Serious topics to digest, even as we enter silly season

December 10, 2021

Employment data and impending central bank meetings keep markets focused despite some jarring political (& festive) distractions.

Risk appetite recovered over the past week, with fears regarding the Omicron variant starting to fade on news that three vaccine doses offer strong protection against infection, with two doses giving substantial protection against serious illness. Flight-to-quality trades, which had dominated in the prior week, were substantially unwound. Equities and bond yields pushed higher and credit spreads for both corporates and sovereigns recouped prior losses.

At this time of year, market liquidity is seasonally thin. Consequently, it is not taking a great deal to drive outsized moves in markets. There remains some confusion and uncertainty with respect to Covid and in Europe, further moves to tighten restrictions cannot be ruled out as cases rise. Yet, suggestions that Omicron is a milder form of the virus could yet prove to be a blessing in disguise. Meanwhile, a rapid spread could also mean that any wave may burn itself out very quickly.

As such, this could yet end up accelerating the move out of the pandemic in the early part of the new year.

Away from virus news, all eyes are focussed on next week’s key central bank meetings in the US, UK and eurozone. Following a robust employment print that suggested reduced slack in the economy, we expect the Fed to announce an acceleration in the pace of its taper, in order to end asset purchases at the end of March. This should set the stage for a first rate hike in May 2022, with two more hikes to follow in subsequent quarters.

This trajectory is largely priced into money markets, but where we continue to disagree with embedded pricing is that we subsequently see rates continuing to move higher in 2023 at a more rapid rate, without this leading to a material slowing in the economy.

We would emphasise that with interest rates deeply in negative territory, initial Fed hikes will do little to slow demand unless a re-pricing of financial assets subdues positive wealth effects. From this perspective, 10-year Treasury yields at 1.5% continue to look materially too low in our opinion.

In the eurozone, the rise in Covid cases has led us to think that the ECB should have plenty of cover to extend asset purchases in APP, even as it winds down the PEPP. We have often seen the central bank ‘kick the can down the road’ and it may choose to defer any plans to start paring back on purchases until the monetary policy meeting next March. However, hawkish voices within the ECB do have us feeling more concerned.

Many hawks in the ECB have been reluctant supporters of asset purchases and now that inflation is at 6%, are becoming much more vocal in their objections. In this context, there is a risk that the ECB delivers a hawkish surprise that could see yields higher and spreads in the periphery moving wider.

There is a sense that central bank support has inflated asset prices and as this fades, so markets will need to find a new equilibrium clearing price. However, we suspect that the ECB has limited tolerance for wider spreads – even if market participants will recall Madame Lagarde voicing that it was ‘not the responsibility of the central bank to control the spread’.

There is some suggestion that the ECB may announce a precautionary facility, which would permit a resumption of asset purchases should spreads within the eurozone start to widen. Since sovereign spreads within the single currency are largely a function of single currency break-up risk, it seems possible that the ECB could argue that seeking to backstop spreads in such a way was consistent with its mandate.

However, this is difficult territory and could well see a more assertive challenge to the central bank’s actions in the German Constitutional Court than anything we have seen to-date.

In the UK, it is probably easier for the Bank of England (BoE) to sit on its hands. However, as it does so, there are signs that inflationary pressures continue to build and inflation expectations continue to de-anchor. This may mean that the BoE needs to hike rates more rapidly in 2022.

Alternatively, the BoE may yet decide to start shrinking its balance sheet in order to restrict liquidity if it is concerned that interest rate hikes could hurt consumers and house prices. However, the bank seems to pride itself on being unpredictable, hence a surprise could still occur at the upcoming MPC.

Elsewhere, price action in emerging markets has been the mirror image of the week before. As valuations recover, it is uncertain whether this rally can retain momentum and it seems much may hinge on perceptions relating to the FOMC. If markets can be reassured that the Fed is not becoming too hawkish relative to the growth outlook, then there may be room for spreads to compress if developed market yields rise.

Corporate spreads may also benefit from a lack of supply into the end of the year and investors starting 2022 with cash they will look to put to work.

Looking ahead

Before we get to next week’s central bank meetings, we have important CPI data releases, starting with the US later today. We remain inclined to look for CPI prints to surprise above expectations and we could see US inflation push towards 7%.

A somewhat softer oil price in the last few weeks could mean that the November print is a near-term top, but we still think we could see inflation higher until we reach the end of Q1, when some powerful base effects should start to see inflation decline – albeit remaining at levels far above the central bank target.

Meanwhile, Christmas is fast approaching and the clock is counting down on 2021. With this time of year being pantomime season, it has been fun watching the UK government do its best to make a laughingstock of itself. This week’s gag related to the government’s hilarity at hosting a Christmas party in 2020 in the middle of lockdown and boasting how funny it was they could get away with it, even after cancelling Christmas for others. How they make us laugh (at them, not with them, it has to be stressed).

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