesterday being the latest in a long list of world leaders and foreign ministers that have visited the region in the past weeks. Their messages are a broad mix of support for Israel and the acknowledgment of the pain its people have suffered as well as concerns over humanitarian conditions in Gaza (as the health care system has basically collapsed now), efforts to influence the future response of the Israeli forces and ideas about the future after the war. Each representative strikes a different balance in that message, but the overriding aim that they share, namely to prevent escalation of the conflict, will fall on deaf ears among those who have been directly involved and affected by the war.

It does appear, though, that – through the fog of war – the probability, and potential form, of escalation has shifted since last week. The prospect of more hostage releases after the (just) four so far and humanitarian relief efforts by the UN are often mentioned as reasons for the delay of the Israeli ground assault. But far more important it seems is the pressure that Israel’s allies, in particular the US, have been exerting. One reason – as put forward by the FT today – is to buy time for the US to build a sufficiently strong deterrent force to head off Iran or its regional proxies, which have been stepping up attacks on American targets in recent days. And if de-escalation fails, controlled escalation is to be preferred. Indeed, it was President Macron who actually hinted at the direction of where things may be moving. For he suggested that an “international coalition to fight Hamas” similar to that aimed at fighting ISIS should be set up, whilst “other Iranian-backed militant groups” are warned not to open new fronts in the war. In other words, allies may be willing to join Israel in a war against ‘terrorism’ and have its back for that, but in return Israel should ditch/adjust its plans to start a much broader and risky (ground) war against ‘terror’, potentially falling in the same trap the Americans have done several times in modern history, in particular after 9/11.

However, the ‘fog of war’ – especially in the powder keg of the Middle East – makes an assessment of the current situation, let alone predicting the future a daunting exercise. As we pointed out in previous global dailies in recent days, there is really so much that can go wrong when several powerful states are playing chess against each other on three different chess boards around the globe. Let’s just hope that none of the participants in this game is on psychedelic mushrooms and tries to pull “both emergency shut off handles, because they think they are dreaming and just wanna wake up”.

Global financial markets, are also signalling this week that risks of an uncontrolled escalation have receded somewhat. Equity markets posted modest gains yesterday, despite weak PMI surveys in Europe and Japan and the VIX index dropped more than 10% to sit below the 20 handle again. Oil prices have also fallen below $90/bbl (Brent) and the Dutch 1 month forward gas benchmark traded just below EUR 50/MWh after hitting 55 last week.

Arguably, part of the optimism stemmed from China’s announcement of fresh economic support measures to deal with the fall-out from the real-estate crisis. Yet, this was not a complete surprise as it had been flagged in recent weeks. Measures worth a sizeable 0.8% of GDP will focus on disaster relief and construction (such as water management), rather than boosting consumption.

Against this backdrop, the fall in long-term rates in recent days may not be a sign of risk aversion but rather an acknowledgment that the economic outlook has further deteriorated. That certainly holds for Europe. Preliminary PMI reports for Germany, France and the Eurozone as a whole, released yesterday, pointed at continued weakness in October. In fact, on balance the surveys were weaker than expected. The reports provided further confirmation that the services sector is converging towards the weaker manufacturing sector in terms of growth in activity rather than the other way around. The fact that activity weakened in both sectors lends support to our view that the Eurozone economy is in recession. The headline composite output index fell from 47.2 to 46.5 in October, the fifth consecutive monthly decline in business activity. S&P added that the fall in activity was the sharpest since March 2013 if one excludes the pandemic months. More importantly, the PMIs also offered some tentative evidence that the contraction in activity is starting to have an impact on the labor market. According to S&P, companies cut employment for the first time since the lockdowns of early 2021.

That the elevated interest rate environment and tightening credit conditions have become a key factor in explaining this development could already be gauged from the private sector credit impulse, which fell to -5.6% annually in August, the lowest since January 2010. Yesterday’s ECB Bank Lending Survey further cemented this view. This survey reported not only a continued tightening of credit standards in Q3, but also a continued strong decline in demand for loans across the board. Credit standards were tightened a bit more than banks had anticipated ahead of the quarter. Yet, almost all banks continue to report that they had tightened the conditions ‘somewhat’ – as opposed to ‘considerably’. The ECB has previously highlighted this distribution as an indication that the effects of policy tightening are still occurring at a measured and controlled pace. That said, there was a slight uptick in the number of respondents reporting a ‘considerable’ tightening. If this is caused by just one or a few member states, it could still be a significant development that needs to be monitored as it raises the risk of impaired transmission. We expect the ECB to be mindful that this trend doesn’t continue. Overall, the PMI and BLS reports strengthen us in our view that the ECB is done hiking, even though we continue to expect them to keep rates at these elevated levels until, at least, 2024Q3.

Meanwhile, Australian third quarter trimmed-mean CPI printed much stronger than expected at 1.2% q/q vs 1% median estimate on the Bloomberg survey. The RBA has previously said that they have a "low tolerance" for inflation taking longer than their mid-2025 estimate to return to target. Today's number is well above the RBA's implied forecast of 0.9% q/q and means that for inflation to be in-line with the Bank's 2023 year-end forecast of 3.9%, Q4 would need to print at just 0.4% q/q. That seems very unlikely. As such, today's result gives us increased conviction on our call that the RBA will resume its hiking cycle at the November meeting, lifting the cash rate by 25bps to 4.35%. It also puts the December meeting into play for a further 25bps increase just to completely ruin Christmas. More detail from our Australia and RBA watcher Ben Picton can be found here.