Thinking about thinking
It appears that the US Federal Reserve (Fed) is closer to achieving its inflation target than it expected to be when the “average inflation rate” framework was first presented. Some officials have brought forward when they think the first rate hike should take place. Hikes in 2023 look very likely now with the risk of a 2022 hike increasing. However, markets are sanguine with yields more or less unchanged from last week, equities higher and credit spreads narrower. The bottom-line is that growth is strong in developed economies, liquidity is plentiful, balance sheets are in good shape and rates will remain very low for now.
I wrote about US inflation last week and the Fed’s tolerance for an inflation overshoot. This week the Fed signalled that tolerance might have its limits. On the basis of the recent run of higher inflation data and its updated forecasts, the Fed appears to be paving the way for an earlier lift-off in rates than it had previously suggested. Following the June 15th-16th Federal Open Markets Committee Meeting (FOMC), the press release summarising the updated policy stance and the revised Summary of Economic Projections (SEP) suggested that the central bank is likely to have achieved its “average inflation rate” target long before the end of 2023. Contained in the SEP is the famous “dot-plot” which represents the individual expectations of Fed officials of where they expect the Federal Funds rate to be over the next two years and over the long term. The big change was that some officials now think there should be a tightening in 2022 and that the median expectation is now for two rate hikes in 2023. By the end of 2023 the Fed Funds rate is expected to be at 0.6%.
Is it a “wow” moment for markets? Probably, to be fair. The forward guidance that had been in place was essentially formulated last year when there was much more uncertainty over the pandemic and the ability of vaccines to bring down infection rates. It was also before it became clear that demand was recovering quickly and supply frictions were leading to unexpectedly large increases in prices. The FOMC statement and the subsequent press conference by Chairman Powell acknowledged that. Things have moved on and the Fed is now thinking about changing its current monetary policy stance. Inflation is higher and is looking to be more than just temporary. Investors need to start getting ready for higher interest rates.
But there is no need to panic. The timeline is still for at least another year of unchanged rates, giving the Fed time to go some way to reduce its quantitative easing (QE) programme first. In the statement, the Fed reiterated that its macro-economic targets were unchanged – average inflation over 2% for some time and full employment. It’s just that it looks as though the forecasts are for those targets to be hit earlier. The unemployment rate is expected to fall below 4% next year and the core personal consumption deflator inflation rate is forecast above 2.0% for the entire 2021-2023 period. As always, the data is important and while one could argue that the inflation condition is being met right now, the labour market data has some way to go. The unemployment rate was 5.8% in May and the employment to population ratio was 58%. In recent monetary cycles, the Fed has never initiated tightening with that ratio below 60%.
For the bond market the key is to price in where the terminal Fed Funds rate would end up in the upcoming cycle. The medium expectation in the SEP is 2.5% which is exactly where it ended up in 2018. The 10-year bond yield peaked at 3.25% a few months before the last Fed Funds hike of the cycle in 2018. It would not be out of the question to expect a similar profile of rates and bond yields for the coming 2-3 years. The initial reaction was for bond yields to jump in response to the change in the Fed Funds rate projections. However, yields remain well below their peak level at end-March. Technical analysis of the charts suggests that the 1.63%-1.65% area is key – a move above that would certainly open the way towards 2%. If not, we could be range-trading for a lot longer. At the moment, we appear to be very much in the range.
The market hasn’t got to 2% yet and this has confused and seemingly “upset” many commentators in recent weeks. After all, the macro argument has been clear – rising inflation, closing output gap, wage growth, large fiscal deficit and so on. Our teams use a framework that looks at other factors beyond the macro to try to understand and position for market moves. We have always paid a lot of attention to technical factors. Central bank buying has been massively important in keeping bond yields down in global markets in recent years. It seems, more recently, that commercial bank buying has also been a key driver. Fiscal stimulus in the US and the rise in personal sector savings have been behind the huge rise in deposits at banks. Banks have responded to the increase in liabilities by raising their Treasury holdings on the asset side of the balance sheet. This accelerated since the end of Q1 as the Biden stimulus hit the economy and was partly financed by a reduction in the Treasury Department’s general account that it holds with the Fed. Those monies hit the real economy and boosted bank deposits. It is not clear how long this technical factor will continue to impact on bond yields, but it could again frustrate those players positioned for a big immediate rise in yields.
When yields peaked in 2018, the break-even inflation component of nominal yields was fairly close to where it is today (2.17% relative to 2.32%). However, real yields were much higher at 1.0% compared to -0.76% today. The bond market is suggesting that inflation will remain just above 2% for a long-time so to get nominal yields up we need to see either those inflation expectations rising further or real yields to significantly increase. The most likely driver of rising real yields is more conviction in the market about when the tightening cycle starts and how far it eventually goes. With QE tapering on the horizon for year-end and the Fed suggesting rates hikes are moved forward, it is hard to think that real yields will go much lower from here.
Higher bond yields in the US will have some spill-over to other markets. However, Europe remains in a different position regarding the size of its output gap and underlying inflation trends. The UK is seeing a rise in inflation and that could go on given how quickly the economy is bouncing back amid severe shortages of labour in some sectors. The Bank of England is much more likely to follow the Fed than the ECB is. By extension, I see how yields on UK gilts might rise quicker than yields on German bunds. In terms of yield curves, if the Fed is going to tighten more quickly than was expected before the FOMC, the flattening of the yield curve should continue. In the context of rates and yields not going up too much, this is a supportive signal for growth equities.
The bigger picture is that the Fed is just beginning to adjust its policy stance. Soon we will see it reduce bond buying and there is likely to be further signals that the lift-off date for rates is creeping forward. The data should support that as furloughed workers return to jobs over the summer. The overall level of rates and liquidity should stay supportive for markets, but maybe less so than has been the case over the last year. I don’t think it’s the time to turn bearish on credit or equities yet but the big QE/easy monetary policy era is slowly coming to an end. Luckily, balance sheets are in good shape (except maybe for governments) and investors know that should the ship start to lurch, central banks know what to do.
The first week of the Euros has been very entertaining. The standout team so far has to be Italy with France not far behind. Belgium and the Netherlands also look to have longevity potential in the tournament. The standout result though belongs to Wales with a masterclass from Ramsey and Bale. As sixteen of twenty-four countries will move on to the knock-out stages I doubt there will be any big surprise exits from the tournament next week. There are some mouth-watering games ahead. Enjoy.
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