Hoping we’re back in the 1990s, not the 1970s

June 17, 2022

Markets are bumpy and union action is pointing to a summer of discontent...it's all gone a bit (Johnny) rotten.

Disappointment at last Friday's above-consensus US CPI report saw investor expectations for a 75bp hike build at the start of this week, meaning that the FOMC confirmation of such a move came as little surprise to the market.

In the days prior to the Fed’s announcement, yields had risen to new highs across the curve, with futures markets discounting a peak in US rates around 4%. The failure of inflation to quickly start moving lower has begun to represent a threat to central bank credibility. In this context, a more assertive stance by the Fed can be welcomed inasmuch as this lays such concerns to rest.

Broadly speaking, a range of price measures are starting to show signs of a slowing in US inflation and economic activity appears to be weakening in response to the ongoing tightening of financial conditions. Based on an assessment that the Fed will continue to push rates higher until PCE core inflation moves below 3%, it seems likely to us that rates may now rise towards 3.5% by the end of 2022, before peaking in early 2023.

We think that a recession can be avoided if this peak in rates is below 4%, but this will hinge on the path of prices. Consequently, this is now looking like a relatively close call. However, the higher rates move in the interim, the more it becomes likely that the FOMC will end up reversing course later in 2023 and therefore it may appear that a lot of the bad news is already discounted into market expectations.

In some ways, the current hiking cycle may be viewed similarly to a trip to the dentist. From that point of view, it may be preferable to take the pain quickly and get the hiking cycle done, rather than drawing it out. In this way, the peak may end up being lower than otherwise may be the case.

However, the combination of higher rates, slowing growth and lingering inflation concerns represent strong headwinds for risk assets for the time being. We sense that for markets to stabilise, trust in central banks will be a primary precondition, but then it will also be necessary for incoming data to clearly demonstrate that inflation concerns have been addressed.

Once this is seen to be the case then we think that government bond yields need to stabilise before a turn in high quality credit spreads can occur. A turn in higher yielding credit spreads can occur thereafter, but this will also require a level of confidence that the economy is not falling into recession.

Meanwhile, equities may be the last asset class to exit the bear market, as it seems the outlook for earnings may remain challenged for some time. From this point of view, we believe that it remains appropriate to maintain a relatively cautious stance on a portfolio basis.

We would also observe that, just as bull markets are characterised by prices grinding higher with periodic retracements, so the price action in a bear market can see prices slipping lower, punctuated by short and sharp bear market rallies. From this point of view, we think there is merit in being cautious when it comes to buying dips, whilst being prepared to sell into rallies.

In the eurozone, rising yields in the periphery prompted an emergency ad-hoc meeting of the Governing Council to be called in the middle of this week. This saw spreads rally. The outcome of the meeting itself offered little new information, though leaks thereafter suggested a desire to have a new tool in place by the July European Central Bank (ECB) meeting. Yet with spreads now inside of where they were trading at the last ECB meeting, we doubt that any contingency plan will be triggered unless there is material additional weakness in spreads.

Moreover there seems to be more talk and posturing than substance for the time being. Ultimately, it will be difficult to agree an additional bond buying program at a time when the ECB is trying to tighten its policy stance.

Such a program may also fall foul of charges relating to a deviation from the central bank's mandate, if government financing is deemed to be provided in the absence of material conditionality - the like of which large countries, such as Italy, are unlikely to find politically acceptable. A more credible rebuttal of fragmentation risk would come from steps towards a more tangible fiscal and political union within the eurozone.

However, there remains a sense of intertia on this front and therefore we continue to think that a greater sense of crisis will be required before policymakers act to address weaknesses within the fabric of the monetary union. As a result of this we have been inclined to sell BTPs in the wake of the rebound in prices that followed the ECB announcements this week.

In the UK, we continue to look at the BoE in contrast to the Fed. Notwithstanding this week’s decision to hike rates by 25bps, we think that the Bank is being much too slow to address a de-anchoring of inflation expectations. As a result, we think that inflation will become more embedded and difficult to eliminate, meaning that rates need to rise by more over the medium to longer term.

It appears that there is reluctance from Bailey and colleagues to bring inflation down quickly and act decisively in the way their global peers are addressing the situation, with a greater focus on the near term relative to the long-term growth consequences. This is likely to undermine credibility in the institution in our eyes and we continue to maintain a bearish stance on UK assets.

Unlike the situation in the US and Eurozone, where a more hawkish stance may see yield curves flatten or invert, in the UK, rising medium-term inflation expectations may well steepen the curve unless and until the Bank decides to alter its course of action.

Japanese yields also rose during the past week, with JGBs posting their biggest daily moves since 2013. We have highlighted how a more hawkish stance from the Fed is putting upward pressure on global yields and as JGBs hit the Bank of Japan (BoJ) imposed yield ceiling under Yield Curve Control (YCC), so this forces the authorities to buy more bonds in order to maintain this target.

Thus, a more hawkish Fed can force the BoJ to act in the opposite direction, putting pressure on the yen to weaken. With this, in turn, raising Japanese inflation, as well as attracting increasing ire from policymakers, so this makes it increasingly likely that the BoJ will conclude that it is time to exit YCC. We think that a policy pivot may occur in Q3 and that a short stance in JGBs has been an attractive position given the much greater scope for yields to rise rather than rally.

With the focus in the past week on developed market central banks, emerging markets have been quieter. We continue to see contrast between relative winners and losers. Yet in the short term, market moves have been dominated by broader trends in risk sentiment.

The same has largely been true with respect to corporate credit spreads. Herein, eurozone spreads have tended to underperform and have been more volatile due to developments in the periphery and more elevated recession worries within the region.

Elsewhere, price moves in crypto assets have also continued to attract some attention. The collapse of several smaller digital currencies and stop losses from crypto funds have seen prices continue to fall sharply in the past couple of weeks. The total market capitalisation of all crypto currencies has fallen below USD 1 trillion, representing material wealth destruction compared to peak valuations a few months ago. With many coins nursing losses of more than 60% from their peak, past gains have quickly evaporated. This may have consequences for discretionary consumption as well as for the labour market.

We would also observe that movements in crypto, as well as emerging stress within private markets, are factors not captured in traditional financial conditions indices. In discussing these developments with policymakers, we sense that it is understood that recent tightening in conditions may therefore be understated. Consequently, this may represent a downside risk and one to monitor in the weeks and months ahead.

Looking ahead

It seems like markets can remain in a bumpy and volatile landscape. It has been 28 years since we last saw the Fed hike by a 75bp increment and given the speed with which economic and interest rate projections have been revised, than re-revised, over the past several months, the level of macro uncertainty at the moment continues to be elevated.

It strikes us that much may depend on developments with respect to prices and in this regard, the market has shown a tendency to be very poor in projecting and forecasting the path of inflation with any accuracy of late.

Therefore, it continues to make sense to us to proceed with a degree of caution for the time being. That said, we can certainly see much more medium-term value in yields and spreads than has been the case for a long time and this may point to a more constructive stance in the months ahead. If the current decade bears some resemblance to the 1990s from a macroeconomic and financial market perspective, this may be no bad thing.

However, in order for markets to find a firmer footing, it may be necessary to prove we are not on our way to the 1970s first. In this respect, it appears that this is a much more likely outcome in the US, than is the case of the UK, where union action is already pointing to a summer of discontent. Thanks to the unions, it seems we won't be getting on 'the Groovy Train' any time soon, with the mood music looking a lot more Johnny Rotten.

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