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STATE OF AFFAIRS
Last Friday’s US labour statistics have been another proof of the fickleness in current economic data series. An advance of 559k in Nonfarm Payrolls was a set-back and could not be dismissed by the sell-side strategists as a calculation error due to methodology machinations. We have to accept that most economic data indicators digest an episode of high volatility. Soft indicators tend to be overoptimistic while hard indicators carry more uncertainty. This episode will endure well into 2022. Technically speaking, in the Gregorian calendar, this decade started at the beginning of 2021. So, are we heading into a decade that resembled the roaring 20’s of the 20th century? That decade was indeed a prosperous decade coloured by extensive innovation in technology and the arrival of new business practices. The pandemic that dominated our private and professional well-being carries elements that also propelled technological breakthroughs and the start of a new working culture. The medical spurt witnessed over the past year is impressive. Accomplishments in the control of virus outbreaks cannot be underestimated. To measure the impact on labour markets we are still in a premature stage. However, we sense that the impact across industry sectors, be it in manufacturing or services, is profound. Low-skilled jobs belong to the high-risk category. Automation is accelerating due to less globalization as a result of change in geopolitical priorities next to a regulatory push to adopt shorter supply chains. The regulatory zeal encompasses climate-related risk mitigation as well as the quest to achieve less inequality. The G7 accord on a minimum tax rate reached over the past weekend is testament. At the end, we can summarise that the combination of the above regime shifts might propel productivity and indeed attenuate the lift in developed market inflation rates. Another conclusion is that we should take the premise that the ‘roaring 20s’ are laying ahead with a pinch of salt. If anything, the risk of increasing inequality over the short term is dwarfing the potential for more equality over the long term. It is that realisation, that uncertain condition or ambition that will affect monetary policy over the next 3 to 5 years. The US FED is aware of that. It is embedded in the fragile readings in labour participation rates. The weak headline number hides even weaker underlying dynamics of people losing their grip, in required knowledge and work intensity, with the growing labour demands pushed by society. That brings us to the reaction curves of central banks. How should they set monetary policy in order to alleviate the difficult transformations across labour, business and human factors? The days that central banks ‘only’ had to focus on setting overnight rates and steer credit and economic growth onto a sustainable path under a stable inflation sky are well and truly behind us.
The US FED will adhere to the tested policy strategy of gradualism without wanting to force an aggressive bubble popping. Over the past 25 years, barring a few exceptions, the US FED has adjusted towards higher transparency and prepared or informed private (households & corporates) and public agents (governments & supranational funding vehicles) well in advance of the potential breath and pace of monetary accommodation or tightening cycles. Beyond the GFC of 2008-2009 this exercise became more difficult as the number of tools in the kit increased. Notwithstanding, the track record has been effective in preventing deflation to set-in as well as keep the US growth path on a respectable journey. On Wednesday June 16, we can expect that the FED will inform the public at large that, conditional on a successful exit out of the health crisis, they will consider a QE tapering strategy as of early 2022. We stress that the market has already fully priced in such an event. Given the expectation of a temporary rise in inflation over the medium term one should consider a mute FED as irresponsible. A 2022 taper is a given. Doing nothing at all, might even backfire disturbing the consolidation of US long rates since end of March and, by ‘accident’, fall into a disorderly spike in long term rates. The FED will prevent such an event to take root and announce the first act of the play well in advance. The play also features a gradual increase in policy rates starting over H2 2023 or early 2024. I reckon that the big debate should focus on the target or terminal policy rate. Today, the market has priced an end state in line with the current FED dot plot pointing to 2.25%-2.50%. The FED should achieve that level by mid-2025 or 2026 at the latest. The stealth market agreement with this path fully explains the current consolidation phase in US long-term Treasury rates. Observing the US yield curve 5 years forward we find a fit with a terminal rate of 2.25%-2.50%. However, there is a school of thought making headlines that states that the terminal rate might/should be lifted towards 3.00% to 3.5% in order to stem inflation from becoming unanchored next to the formation of asset bubbles. I leave in the middle what precedes: is inflation the trigger for bubbles in asset markets or will bubbling asset markets lead to inflation?
Fact is that we need to pause and reflect on the probability that such a FED reaction function crystallises. And here, history might be our guide. The FED has stated many times that monetary policy targets the economy and not asset markets. The FED has pointed out that inflation is not a short-term policy concern as it views inflation as transitory. The FED is concerned about the quality of the labour market recovery. These messages are repeated time and time again. Still, sell-side strategists point to the possibility that the FED departs from its proven gradualism and forward guidance policy setting. I agree with the proposition that froth in markets is better left to market participants to deal with. Already in 2002, Bernanke had dismissed that FED policy should adopt a “lean against the bubble strategy”. That kind of policy would act as insurance and pre-emptively deflate asset market bubbles. The main argument he used to dismiss such policy (increasing the probability so that participants expect for instance an extra 50bp in policy tightening on top of the current estimated path) was that the collateral damage to the economy might be high. Essentially Bernanke stated that such a policy stance would go against sound practices of central banking using the blunt tool of monetary policy. He stated that the FED could not reliably identify market bubbles better than professional market participants would be able to! Moreover, next to solving an identification problem, the FED would also be confronted with the issue of ‘safe popping’.
A reminder of the FED policy mistakes that took root as of 1925 provide for excellent reading. Benjamin Strong, Governor of the central bank of New York, resisted attempts to aim monetary policy at the stock market, pointing to potential negative consequences. Unfortunately, he died in early 1928 and the FED came under the control of bubble fighters. The most fervent enemy of speculation was Board Governor Adolphe Miller, friends with soon-to-be-elected-president Herbert Hoover. Strong’s successor at the New York Fed, George Harrison pushed for higher rates, instead of better macro-prudential measures. The Fed raised rates from 3.5% in January 1928 towards 6% by August 2029. What follows is indeed history…a bad history, as the crash led to a prolonged depression. Bernanke states that the correct interpretation of the 1920s is not the popular one. The narrative goes that the stock market got overvalued, crashed and caused the Great Depression. However, the truth lies in an over-ambitious Fed that wanted to stop the rise in asset markets. I reckon that the Fed will not repeat that mistake. The current level of US long rates already has priced a policy lift of and towards 2.50%. An adjustment that took place in the 20s about a century ago. I reckon that financial conditions are accommodative and correct in alignment with current economic uncertainty. Today, long-term US interest rates have priced QE tapering over 2022 and a gradual tightening path from mid to late 2023 into 2025. Gradualism will be the preferred strategy again. Whether the Fed ever achieves to reach the current target rate should be at the center today’s debate. As stated in previous letters, under a scenario where the terminal rate is 1.5%, we should prepare for strong US bond markets in the years ahead.
We witnessed a solid bull flattening of the US yield curve after the release of May labour market figures. 10-year and 30-year UST dropped by 5bp towards 1.55% and 2.23% respectively. A surprising move as the funding schedule over next week will issue a total of USD 120 billion in US coupon bonds across 3, 10 and 30-year maturities. The market is aware that we will witness peak issuance over 2021. QE will remain present and cater for the US Treasury funding program. The demand supply balance will flip over 2022 and 2023 as the US deficit will drop concurrent with higher economic growth and government revenues. The probability for upside surprises in long rates is waning. Investors with a global perspective and long-term horizon lock-in correct US yield levels.
The JP Morgan EMU index is staging a comeback, adding 22bp over the week. Since mid-May, European Government Bonds (EGBs) have recovered more than a full percentage point and retreated 3.33% since January 1. EMU rate convergence is back to trend. Consensus on the outcome of the ECB meeting is broad-based. The PEPP will be do the job of keeping long rates at bay after a somehow unnerving month of April and May. The ECB will not accept an uncontrolled rise in real rates. It did not occur until today. It should not occur over the remainder of 2021. A controlled rise of nominal rates at the long end will be welcomed, until the ECB says stop. They are well in control.
On the back of strong EGBs the European investment grade (IG) and high yield (HY) bond sectors returned 22bp and 36bp respectively. The IG corporate bond sector is limiting the damage over 2021. The HY sector is cruising ahead and at this pace will post a 3%+ year. That will require steady, unfazed and transparent central banking policy. It’s hard to find an argument that would spoil this condition.
A solid week for returns in local EMD, uplifted by EMFX. The JPM GBI EM Index returned +1.20% in EUR terms and +0.67% in USD terms. Over the past month, performance plots at +2.1% in EUR terms and +2.6% in USD terms. The JPM EMBI GD index for USD denominated sovereign bonds returned +0.23% and +1.3% in USD terms on the same periods. EM currencies are currently benefitting from a combination of a weakening US Dollar, decreasing volatility, stable US rates, strong commodity prices, cheap valuations and relatively modest positioning. Main risks are the growth differential to DM and a volatile political agenda in Latam.
Chinese authorities have expressed their discomfort with the recent CNY appreciation. Former PBoC officials expressed views the currency was overbought and the short-term rise was due to speculation…unlikely to last in their view. Also, CNY rate fixing versus the US Dollar has trended higher over the past week and, most importantly, the banking Reserve Requirement Ratio on FX deposit has been raised from 5% to 7%, the first raise since 2007. China has been the main beneficiary of capital inflows into emerging markets this year, which pushed the currency stronger. Some regulatory changes regarding capital account liberalisation, allowing domestic participants to invest in the offshore bond market, are likely to boost capital outflows from the country.
Russia announced it will cut US Dollar holdings from its sovereign wealth fund worth USD 119 billion. The National Wellbeing Fund will shift its dollar holdings into Euros, Yuan and gold, according to the finance minister. This move comes just a few days before the meeting between Joe Biden and Vladimir Putin. Tensions run high given US sanctions on Russia.
Over the weekend, investors will be following elections in Latin America closely. In Mexico, mid-term elections will see all 500 seats in the Lower House, 15 governor seats, 1,926 municipal mayors and 18,000 seats on community boards up for vote. This will be a test for AMLO’s Morena party which needs to hold its supermajority in congress in order to keep its ability to pass constitutional changes. How the Morena party comes out matters, because some recent laws relating to the labour market and the energy sector have been challenged by the constitutional court. In Peru, the second round of the presidential elections will oppose little-known leftist Castillo who spooked financial markets and the unpopular Keiko Fujimori, daughter of the former president who was convicted for a number of crimes related to corruption and human rights abuses.
The decade ahead of us looks promising as new innovations in business and labour might allow for a steady and promising growth path ahead. Such innovations should support and lift productivity. That will be an essential ingredient to prevent bad inflation from taking hold.
The Fed will not damage the asset inflation witnessed over the past year. The Fed will not play the role of arbiter in speculation across markets. The Fed will lead in monetary policy as well as in supervision, protector of market functioning and lender of last resort.
The Fed reaction function is clear for market participants and points to a terminal rate of 2.25%-2.50% by 2025. Do not expect higher levels, as such policy might derail markets to the point of feeding into a negative feedback loop on main street. The mistakes leading to the market crash of 1929 will not be repeated. .