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No Summer Lull

By Henry Adams on 2021-07-30

Whilst we may be entering summer markets and many are finally able to take the opportunity for a well-deserved rest, there have been a plethora of interesting developments that should not go unnoticed. This time around we also update on when we might expect to see benchmark interest rates rising across the major markets. Apparently, inflation is expected to remain “transitory” and thus supportive of lower rates for longer?!

Second quarter results have been streaming in from the financial and technology sectors, with stock indices in the US having reached new records several times over the last few weeks. Earnings are meeting or beating expectations more than 75% of the time, despite continued drag on any grand reopenings. Clampdowns in China have seen aggressive sell-offs in the region with both the Hang Seng and CSI 300 wiping off gains from the beginning of the year as technology companies have come under attack with user data and monopolies firmly in the regulators’ sights. This, along with the removal of private tutoring, have made investors nervous. Increasingly, this is a global issue, with foreign ownership of Chinese stocks and bonds at record highs as a result of the hunt for yield. With the backdrop of rates remaining anchored at or close to all-time lows and a continuation of high levels of cash both in personal and corporate bank accounts, behaviour is merely a victim of circumstance. Either way, the number one risk to markets (outside of the pandemic directly) according to the Bank of America, UBS and yours truly, is that we see distress in China's credit market potentially infecting the rest of the world (more on this in link below).

The good news? In the last days and weeks, the Bank of England, the European Central Bank and the Federal Reserve have all been through stress-testing of the financial sector and feel confident enough that capital buffers are looking good and able to withstand a considerable downturn should conditions worsen. Dividends and share buybacks have now been permitted to resume. Profits have remained strong, in part due to a reduction in loan loss provisions as delinquencies and defaults have come in considerably lower than one might expect in a world that has remained on the back foot. Additionally, record merger and acquisition activity has bolstered earnings and helped offset the reduction in returns generated from equity and fixed income trading with volatility having subsided.

In Europe, we have seen the launch of recovery bonds, a program that has managed, at scale, the mutualisation of debt across the region, something not even achieved in the global financial crisis and its aftermath during the European sovereign debt crisis. The ECB has, much like other central banks, put concerns over inflation by the wayside. The focus is now on fixing what has been a considerable shock to the workforce, creating a double whammy of decreased income from deflated income tax and consumer spending as well as increased spending on support programs for those seeking employment. Current expectations point to a rate hike no sooner than the summer of 2024 as Lagarde last week made clear to markets that the bank will not derail the current recovery by removing stimulus too soon. There has probably never been a better time to borrow; over-indebtedness though should not be encouraged as the risk of inflation, whilst communicated as transitory, should be followed closely as rates would need to be adjusted to cool runaway price increases.

The UK has managed to change its fortunes for the better. Having last year seen the biggest drop in GDP of all major economies, the IMF on Tuesday upgraded the outlook for “Blighty” to less blighty. The island is now projected to grow 7% this year, leading the pack, along with the United States. In further signs of normalisation, the EUR swap line with the ECB is set to be discontinued as of the end of this quarter and banks are on track to be able to book negative rates, were policy to require it, in future crises. Treasury bill auctions have continued to be very well bid amid muted supply and a complete lack of alternatives in Sterling markets, with the 1, 3 and 6 month maturities trading within a range of 0.00% to 0.025%. The 10 year gilt has also been heavily bought over the past weeks, well off the 80s (in basis points) seen prior to the reversal of the global reflation trade witnessed across major markets, the bond sitting comfortably inside 0.60%.

Depending on which voting Bank member you listen to, it will take several to many quarters before rates lift and the pace will be unexciting. Pricing in markets points to similar timing to the ECB as the Bank remains cautious of the impact of variants on the ability of the economy to remain open and thus recover. Inflation does remain a concern, and with IMF projections remaining strong, coupled with decent employment data coming in and far better than projected, there might be a case for higher, sooner. When discussing the UK and in particular the furlough scheme (which can be polarising), it was very encouraging to see the latest data released yesterday indicating that numbers were sitting at all time lows and a high percentage of the young have re-entered the labour market. The scheme was used by almost 12 million workers over the period and estimates now have the figure potentially as low as 1.1MM with two months to run.

Wednesday evening (European time) saw the release of benchmark interest rates and the pace of the Federal Reserve's bond buying program. Market reaction remained muted as there were no changes to existing policy and, more importantly, this is exactly what was expected. One development that has been headline grabbing historically is a more permanent facility for those seeking financing on government debt, which can add to instability during times of crisis when buyers disappear. The “Standing Facility” solves just this gap, with the FED stepping into finance as a last resort. With their Reverse Repurchase Program (or RRP) consistently breaking records in terms of usage, the problem remains excess cash holdings (currently usage is around a record of just under $1 trillion) for which the central bank is helpfully putting a floor on to maintain levels within ranges set out. It was reiterated that both inflation and employment must be “on track” before any adjustments, first, to the bond buying program (and thus a likely rise in borrowing costs as the supply of cash in the system drops) and then to rates. In the words of Chair Powell, “substantial further progress” must be made. Inflation remains the out-performer on this path, printing Thursday at 6.5% quarter on quarter, below being compared to the upper bound of the fed funds target range. Rates look low!

(Courtesy of Bloomberg LLP)

By one measure of the risk-free rate and expected path of future interest rates, the OIS (overnight indexed swap) curve tells us that there may be a meagre 10 basis point move to come in June next year.

Employment data continues to show an inability to create jobs quickly enough, with those continuing to claim unemployment benefits sitting at 3.3 million. However, looking back to 1991, we are not far off the average across the period. Stripping out the spike from the pandemic, the average from 1991-2019 does drop, but only to 2.87 million. Below one can see the relationship between those receiving benefits mapped against the upper bound once again.

(Courtesy of Bloomberg LLP)

Arguably the FED has been targeting jobs all along! Might central banks be holding off on hiking to inflate all this new debt away? “Transitory” seems ill defined yet powerful in beating down expectations. To be continued…

Best Wishes
Henry Adams, Chief Product Officer

Articles of interest:

Credit Market Pain Seen Potentially Spreading From China to U.S.
Treasury Market Meltdown in 2020 Shows Need for Overhaul, Report Finds
England scraps quarantine for fully vaccinated EU, U.S. visitors

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