Henry Adams
Wednesday, Feb, 09, 2022
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Central bank policy through this crisis has moved the debate from purely targeting inflation and price stability to (quite sensibly) incorporating employment data. And it is promising to see strong numbers here across the board, leading even to inflation of salaries! With the final piece of the jigsaw in place, it seems that there is almost unanimous agreement that the time for action is now, if not yesterday.
The major uncertainty is no longer if, but when, and by how much rates will rise. Until this becomes clearer, volatility across financial asset classes will persist. There is and will continue to be a natural repricing to find new equilibriums.
Over the last week we have digested both hard data and policy rhetoric from three of the major jurisdictions we cover; and it is quickly becoming evident that we are witnessing a landmark shift in post-pandemic Central Bank policy. Inflation is not going away, and is affecting everything from energy, to food and housing in the UK, the US and… wait for it, yes, even in Europe. The time for cheap money has ended and the extraordinary injections of liquidity to stabilise markets and support the broader economy are now at the beginning of their end.
Risk assets have seen sharp selloffs, along with bond markets repricing for considerably higher interest rates sooner than anticipated. To put moves into context, the technology-heavy NASDAQ narrowly missed an all-time record dive. January 31’s recovery cemented instead its performance as the worst since January 2008, when disaster really had struck – it is always interesting to reflect on how different the drivers of such precipitous declines can be. The bellwether that is the S&P 500 had its worst overall month since the pandemic-induced shock and crash of March 2020. Winners are beginning to emerge though – those sectors that can better handle inflationary pressures and reprice to accommodate higher running costs. Financials should continue to do well as, as with higher rates, the ability to charge more for lending and pay less (on a relative basis) to depositors adds to the bottom line.
For those interested in markets, Thursday was a real treat. We heard from the ECB and to summarise in one word – it was pivotal. Whilst rates did not change, all-important language did. Just as critical as what was said by Christine Lagarde is what was left out, both from pre-prepared statements and accompanying Q&A. In summary, we may well see a rise in rates, fuelling hopes and dreams of those holding Euros with the prospect of not losing money on deposits. Whilst inflation will continue to do that anyway, we all feel a little better by not watching it shrink in nominal terms at least. Timing? If futures markets are anything to go by, ¼% in September and again in December, with Christmas potentially coming early this year. Below is the price action on the 2-year German Government bond benchmark over the last two years, which helps put this sentiment into context.
The Bank of England also brought with it surprise to the upside, narrowly avoiding a 0.5% rise which nobody had expected. The end to its corporate bond purchase program was also a shock. Less popular was Governor Bailey’s request for workers not to ask for pay rises, despite the cost of living rising at the fastest pace in 40 years. Some commentators were quick to highlight the Governor’s own take home pay. This announcement, on the very same day as subsidies for council tax and loans for soaring energy prices tells us both the Bank and Government are concerned by potentially runaway inflation here.
Sterling markets moved significantly again off the back of the Bank’s announcement, including our old friend the UK Treasury Bill market, with 1, 3 and 6-month issuance being auctioned in the 30s, 60s and (very high) 80s (all in basis points) on Friday. A far cry from only a few short months ago when each tenor would round down to zero. Naturally the curve also steepened with more hikes sooner looking like the future path. What is surprising is how we are now projecting levels last seen pre the collapse of Lehman Brothers in the autumn of ’08. The price of money is indeed rising, along with a very welcome return to a yield worth maximising for those sitting on liquidity.
Hike-fever is not lost on the economic powerhouse that is the USA. With inflation there topping all other major countries and regions, it is no surprise following the added benefit of very strong employment data that speculation on the other side pond is also not “when” but “how much”. Not only was there a significant increase in those on payrolls, wage inflation beat already generous expectations. March 16th is lift off, clearly demonstrated in the government bill curve. An ocean of cash is sitting on the sidelines waiting to invest at higher levels, with almost every bill maturing before the next FOMC meeting in negative territory. Things do not look much better in other short-dated pockets, including money market funds where returns are struggling to register above zero.
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