WEEKLY FOR MUNIX 17 May
Ripples in the pond
When a stone is dropped into a pond, the ripples last some time before calm eventually returns. So it is with economic data, initially sparking a wave of newspaper and newswire commentary, then depending on the capabilities of policy makers to calm down or aggravate the situation. In a commonly used phrase, amongst people whose career it is to watch and participate in financial markets, are central bankers ahead of or are they behind the curve.
After last week’s news of a sharp jump in headline inflation in the USA, further ripples could be seen as more countries reported higher figures and economists started to raise their forecasts for the rest of the year. A base effect from energy prices – Brent oil is about $70 per barrel today when it was close to $30 a year ago – can also occur in economic modelling; a higher starting point means that even modest monthly changes in inflation numbers could lead to headline rates above 4% over the summer months. The same effect can be seen in the UK where the annual CPI rate more than doubled to 1.5% pa in April, on course to reach the Bank’s 2% target soon. It is no surprise that inflation expectations reported by consumers have also started to respond. Frequent purchases of food, fuel and travel costs feed into people’s analysis of where prices are going next – less frequent purchases are simply not front of mind.
The ripples die down, however, unless more stones are thrown into the pond or the ripples are so large that they dislodge the sides. Second round effects might appear via the labour market – are wages bid up sharply, for example due to bonuses and minimum wage increases to draw staff towards a firm. There are local problems, obviously, but the big picture remains a historically high figure of 10 million people seeking jobs in the USA; 12% of the working population on furlough in the UK; a double dip recession in the EU.
Central bankers also use speeches to guide market sentiment, and their response continues to try and calm down those second-round effects. Whilst Andrew Bailey recently stated that the Monetary Policy Committee would not tolerate a persistent overshoot in inflation from its 2 per cent target, the key word is ‘persistent’. This week’s comments from Fed officials reiterated that they are in watch and wait mode. Of course there is a debate taking place; the latest set of Fed meeting minutes noted that “A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.” Some members also commented on the side-effects on markets and investor behaviour of a prolonged period of low interest rates and highly accommodative financial conditions. Nevertheless, the end result is that markets still assume that the first Fed rate move is 18 months away. There has been a steepening of yield curves, but within a range trading environment for government bond markets. In the past month, UK gilt yields have risen by 4 basis points for 2-year gilts, 7 bp for 5 year and 13 bp for 10 year.
Outside the sovereign bond markets, there is considerable action. Companies are issuing copious amounts of debt, M&A and IPO activity is strong, and investors are desperate for yield forcing risk spreads on corporate bonds to the bottom of their historical distribution. Indeed, one issue is that central banks themselves are being forced to move into riskier or less liquid assets in order to achieve their mandates. A recent conference on central banking asset liability management noted that longer-duration bonds, emerging-market assets and even equities may offer the extra yield that central bank reserve managers need. Truly a case of the right hand not knowing what the left is doing.
The big picture remains the speed with which vaccinations allow a return to pre pandemic levels of commercial activity, the impact on wages, productivity and core inflation, the need to withdraw the public sector’s stimulus as the private sector is more capable of growing sustainably. Central bankers consider, rightly or wrongly, that they know how to deal with inflation and hence they are happy to watch the data and be behind rather than ahead of the curve at this stage of the cycle.
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