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The cocktail of increasing global geopolitical stress, an outbreak of war, overheating economies and hawkish central banks is a sour one. The tension in markets is palpable. ‘Return of capital’ considerations overshadow the ‘return on capital’ primal objective. That all four events occur simultaneously puts the onus squarely on the major central banks. Why? Because the first two are by their very nature fluid and hard to model. Solutions on that front requires political skill. It also pushes the political elite to deliver on grand ideas that have been simmering in the back but never received correct catalysts to put them high on agendas. Political boldness is called for now. We’ll tackle the boldness requirement in the second part of this week’s musings. First, I comment on the upcoming change in central bank behaviour. A change towards restraint.
Overheating economies resulted from an overdose of monetary and fiscal stimuli applied over the past two years. Expect sustained fiscal support over the decade. This leaves us with central banks that must act responsibly to quell an inflation problem but also to maintain market stability. Central banks should admit that they have little control over inflation born out of a protracted supply disruption. Still, they should apply restraint over the upcoming policy rate normalisation cycle. Let’s tackle how restraint might look like.
Whereas the base case scenario mid-January was for the FED to hike 3 to 4 times over mid-2022, a 7.5% yoy US inflation print on February 10 stirred markets and, almost overnight, the 7-hike risk scenario became the base case. With the in-line release of core PCE inflation figures last Friday, at 5.2% yoy, we might see another change of heart by FED officials as they set the stage for the March 16 FED meeting. They will preach restraint by preparing for a 25bp policy rate move. They will preach restraint by pointing to the complexity of the measurement of the economic fall-out as a direct consequence from ss-Russia war. Restraint should also calm nerves in markets and sooth volatility. Flight-to-quality government bonds will persist as long as this war rages on. Rates at the longer end of yield curves for AAA rated countries will receive proper interest leaving them anchored around current levels. However, if the war intensifies and/or spreads out to other countries such as Georgia or Moldavia, expect a drop in long-term rates. Inflation worries might take a backseat in markets, as the attention of participants will be directed towards credit (sovereign and corporate) and equity risk within their overall portfolio construction. Market liquidity received a blow. Central banks are aware that excessively aggressive tightening language might push markets over the edge and worsen the problem instead of clearing nasty liquidity problems. Returning to EU and US inflation issues, it serves mentioning that supply chain uncertainty has driven most companies towards contracting a higher number of suppliers. Inventory replenishment quickens. With a waning pandemic, we might flip from scarcity to glut the moment demand normalises or drops as the economic cycle faces war headwinds.
US markets price the FED Fund policy rate at 1.75%-2.00% by end Q2 2023 to reach a terminal rate of 2.00%-2.25% by Q1 2024. The current events might lead to a more protracted and prudent FED reaction function. Markets should consider a scenario whereby the FED hikes 4 times over 2022 and takes a prolonged pause over 2023 only to arrive at target over H2 2024 or 2025 if economic conditions warrant it. Time should become the friend of the FED, whereas today it’s their enemy. The ECB is correctly tempering expectations. For once, the FED might be inspired by the ECB. The ECB could bring policy rates to 0.00% from the current -0.50% over 2023 the moment the FED is on hold. Sound central bank risk management is in order. The stakes are high. Monetary restraint should be applied in combination with political boldness.
With war bursting out at our borders, you can expect that EU and NATO political leadership unites around common goals. That is the case. However, sanctions will not impress the Kremlin. The invasion of Ukraine has been well prepared since the successful campaign and annexation of Crimea 2014. The West is succumbing again this time around. So it serves purpose to strengthen the EU from a military angle. The idea around a European army and close cooperation model will accelerate. But, a big but, because the 27-member EU is split and in dispute with Poland and Hungary, the EU approach is constrained. Enter the 19 strong Eurozone (EZ) member countries. The EZ member countries could opt for closer cooperation, economically and military. In order for the EMU to survive they will need to adopt a United States of Europe approach. If that leads to a two-speed Europe, so be it, as benefits greatly outweigh the risks. Work with the willing EZ countries. A military financed by the EZ countries will become a necessary step towards mending the faultline that existed as the Euro got launched in January 1999. Solving the funding equation will lead to more fiscal union. The 19-member EZ construct includes Finland and the three Baltic states Estonia, Latvia and Lithuania. Romania has set 2024 as the target year to adopt the euro and say farewell to the Leu. That would seal the Eastern borders from threats coming from Russia or elsewhere.
A monetary, economic, fiscal and military EZ union is a strategic objective worth considering today. Can the European Commission show boldness and deliver on such an ambition before the end of this decade? It would immediately solve the ECB’s recurring problem related to fragmentation across EZ government bond interest rates. As the Euro announcement sparked the end of national currency speculation, taking an accelerated path towards fiscal and military cooperation would stifle rate speculation against Italy, Spain, Portugal, Greece…It is disheartening to observe yet again that the Italian 10-year interest rate spread to Germany climbed as high as 1.70% to close at 160bp last Friday. The European Commission has the power to end this pricing of credit risk in an unfinished monetary union.
Europe is in crisis. This crisis deserves hope. Time for bold political action and monetary restraint.