Weekly Update 8th February 2021

MUNIX WEEKLY 11th February

IR + GS + CP = I

Financial markets are not always ra1onal, as shown by recent surges in certain US share prices or numerous digital currencies. A=er all, human beings are emo1onal creatures. Nevertheless, for most of the 1me financial markets are highly logical – they listen and watch and follow the signals from policy makers.

The first item in our equa1on – central banks will keep Interest Rates low for some 1me to come. There have been enough speeches from central bankers in recent weeks and months about the need to support the economy during the pandemic, especially to restore the health of the labour markets. These have been backed up by policy statements such as last summer’s shi= to average infla1on pricing in the USA. Hence, there is much talk about any rise in infla1on being transi1onal rather than a cause for concern.

The second item in our equa1on – Governments around the world are s1ll Spending, and relying on borrowing rather than tax increases to meet the bill. DeloiJes has es1mated that government deficits in advanced economies ballooned to 13% of GDP last year, twice the levels seen in the financial crisis in 2009. A classic example is the rapid agreement in the USA that the forthcoming fiscal s1mulus will be well above $1 trillion rather than closer to the figure of $600 billion which many Republicans desired. Here in the UK, as the Budget approaches on March 3rd there is more talk from the Treasury about industrial policies and extended loans to business rather than forthcoming tax increases.

The third item in the equa1on is C for Commodity prices. A variety of prices are moving higher, for different reasons. The Brent price of oil has returned to $60 per barrel, helped by con1nued restraint by OPEC. Many metals prices are jumping on the back of Chinese demand or the transi1on towards renewable energy. The cost of copper, for example, is the highest since 2012. Food prices have been supported by various climate issues.

IR + GS + CP = I. The condi1ons are falling into place for a no1ceable rebound in economic ac1vity alongside a rise in headline InflaEon later in 2021 and into 2022. Together with the fiscal s1mulus, there is an expecta1on that successful vaccina1on programmes in most of the advanced economies will allow a recovery in consumer spending and business investment. Households have sizeable cash balances, in some countries the highest for several decades, amidst signals that they wish to pivot their expenditure away from home delivery of goods towards spending money on experiences, hence the poli1cal debate about holidays this summer. On this basis, the US Congressional Budget Office expects US GDP to return to its pre-virus level by mid-2021, although as Chris1ne Lagarde at the ECB has stated “Let’s be clear, we will not see a return to pre-pandemic levels of economic ac1vity before mid-2022”.

The main result is a no1ceable change in infla1on expecta1ons so far this year. US headline consumer infla1on is currently up 1.4% from a year ago. Depending on the market, some forward looking infla1on measures have returned to levels seen back in 2018, well before the crisis. US 10- year infla1on break-evens and 5-year 5-year forward break-evens are just over 2%, when they had been as low as 0.75% a year ago. As ever, the UK infla1on linked markets are on a somewhat different path, as they have been squeezed by con1nued ins1tu1onal demand. Nevertheless, the global uptrends are clear.

The front end of the bond curve is firmly fixed by central bank ac1ons at this moment in 1me. Unless and un1l yield curve control becomes much more widespread, then bond markets in the UK, the USA and Europe are signalling rather a lot of change in the world economy over the coming few years. Central bankers may be sanguine …..

“I don’t think we are worrying about refla<on and it’s going to be a while before we worry about infla<on” European Central Bank president Chris1ne Lagarde

“As we look forward, we will probably see an increase in [infla<on] readings. That is not going to mean very much. It will not be larger or persistent” Fed chair Jerome Powell

…. but markets are less so.