Central bankers need to earn their stripes in the Year of the Tiger

January 14, 2022

Let’s hope they have a better year than Boris has so far.

Global yields retraced somewhat from their highs during the past week, notwithstanding confirmation from the Federal Reserve (Fed) that a material pivot in thinking is underway, which seems likely to see the Fed hike in March, having completed the taper of asset purchases.

Research meetings in the US this week suggest to us that four Fed hikes should be a baseline for 2022, with risks tilted to the upside if rising wages suggest tightness in the labour market and second-round effects on inflation after it has risen to a 39-year high at 7.0%.

The Fed has been moving in a progressively more hawkish direction over the past several months and Powell’s testimony this week suggested that it may need to raise rates beyond neutral over the next couple of years, inferring a projection that the peak of the rate cycle will be a figure in excess of 2.5%.

Balance-sheet reduction through quantitative tightening is likely to commence this summer. It is thought that the pace of balance sheet reduction will be more rapid than seen in the past but the cadence of this is still a topic of some debate. With the Fed paying attention to financial conditions, it is noted that the resilience of risk assets, even as the Fed becomes more hawkish, is something which may enable an unwind of policy accommodation to progress quickly.

It is also clear in Washington that the Fed is taking a lot of blame on both sides of Congress for allowing inflation to rise as far as it has. In this respect, it is one of the few unifying themes in US politics at the moment, the other being a hawkish consensus regarding relations with China.

Further fiscal stimulus is unlikely and a fiscal cliff could weigh on growth over the next couple of months. In addition, the spread of Omicron is seen as a short-lived inconvenience, but also a factor that may lead to a soft patch in economic data until February releases are posted in March.

From a political perspective, the Republicans are expected to take the House and Senate at the mid-terms, despite fielding several questionable candidates in a number of Senate races. Trump is seen as the forerunner for 2024, with Biden very unlikely to stand for a second term.

However, much can happen before then and in the interim, a lame-duck president means little may be delivered over the next couple of years. With Congress in gridlock, more policy initiative may be taken by government agencies. It is thought that Gensler at the SEC may rule on cryptocurrencies as securities, which may act as a catalyst for a deeper retracement.

Nevertheless, the US economy looks to be in robust shape. Labour shortages are driving wages higher and the unemployment rate higher. Strong income and wealth gains (as also highlighted in tax returns) suggest that the outlook for consumption is robust. Onshoring is adding to investment spending and housing activity remains robust.

Moreover, a short-lived Omicron wave is seen leading to an acceleration away from pandemic status as Covid moves into an endemic phase in the weeks ahead.

Yet, with China and other countries in the Eastern hemisphere still trying to implement a zero-Covid outcome, this could mean additional shutdowns and supply disruptions, slowing a normalisation in prices.

Inflation expectations are trending higher the longer that inflation remains materially above target – something that also appears to be a growing issue in Europe. There is criticism that central banks may have been guilty of assuming price stability as a given and allowing mission creep into areas such as diversity and climate change, which arguably central banks don’t have the tools to do much about.

In that sense, central banks need to get back to basics and there is confidence that this will be the case in the US. By contrast, it is observed that there is less true central banking experience within the senior echelons of the ECB.

With political divisions within the EU starting to increase, it seems that the ECB’s job is getting increasingly challenging over the coming months as it tilts in a more hawkish direction and moves towards ending asset purchases, which have sustained valuations in areas such as the eurozone periphery.

We also expect a more hawkish pivot from the Bank of England in the coming month. Central bankers will communicate that once inflation starts to move higher, it makes sense to move policy quite quickly.

In this respect, the Bank of England finds itself behind the curve. However, for the time being, the focus in the UK has been on events in Westminster. It strikes us now that there is a material probability that Prime Minister Johnson won’t survive the latest scandal with respect to the government’s law-breaking parties in the midst of the 2020 lockdown.

Elsewhere, it has also been striking to see Japanese yields pushing higher as inflation risks in the country move higher.

Prospects for a more hawkish Fed continue to cast a long shadow over risk assets. We retain a relatively cautious view with respect to credit spreads.

In EM, we also feel that it is important to pick spots to invest as we are of the thinking that indices may continue to struggle at a broad index level. If inflation can peak, then there is value in local currency rates markets in EM. However, experience suggests that a trend to lower inflation is unlikely before a similar turn is witnessed in the US. From that perspective, these markets may offer more opportunities later in 2022.

Corporate credit spreads have been broadly stable over the week with marginally wider spreads seen in the cash market, driven by what has been a heavy week of supply, particularly in Europe. The long duration part of the European market is seeing less demand, and with the current macro backdrop, this is leading to steeper credit curves. Primary issuance should start to drop off in the coming weeks, in turn improving secondary market liquidity. We remain more cautious on overall credit beta at current spread levels and expect to see bouts of volatility in spreads in the coming months.

Looking ahead

We think that a peaking of Omicron numbers in the US could fuel confidence that we are close to the end of the pandemic. However, restrictions on economic activity may persist for some time and represent a bit of a drag on growth in Q1. Washington and New York have been abnormally quiet this past week, with a desire to work from home exacerbated by particularly cold weather.

Nevertheless, the backdrop looks supportive and we continue to think that there may be a surprise that inflation does not fall as rapidly between Q2 and Q4 as many may expect. Consequently, we see the Fed pushing its inflation forecast for 2022 to 3% in March, as a justification for bringing forward policy tightening.

For the time being, risk assets continue to trade relatively well but there is a lot of uncertainty in policy circles over how far policy can move in a hawkish direction before leading to a more substantive retracement.

In what is the Year of the Tiger, central bankers are really going to have to earn their stripes. Let’s hope they have a better year than Boris is having so far; as kids in the UK would say – liar liar pants on fire!

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