Wake-up call

Mark Dowding 80 x 80.jpg
Mark Dowding
September 24, 2021

In the US, the tapering trajectory looks set to meet expectations, while Biden seems to be having a difficult time at home and abroad.

This week’s US Federal Reserve (Fed) meeting saw Jay Powell signal that QE tapering is likely to be announced around November, with net purchases set to cease in the middle of 2022.

This is in line with the trajectory we have been expecting for some time. We continue to look for a first rate hike in the US in the fourth quarter of 2022, which is now in line with half of the Fed participants, based on the latest ‘dot plot’.

We believe the US economy remains in good shape, with policy remaining accommodative, consumer balance sheets in a strong position and corporate earnings growing at a robust pace. In this context, we see scope for growth to outperform official forecasts.

We also see inflation remaining more stubborn during 2022 than the Fed projects. Although Treasuries were initially unmoved in the wake of the Fed, it has been interesting to see the curve bear-steepen subsequently as investors begin to grasp how the tectonic plates are starting to shift as the Federal Open Market Committee moves towards a policy exit.

In the short term, the Fed continues to purchase USD120 billion of assets per month. As the fiscal deficit shrinks relative to the past year, lower issuance requirements may infer that market technicals can continue to be supportive for now.

However, the power of technicals are set to wane and we continue to see the valuation of Treasuries as materially over-inflated, relative to underlying fundamentals. Patience may continue to be warranted.

That said, during the fourth quarter of 2021, we may see a period when strong growth and inflation data meets the Fed starting to reduce purchases, which could lead to a more material re-pricing.

Yields rose materially in the first quarter of this year, and have trended lower in quarters two and three. As we head to quarter four, we look for the pattern at the start of the year to be repeated in something of a mirror image.

China

Away from the Fed, much focus was on developments in China during the past several days – even if China itself was closed on holiday for the first half of the week.

We have been flagging the woes of Evergrande for some time. Notwithstanding the bonds having fallen from par to 25 cents on the dollar over the past six months, suddenly this became the focus of market attention on Monday, with scope for a debt restructuring imminent.

We have tended to believe that Beijing has been keen for property prices to retrace in order to meet concerns related to housing affordability. At the same time, China will not want to see a disorderly collapse of Evergrande creating systemic issues for the Chinese financial sector.

In this context, we believe that China has a lot of control over the economy and its asset prices, and will ease policy as required. Construction is set to slow, based on a desire to promote more growth via consumption and exports, and less through building projects or speculative activities, but we think that a hard landing is unlikely.

We expect policy easing in China to support growth and remain constructive on Chinese rates, with policy in China becoming more accommodative, even as it becomes more restrictive in the US.

UK

In the UK, a more hawkish stance from the Bank of England saw Gilt yields move higher. Rising energy prices are set to drive prices higher in the coming months, adding to inflation pressure across the economy.

The Bank of England sees inflation above 4% through the second quarter of 2022 – and we could see it higher still. We expect a first rate hike in the UK in the first quarter of next year, with rates at 0.50% by the middle of next year.

Supply shortages and Brexit disruptions are becoming more widespread in the UK, leading to government intervention. Indeed, it was a bit depressing to see the UK government give subsidies to a US firm to produce carbon dioxide in the UK this week, on the same day as we saw the issuance of the country’s first green Gilt.

Notwithstanding the green agenda, it seems that carbon subsidies are currently the order of the day. At the same time, the magnitude of the rise in gas prices is such that smaller energy providers that have failed to hedge against moves have been continuing to collapse at an accelerated pace, leaving taxpayers and consumers to foot the bill.

Europe

Elsewhere in Europe, we await the German election this Sunday. As discussed before, there are different permutations with respect to the coalition outcomes that may result. Predominantly, these represent a continuation of the status quo for fixed-income investors, with the exception of red/red/green.

This outcome would be seen as more fiscally expansive, and likely to push Bund yields higher and spreads tighter. However, we would only assign around 20% probability to this combination. Within the periphery, spreads have narrowed somewhat as September supply passes.

Credit markets have remained relatively quiet, with spreads contained within a narrow range. Weakness in equities saw volatility indices rise at the start of the week, putting upward pressure on spreads, though there seemed to be plenty of buyers happy to add on any dip.

Price movements were more substantial in emerging markets, though there was relatively little turnover behind moves – either on the way down or the move up, which followed as near-term Evergrande worries were mitigated somewhat.

FX

In FX, the US dollar and most major crosses have continued to be relatively rangebound for now. An exception to this has been the Norwegian krone, which outperformed over the past few days, with the Norges Bank hiking rates at this week’s monetary policy meeting. We continue to see scope for the krone to outperform further as policy continues to diverge with the eurozone.

Meanwhile, a decision by Turkey’s central bank to cut interest rates by 100 basis points, even as inflation rises, saw the lira come under renewed pressure. In recent weeks, it has seemed that President Recep Tayyip Erdogan is again losing patience with high interest rates, putting the central bank under pressure to act.

Indeed, it was interesting to listen to the central bank governor, Sahap Kavcioglu, talk about inflation being transitory in Turkey – when this particular ‘t’ word was absent from Powell’s press conference.

Looking ahead

Looking ahead, with the Fed roadmap now likely confirmed, we feel that the focus for markets will shift back to the data. The strength of the labour market will remain a key focus, with two payroll reports due before the next Fed meeting.

An end to additional unemployment benefits earlier this month has seen weekly jobless claims trend lower in the past few weeks and there is ongoing evidence of strong labour demand.

However, ongoing worries related to the Delta variant continue to pose a risk to jobs data, though, in this context, news around Covid seems to be improving, generally speaking.

Meanwhile, in Washington, the focus will be on a vote to avert a government shutdown at the end of next week. With Democrats linking a vote on this with an extension of the debt ceiling (which falls due mid-October), political point-scoring may mean that a shutdown occurs for a few days at the end of this month.

These votes also feed into discussions around the latest infrastructure bill Joe Biden wants to push through Congress. Although some of this looks like political theatre, analysts will be closely watching which party is seen as most culpable for paralysis in the eyes of voters.

This may then have a more significant bearing on the fate of the infrastructure bill and the ability for moderates in the Democratic party, such as Joe Manchin, to support it.

The past week has also seen Boris Johnson pay a visit to the US capital. Biden’s dismissiveness in the face of a request for a trade deal can be seen as a bit of a slap in the face for the UK, a week after the US administration upset France after poaching a lucrative submarine contract for Australia from under their noses.

As was seen in Afghanistan, it seems that the US is a pretty inconsistent friend these days. For all the hopes of a re-set in US-European relations following last year’s election, the dawning reality is that, under Biden, we are witnessing much of the same Trump-ism and ‘America First’ without the personality of Trump himself.

At least in the past, any ire could be directed to the Tweeting Twit-in-Chief. Nowadays, it seems that Joe is rather asleep at the wheel, per Benjamin Netanyahu’s suggestion this week…

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