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Over the past week, the FED hiked policy rates by 50bp and announced another lift of 50bp on June 15 and July 27. In the mid-summer, we will have Fed Funds rate at 1.75%-2.00%. Consensus is broad-based and markets price for US policy rates to hit 3.00% around the turn of the year. Clearly, the market is not impressed by the words of Chair Powell, as after the FED meeting, risk assets got pummelled and core 10-year rates in the US and Germany pushed another leg higher, adding a whopping 20bp over the week. US 10-year rates settled at 3.13% against 1.13% on the 10-year German Bund. For German 10-year rates, we have to look back almost 8 years to July-August 2014, when such levels were present. The 130bp or 1.3% ascent in 10-year bund rates since the start of the year has caused a flash crash across European bond sectors. On an index level, since January 1, EMU government bonds are down an impressive -10.12%. European investment grade corporate bonds suffered a -9.16% retreat. European high yield bonds dropped -1.76% last week and -1.46% the week before. Whilst high yield was resilient till mid-April, investors have had a rude awakening since then, taking the European HY index down -9.19% on the year. There are few places left to hide.
We are amid a big reset. A reset characterised as an inflationary bust after the reflationary boom between April 2020 and December 2021. How long will the current inflationary bust take before morphing into a disinflationary boom?
The inflationary bust over the much-debated 70s effectively took about a decade. Why? Because monetary and fiscal authorities lacked the courage and skill to conduct credible and transparent policies. Economic agents back then were mired in uncertainty bumping along recessionary economic conditions. After multiple supply side oil shocks, President Carter appointed Volcker in 1979. FED Chair Volcker conquered the 70s stagflation crisis by lifting the FED fund rate that averaged 11% over 1979 towards 20% over June 1981. By then inflation peaked at 13.5% but quickly fell towards 3.2% by 1983. Effectively, in order to combat inflation credibly, a ‘fast and furious’ hiking cycle is in order for inflation and inflation expectations to settle around the 2% target.
The more credibly such a policy is rolled out the ‘easier’ the path towards objective. That might explain the surprising market reaction on Thursday and Friday after the May 4 FED decisions. During the press-conference, Chair Powell defused the idea of a 75bp hike. Maybe a small policy mistake in hindsight. In order for the current inflationary bust to be as short as the 2-year reflationary boom, the US central bank and the ECB should be ‘as aggressive as it takes! The more DM central banks hesitate, the longer the inflationary bust episode might be. The ECB should take its cue from central bank history. The ECB should not make mistakes that coloured the 70s through the 7-year stint of Arthur Burns and the short chair by George William Miller. Both US FED presidents were gentle healers making stinking wounds. Second round wage inflation effects are getting stronger across the US and the EU.
In order not to fall into an indiscriminate global bond bear market, DM central bankers are advised to get inspired by EM central bank leadership. EM central banks kicked-off on steep policy normalisation paths over 2021. Such proactive stances have maybe not resulted in an immediate reversal of inflation pressures, it however did protect the value of their currencies and enforced their credibility. As such, the impact of the bond bear developing in DM markets has inflicted less damage across EM government bond markets.
It might be fair to give more weight to a steady FED and to expect the ECB to hesitate. The ECB will not be able to separate their inflation mandate from the ills generated by the Russia-Ukraine war, the Eurozone growth slowdown induced by the energy crisis and the stalling export trade given the Chinese zero-COVID policy. The latter is becoming a testcase that reveals the dependency of world real GDP growth vis-à-vis the Chinese economy and leadership.
In these musings, the destination of 10-year real rates across the US and the EU has often been mentioned as an indicator that works as a barometer for market valuations. In the US we have witnessed an adjustment of 137bp from -1.10% towards +0.27% on the 10-year real rate. Across cycles, over the past 20 years, none (of course) exposing an inflation problem as today, the average 10-year US real rate came in at +1.20%. Between 2009 and today, the average for the 10-year US real rate sits at +0.60%. We are all aware that using past frameworks often leads to disappointments. Still, against that framework, the adjustment has run its course for about ¾. Another ¼ or 35bp would put us around a historical average i.e. +/- 60bp on the 10-year real rate. Such a level would serve improved asset allocation decision-making. It might fit a ‘new’ world order where regional blocks, US – EU – China, vie for leadership. An anaemic productivity background might refrain a test or an attempt to reach levels above +1.00% on the 10-year US real rate.
The German 10-year real rate spiked from -2.42% towards -1.42% over the past 2 months. A stable US-German 10-year real rate differential might see a EURUSD pair consolidate between 1.05 and 1.07. However, the moment the ECB decides to ‘play it safe’ and go for a protracted policy normalisation, expect EURUSD parity to become a target for speculators.
The message today is one that provides no easy outcome. In order for the current inflationary bust to be short we require high resolve and commitment at the level of central bank presidents. Under such a scenario a ‘quick’ reset across valuations in bond and equity markets might make financial markets investable again faster than estimated