MUNIX COMMENTARY – 4th November
Better late than never….
Just like a convoy of London buses, so central bank meetings are following hard one after another. Markets are responding to official signals about how rapidly monetary policy might be tightened into 2022, reflecting some difficult assessments about inflation pressures current and future.
Starting last week, the ECB tried and failed to persuade the money markets that the hurdle to raise interest rates would be rather high. Christine Lagarde emphasised that inflation pressures were transitory and that the central bank would spend the next six months deciding when and how it should start to withdraw its QE programme. Nevertheless, the financial markets have decided that inflation is just too deeply embedded into the European economy – after all headline CPI above 4% and core CPI above 2% from a year earlier are the highest rates since 2009. The markets have priced in the first ECB rate move for late 2022.
As was widely expected, the Federal Reserve announced this week that it will begin tapering its $120bn monthly asset purchases. It is on track to halt such purchases completely by summer 2022, after which interest rate increases could follow. Hence investors were listening closely for any hawkish signals that could indicate when interest rate increases may begin. Powell tried to be balanced, talking about temporary supply-demand imbalances yet recognising that the employment market might look rather different from conditions prior to the pandemic. He faces the backdrop that the markets are close to pricing in three interest rate increases by the Federal Reserve over the course of 2022.
The markets were happy to give the Fed the benefit of the doubt. After the meeting the US dollar was modestly lower whilst benchmark US bonds remained in their recent trading range, so it looks as if investors believed the Fed‘s commitment to be slow on policy rate hikes. It remains the case that the employment figures will be particularly important to in relation to Fed thinking. Does the evidence grow that some people have permanently left the labour market – for example retiring early – and will not return.
Mistakes by the Fed would be a concern. The US and other major economies do not require so much dollar liquidity, which was injected in massive amounts to support the financial system after Covid struck. The Fed’s balance sheet will grow at a slower rate into 2022. The danger for financial markets is that even small changes in the stock of dollars could have serious implications when the valuations of so many financial assets are stretched.
The next central bank decision was a surprise – the Bank of England decided not to raise interest rates at its November meeting, by a 7-2 vote. On this occasion, therefore, the consensus amongst economists was more accurate than the consensus amongst the money markets, where a move up to 0.25% had been expected. The Bank often makes decisions in the months, such as November, when it publishes its Inflation Report. Its experts are forecasting that inflation should peak around 5% in April next year and still be above the 2% target in the final quarter of 2023,
Hence, there is every likelihood that the MPC has merely delayed its decision. Reading the accompanying statement suggests that a December hike is more likely than not. Several of the policy makers would like to see more information on how the recent end of the furlough scheme plays out.
As and when the Bank of England does move, it will not feel alone. This week, the Reserve Bank of Australia bowed to the inevitable, abandoned its ‘yield curve control’ target and will re-consider its QE programme next month. It follows in the footsteps of Canada, New Zealand and Norway
amongst the developed economies, whilst amongst emerging market central banks such as Brazil and Russia are rapidly raising rates as they respond to inflation pressures.
All in all, the bond markets have been reassured that central banks are starting to act early rather than allowing inflation to rip roar away. Hence, the shape of the yield curve has altered, namely it has flattened between shorter and longer dated bonds as investors have become more confident. UK 10-year yields are back just below 1% whilst the US are edging down towards 1.5%. This has been helped, of course, by signs that global economic activity is a little more muted into the autumn and a welcome fall back in energy prices from the recent peak on OPEC promises of greater supply. Policy makers can assess the economic situation over the coming month, and then climb back onto the convoy of buses in December.
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