MUNIX WEEKLY 16 December 2021
We like pleasant surprises at Christmas!
Christmas approaches, which should be a time of peace and harmony. Various statements from central bankers have ruffled the markets this week. Looking ahead, it is becoming clearer by the day that there are noticeable differences in speed and direction amongst the major economies. Over time this will lead to cross-border capital flows affecting currencies and the shape of yield curves.
About 20 central banks met this week. The backdrop was a series of outstanding inflation reports in different countries. UK CPI has reached 5.1% year on year, which pales alongside annual US inflation at 6.8% or German producer prices over 16% higher than a year ago.
Financial markets do not like to be surprised, although it is rarely the case that the consensus is 100% accurate. Ahead of the meetings: Jerome Powell was expected to kick off Fed tapering at a quicker pace than predicted even a month ago as US inflation surges. The ECB would likely stay expansionary and insist inflation surprises will not persist, while the Bank of Japan would remain extremely dovish. The Bank of England had already indicated that the case was cooling for a December rate hike in the face of a wave of Omicron regulations.
Where were the surprises? Expectations management is all, especially at this time of year when market liquidity is lower.
The first surprise was from the Bank of England which did raise rates from 0.1% to 0.25%. It decided that inflation risks required it to take pre-emptive action even as the Omicron wave of coronavirus engulfs the UK. On the one hand it had decided not to move in November whilst it awaited further evidence on the effect of the end of the furlough scheme on the labour market – and such evidence a few days ago showed a robust labour market. On the other hand, there are multiple stories of many companies in difficulty as Christmas spending, travel and party plans are curtailed. Gilt yields jumped higher on the unexpected news. Markets now think that three further interest rate moves mean the Bank rate will hit 1% by late next year.
The ECB surprised in the other direction when it laid out its plans for reducing its monthly asset purchases in a very cautious tapering exercise. The signals about its various bond purchase programmes are technical; however, decisions to allow reinvestment from the Pandemic Emergency Purchase Programme to continue until at least the end of 2024, plus its primary purchase program (APP) will be temporarily upsized and continued for as long as necessary, were interpreted dovishly. The markets may grumble that the ECB is being too cautious in the face of stubbornly high inflation, but the ECB remains appears to have ruled out interest rate hikes until well into 2023. German bund yields edged down a little.
Markets were well prepared ahead of the Fed announcement, which had the least impact on markets. It is the case that the central bank was a little more hawkish than the consensus view. It will finish its purchases of bonds by March rather than during the second quarter. This opens the door to an earlier and longer series of interest rates increases. Fed governors indicated three would be their preferred number for 2022, whilst the consensus had expected two. The Fed continues to project three additional hikes in 2023, but now forecast only two rate hikes in 2024.
What was the market reaction? Meh! The policy-sensitive yield on the two-year Treasury note did not move at all. Five and 10-year yields rose an indifferent couple of basis points. Investors accepted the Fed’s statement in good heart, perhaps because it provides more certainty around what they can expect on a macroeconomic level in the coming year.
There were decisions by various other central banks too, such as Australia, Norway and Switzerland, on what has been dubbed ‘Super Thursday’ by some analysts. However, one other central bank remains silent – the People’s Bank of China. The latest communique from the authorities suggests that fiscal policy, such as further support for local governments, will take the lead instead of further relaxation by the central bank. Nevertheless, in the face of a sharply appreciating Chinese currency, it would not be a surprise to see the PBOC try to ease policy in the new year, quite contrary to the direction in the G7 economies.
Looking ahead into 2022, all the expectations priced into markets depend on inflation turning lower. It will not be necessary for the Fed to hike aggressively in 2022 if core personal consumer spending inflation does come down from the 4.5% a year expected for November to the Fed’s 2.7% end 2022 projection, and similarly if European and UK inflation starts to return steadily to the official 2% target. It is true that no single action would bring containers from Asia to Europe any faster, speed up the production of microchips, or lower energy prices. However, if the pandemic or energy or food or climate or labour shocks affect inflation expectations materially, then the markets are in for a surprise.
Whilst there may be two weeks to go until the end of the year, investors will start to wrap up their portfolios after the latest round of central bank meetings. Few Christmas parties this year, so more time to wrap presents – perhaps a few surprises for important people in our lives.
The next Munix weekly note will be issued towards the middle of January.
Andrew Milligan is an independent economist and investment consultant. This note is offered 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