MUNIX COMMENTARY – 10th September
Not yet time to withdraw the punch bowl.
Fixed income markets are highly correlated, partly because many investors take advantage of interest rate differentials between countries, partly because all the major central banks are facing the same issue at the same time. To use the famous words attributed to William McChesney Martin, Chairman of the Federal Reserve in the 1950s and 1960s, central banks should “take away the punch bowl just as the party is heating up.”
Is the party heating up? A few weeks ago investors were listening very carefully indeed to the words of wisdom from Jerome Powell about the state of the US economy and the likely direction of monetary policy in America. The circus then moved onto listening to the words of wisdom from the central banks of Australia and Canada about their policy stance into the autumn. This week a large number of people wanted to listen to the words of wisdom from Christine Lagarde about the state of the European economy and the likely direction of monetary policy in the Eurozone. They were encouraged as several hawkish members of the ECB have recently pushed for a discussion about reducing the stimulus, which none of the doves had publicly rejected.
Accordingly, in the run up to the ECB meeting there was a cacophony of analysis from the brokers and the newswires. How low might purchases go? One bank produced a detailed scenario analysis report, looking at how alternative approaches, such as front-loading bond purchases or an intention to boost the Asset Purchase Programme at the expense of the Pandemic Emergency Purchase Programme, might materially affect markets. The Euro/dollar exchange rate was seen as moving from 1.18 as high as 1.20 or as low as 1.17.
All to little purpose. The changes announced were very small yet at the same time rather more dovish than many had expected. Christine Lagarde was at pains to announce that the ECB was not announcing any tapering but instead the Bank was merely ‘recalibrating its existing programmes’. Purchases would be less, but the Bank declined to announce a new, lower monthly figure as had been widely expected. German bond yields gave back about 4bp of the 14bp rise in yields which had been seen in the previous fortnight. UK gilts and US Treasuries remained in their tight trading range.
The ECB does deserve a little sympathy as it faces a complex situation. There are many conflicting signals, from an economy recovering after lockdown, vs the need for medium term support for a perennially slow growing part of the world, or alternatively while long-term inflation expectations based on market prices are at their highest since 2017, ECB staff forecast inflation well below the official target over the medium term. Monetary policy has little effect when consumer prices are mainly driven by one-off factors, often happening outside the Euro area such as supply chain problems on China or higher commodity prices. Therefore, the ECB’s current benign stance makes some sense. The key issue – as for all central banks – will be whether the European labour market tightens too quickly, sparking higher wages and second round effects throughout the economy. In this regard, Lagarde was at pains to emphasise that unemployment remains about 2 million higher than before the pandemic.
Although the ECB pulled back from any major decisions today, the clock is ticking for it to take action into 2022. The longer the central bank continues to buy bonds, the closer it will get to owning more than 1/3rd of a country’s debt, which is seen as a red line for some members. The FT reported that even at a reduced pace of €60bn to €70bn a month, the PEPP still has enough firepower to soak up all the new debt issued by governments for the rest of the year – another worry for the hawks. Economic growth looks set to be an above trend 5% in both 2021 and 2022, so spare capacity will inexorably be used up. Indeed, with the 60% of the Eurozone’s population having been fully vaccinated, the economy is on course to return to its pre-crisis level in the first half of next year. Markets are patient creatures and will await the next turn of the ECB
roundabout – and signals in October or more likely December that the punchbowl is being taken away.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making