MUNIX COMMENTARY – 3rd December
Ding, ding, round three
Financial markets in general, and bond markets in particular, must be feeling rather punch drunk by the end of the week. Investors have been on the receiving end of a flurry of punches thrown by the virus, policy makers and politicians. The net result is that they are seeing the world in a different light.
The news that Alpha, Beta, Delta and Gamma have been followed by Omicron was unpleasant. This was particularly so to anyone who had fallen into the trap of thinking that just because the western world had mostly been vaccinated then an exit was in sight from the COVID-19 epidemic. The only silver lining from the appearance of this new variant is that it will spur the funding of massive vaccination programmes across the developing world. Only a small proportion of people living in low-income countries have received even one vaccination, a breeding ground therefore for new and potentially dangerous variants to appear.
Even if recession is avoided, the shock to economic growth over the winter could be rather noticeable. Hence investor confidence quickly collapsed, with the largest falls in share prices since June or October last year, depending on the market. The average S&P500 stock is down 10-15% from its 52-week high. The sharp slide in bond yields reflected a shift in interest-rate expectations. Although central banks are still expected to tighten policy, the first interest-rate increase was pushed back by several months, for example from December to February for the Bank of England.
Just as bond investors thought that health news might once again dominate capital flows, along came further surprises. Jerome Powell, the newly re-appointed chairman of the Federal Reserve, gave a clear warning that QE tapering might begin earlier and continue faster. The central bank has decided that it needs to withdraw the excessive liquidity with which it is supporting the economy, allowing too much inflation and expensive asset prices. The latest employment report provided supporting information for both hawks and doves, with hiring by businesses rather less than expected but still leading to low levels of unemployment.
Alongside that came the latest inflation news from Europe. Although headline inflation as high as 4.9% year on year is clearly influenced by the recent energy prices, there were noticeable increases in core goods and service inflation, at 2.4-2.7% year-on-year running well above the ECB‘s target. Christine Lagarde‘s protestations to the contrary, markets think that the central bank will need to act more decisively in the coming year.
Lastly, but certainly not least, oil prices have fallen $10-15 from their peak, which will ripple through into inflation data next spring. This reflected both demand and supply, partly the potential impact of Omicron on economic growth, but also a decision by OPEC to continue increasing global production of crude oil. Consumer countries had mounted enough pressure.
The net impact of all these punches has been a noticeable flattening of the yield curve, that is bond prices selling off at the shorter end whilst prices are rising at the longer end. US and UK 10-year bond yields have declined to about 1.45% and 0.8% respectively. Not only is the curve between 2 and 10-year bond yields the flattest since January, the Eurodollar market is now predicting a substantially lower peak in the Fed policy rate. Traders today expect it to top out after just five 0.25% increases by the end of 2024. The Fed’s previous dot-plot forecast had suggested seven rate hikes by the end of 2024 and another three in 2025. Roll on the next Fed meeting on December 15th not just for tapering news but also the assessment of how the central bank is assessing Omicron, the
state of the economy in the 4th quarter, and updated Fed forecasts for inflation trends in 2022. With important MPC and ECB meetings taking place in the same week, markets could face another flurry of punches before year end.
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