MUNIX COMMENTARY – week of 14 June
The grand old duke of York
The US bond market has marched up and down the hill in the past few weeks. Prices rose and yields on US 10-year debt fell as low as 1.48% shortly after the unexpectedly high US inflation data. The Fed’s response at this week’s FOMC meeting has caused the markets to turn around sharply.
There were debates about why US bond yields had fallen steadily in recent weeks. Did the market agree with the Fed that the jump in inflation would be transitory? After all wage data remains very contained and that is the key driver of core inflation. Possibly this is part of the explanation, but other factors appear to be important too. In recent days there has been evidence of multi-asset funds selling equity and buying bonds as part of their normal portfolio rebalancing. Higher oil and raw material prices have encouraged purchases of high yielding US corporate debt. Lastly, there has been strong overseas demand for US debt in relation to say lower yielding European and Japanese bonds. Too often macro-economic data provide the narrative for journalists to try and explain why a market is moving as it is, but in reality there are other demand and supply factors which only become apparent later on.
June’s FOMC certainly altered market perceptions of how the US central bank will respond to inflation pressures. Benchmark yields rose 10 basis points on the day. One analyst reported that the meeting provoked the fourth-greatest negative reaction on the five-year Treasury in 80 Federal Open Market Committee meetings since 2011! On balance the Fed Governors indicated that they would raise interest rates twice in 2023, when back in March they had expected no move at all. The markets had been waxing and waning about whether to price in one move toward year end. Chairman Powell has also fired the starting gun on talks about talks about tapering the QE purchases, with market speculation that this could begin by the end of this year. At present the Fed is purchasing $120 billion of US corporate, housing and government debt a month.
The rationale for withdrawing Fed liquidity is apparent from the updates to its forecasts: economic growth of 7% in 2022 and 3.2% in 2023 and inflation of 3.4% this year, falling back to 2.1% next. Attention will focus on the pace of healing in the employment market and any deteriorations in inflation expectations for 2022. If these continue, then there is a live risk that the first policy rate rise takes place in the later part of next year. 7 of the 18 policymakers already see a lift-off in borrowing costs in 2022 so speeches by moderate members will be examined even more closely.
The Fed is the world’s most important central bank, but in such an inter-connected world it is best to consider a convoy of decision makers reacting to global and local conditions. China has been slowly tightening monetary policy all year, with the results increasingly apparent in its more muted economic data; a number of emerging market economies have been forced to raise interest rates, Brazil increased them from 3.5% to 4.25% on the day of the Fed meeting; while the UK and Canada have taken small steps towards tapering. As the world economy recovers – the World Bank raised its 2021 GDP forecast week to 5.6%, the fastest since 1973 – and adverse effects on housing and financial asset prices becoming more apparent – so the question is when, not whether, monetary policy is slowly tightened. The same remains true for the MPC. Unemployment is falling steadily, and inflation has returned to the Bank’s target. As more officials follow in the footsteps of Andy Haldane and recognise the need to act, so the flat yield curve out to 2 years in UK gilts will start to steepen in line with longer durations.
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