MUNIX COMMENTARY – July 15th
6 impossible things before breakfast
Many people will be familiar with ‘Alice Through the Looking Glass’, the wonderful world created by Lewis Carroll. The Red Queen explains to Alice “Why, sometimes I’ve believed as many as six impossible things before breakfast.”
Narrative is an important aspect in financial markets too. Amidst the blizzard of economic and corporate and official and think-tank reports which dominate the news-flow, investors try to form a story that fits the facts. This is partly constructing a paradigm to use when making investment decisions, but also the opportunity to create a story to sell their product or views in the market place.
On occasion this leads to people tying themselves in knots as they try to make sense of a complicated situation – ‘six impossible things before breakfast’.
There were two reports this week which shocked economists and newspaper analysts, but rather surprisingly not investors – the inflation data in the USA and the UK. Headline inflation in the States jumped to 5.4% a year, its fastest rate of growth in 13 years. The UK figure only reached 2.5% year on year, but again the highest in 3 years. Both were well above market expectations. The Bank of England’s prediction that headline inflation would peak at 3% already looked questionable. It was no surprise therefore to see the Bank’s Deputy Governor Dave Ramsden admit that inflation could now peak around 4%.
The narrators were out on both the hawkish and dovish sides of the inflation camp. There were many unusual features in the reports: second hand car prices have surged as a lack of computer chips limits production in new cars; airfares, hotel and restaurant prices are responding to a surge in demand when supply is constrained. By focusing more or less on such ‘one off’ factors the situation could be portrayed as reasonable or worrying.
What about the longer-term inflation path? The jury is still out. On the one hand there are clear signs that housing related costs, an important component in the CPI, are on a long-term uptrend. Business surveys also suggest price pressures building across the economy. On the other hand there are few signs that wages, so important for service sector inflation, are yet being pulled much higher. Labour is hard to hire but most firms still wish to control costs. Capacity utilisation remains low, and commodity prices are falling back due to Chinese restraint.
In last week’s note I commented “after the significant move down in bond yields….the next important aspect will be to see how the US central bank responds and whether it tries to give a steer towards the markets”. Although there were hawkish comments from a few Fed officials, the markets focused much more on the views of Fed Chairman Powell. He remained in reassuring mode: the bank “absolutely” would take action if it saw prices accelerating too much. However, a highly accommodative policy is still the right path, as the labour market needs more time to recover; after all about 7.5 million jobs are still missing from before the pandemic. Lawmakers were urged to have faith in the Fed’s judgment that it was still riskier to tighten policy too early than too late.
It was a different story on this side of the Atlantic, however. Both Dave Ramsden and fellow MPC member Michael Saunders made hawkish speeches after the inflation surprise. On current trends it might become appropriate “fairly soon” to rein in some of the stimulus provided to support the economy since the start of the pandemic
How did the bond markets react to all this information? Rather surprisingly, they did not move very much! During the day of the US inflation shock, the US bond market reacted more to a weak 30-year bond auction than it did to the economic news.
At the time of writing, the US 10-year Treasury yield is about 1.30-1.35%, still well below the 1.55% peak from last month. The 2-year yield remains pretty steady about 0.25%. Admittedly, in the UK, the 2-year Gilt yield has edged up, but all of 5 basis points from about 0.9% to 0.14%. The 10-year Gilt yield is similarly a little higher, having reached 0.67%, but still in its recent trading range.
So the story remains confusing. Again, if we return to the narrative, many commentators are pointing towards other economic factors such as US and Chinese growth peaking, the delta variant of the virus affecting the re-opening of the economy, the difficulties in getting the infrastructure spending package through Congress or hints from the Chancellor that the autumn statement will see more austerity than largess.
This may also be the occasion when technical factors matter much more than any economic narrative. For example, the US Treasury is running down its cash balances quickly (the Treasury is on track to end the month with an estimated $450bn cash balance, well below last Friday’s $718bn) which means less issuance whilst the Fed’s QE bond purchase programme continues inexorably. Fed ownership of the Treasury market is steadily rising towards 25% of the total. Supply and demand are far from their normal relationship in this environment.
After a week of major economic data and policy maker speeches, the end result is that market expectations for the first interest rate move in the USA have only shifted modestly, yet again moving from spring 2023 back towards autumn 2022, with the UK expected to follow shortly afterwards. Bond market yields and yield curves are waxing and waning. Time to return to the garden and read some good literature in the sunshine.
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