MUNIX COMMENTARY – August 28th
Don’t frighten the horses
Financial markets can be very skittish at times. After all, despite the inexorable growth of machine trading, driven by artificial intelligence and complicated algorithms, most decisions about buying or selling assets are still made by human beings, lurching between fear and greed as the mood takes them. Hence, central bank governors usually try to be very considered in their statements, leading markets along the desired path.
Investors have been waiting anxiously for Federal Reserve Chairman Jerome Powell’s comments on the state of the world at the annual Jackson Hole conference of central bank governors, an opportunity for the great and good to gather and consider the issues of the day. Previously, many individual Fed Governors had opined their thoughts about the state of the economy and the best way forward for monetary policy, but what would the official Fed view be?
Powell’s first task was to give some thoughts about the future path for inflation. The backdrop was more concerning for the hawks than the doves. Friday saw the release of an important statistic, the Fed’s preferred measure of inflation, namely the core personal consumer expenditure prices index stripping out volatile food and energy costs. This rose 3.6 per cent year on year in July, matching June’s reading which was the highest since 1991, and well above the 2% target. On the same day, the White House also produced a forecast of some note. Inflation is expected to more than double, rising to 4.8% a year in the fourth quarter, although quickly abate, reaching 2.5% by the end of next year.
However, Powell took great efforts to downplay these figures. Higher prices are a passing phase. Many aspects are driven by global supply chain problems which are outside the Fed’s control. Otherwise there is little evidence that inflation is rising beyond a “relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy,” As a sop to the hawks, he did note that “History also teaches, however, that central banks cannot take for granted that inflation due to transitory factors will fade”.
Tapering is the watchword of the moment – when will the Federal Reserve start to reduce its purchases of government bonds, and how quickly? In other words, when will inflated bond prices start to come down to earth? Powell did commit the Fed to tapering, and without naming a particular month most commentators have assumed that there will be a decision in November. However, he emphasised once again that tightening policy too early could affect the expansion. The Fed is very aware of its mandate to reduce high levels of unemployment, especially amongst minorities. Powell also made it clear that “The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate lift-off”. This chimes with market expectations that the Fed will not alter rates until the second half of 2022.
What was the impact on financial prices? Powell succeeded in keeping market movements small. US 10-year Treasury yields slipped just 0.04 percentage points to 1.31%, with two-year and thirty-year bonds making similar moves. In the past month, the benchmark US bond has traded between 1.25-1.35%. Other markets have followed suit, for example UK gilt yields trading between 0.5-0.6% over the past month.
Nevertheless, the die is cast. As spare capacity is used up, the US and other central banks will start to reduce their massive support for bond markets. Putting aside another major economic shock then the trough in bond yields would appear to have been seen.
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