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STATE OF AFFAIRS
The FED press conference rises to prominence. At the start of Powell’s term, the decision fell to increase the number of live press conferences from 4 to 8. The question I address today is the following: “To what avail has such a high stream of communication points led?” Listening to the quality of questions last Wednesday, I got perplexed by how little effort, apparently, the specialist reporters on the call have put in to understand FED policy. The Policy Review results announced at Jackson Hole end of August last year and officially stamped over September 2020 stipulated the path ahead. Today, I call for a time-out in order to take stock and assess the implications of the new monetary policy framework published under ‘Statement on Longer-run Goals and Monetary Policy Strategy’. This letter summarises the explanations given by the FED’s vice chair, Richard Clarida. I ask the reader for a little effort. The purpose is to inform. Twitter or other headline attention-grabbing types of communication are not bestowed on me.
For the FED to abandon its zero-interest-rate policy (ZIRP), three conditions will have to be met:
The US economy has to reach « maximum employment » weighted on a broad basis
Core PCE inflation will have to reach 2.00%
Core PCE inflation should be on track to rise moderately above 2% for a certain time
We will comment on each of the above three conditions in order for the reader to grasp the requirements leading to the next FED policy tightening cycle. A quick reminder on PCE versus CPI. The preferred inflation measure for the US central bank is the core Personal Consumption Expenditures index. Volatile food and energy components are excluded. The FED wants to conduct policy based on underlying inflation trends. Moreover, the PCE measure exhibits less volatility than the CPI index. Historically the PCE index evolves about 0.50% or 50bp below the better-known US CPI or Consumer Price Index. Since 2008, the annual difference has fallen towards 30bp. This wedge or difference is due to a fixed CPI basket calculation, whereas the PCE basket allows for substitution effects, which generally favour cheaper goods and services. On category level, PCE puts a lower weight on the Owner’s equivalent rent factor within the overall shelter or housing component. Housing weighs 33% in the PCE index versus 43% in the CPI index.
First, the maximum employment objective precedes the inflation goals. Indeed, the economic scarring inflicted by the pandemic has caused US unemployment to spike. The latest official readings for March sit at 6.2% on a narrow reading (U3), whereas the broad, underemployment reading (U6) came at 11.1%. Traditionally, full employment relates to the level of employment consistent with the unemployment rate equal to the non-accelerating inflation rate of unemployment. We can ditch this indicator. Whilst both full and maximum employment reflect healthy labour markets under the presence of low and stable inflation, the differences sit in the detail. Full employment is consistent with no change in inflation. Maximum employment is consistent with getting to and remaining at the FOMC’s inflation objective. For arguments sake, if inflation would remain below 2%, maximum employment could be far above full employment. Maximum employment might also be above full employment if it is sourced from higher labour force participation. Then again, higher participation rates might limit downward pressure on the unemployment rate, whilst pushing up inflation, even if employment growth would outpace longer-run growth in the working -age population. Maximum employment could undershoot on full employment the moment participation drops, productivity weakens, or inflation pressure rises due to increases in energy or other external reasons. Maximum employment is also broad-based and looks at various ethnic groups. For instance, the latest narrow unemployment reading for African Americans stood at 9.9%!
Second, on the inflation objectives the following interpretations should be adhered to.
Lift-off considerations from the effective lower bound (ELB) will be delayed until PCE inflation has risen to 2.00% on an annual basis. So, an inflation average of 2.00% over a one-year period must be reached to open up discussions on the second bullet point below. The latest core PCE reading came in at +1.5%. Expectations for readings on Thursday, March 26 and Friday 27 point at +1.4% to +1.5% for QoQ core PCE inflation and the YoY core PCE deflator respectively.
Since inflation has run persistently below 2%, the FOMC will aim to have inflation rise moderately above 2% for some time, in the service of inflation averaging 2% over time and keeping longer run inflation expectations well anchored at 2%. Important: the Survey of Economic Projections (SEP’s) can be used to address the FOMC’s tolerance from deviation from 2.00%. This is key in light of the ‘stories’ developing around excessive inflation. The forecasts released last Thursday call for core PCE (yoy%) at 2.20% over 2021, 2.00% over 2022 and 2.10% over 2023. At the same time, 2021 real growth was increased to 6.5%, 3.3% for 2022 and 2.2% for 2023. Unemployment would hit 4.5% by the end of 2021 and drop to 3.9% over 2022 to reach 3.5% over 2023. Indeed, over the projection period, the FED does not expect average inflation to run away from their longer-term objective of 2%. This explains why policy rates would be left at zero over the current projection period towards the end of 2023 as already stated last year: «The FOMC expects that monetary policy will remain accommodative for some time after conditions to commence policy normalisation have been met.»
In addition, policy will aim over time to return to 2%, but not below, after the temporary overshoot of inflation that is intended to support long-run inflation expectations of 2%. Inflation averaging 2% means that room will be taken to make up for past misses below 2%, but it does not aim to offset a moderate overshoot! These 2 words ‘not below’ carry a heavy weight. They do not want to see inflation fluctuating above and below 2%. These commitments are ex-ante, not ex-post, so we all need to give them some slack and be flexible when inflation is not averaging exactly 2%.
Clarida goes even further and gives us a benchmark rule for the pace of normalisation after lift-off. Essentially, it is a Taylor-type policy rule with a coefficient of zero on the unemployment gap, a coefficient of 1.5 on the difference of inflation from the long-term 2% target and a neutral policy rate of r* (estimated at 0.50% by the FED) + 2% inflation. Richard Clarida leans towards a cautious approach to hiking towards the target federal funds rate after lift-off. He would adjust the pace of normalisation in response to average inflation since August 2020. Let’s suppose that average inflation starts to read 2.5% persistently. Given the rule above, the FED would need to lift policy rates three times (0.5%*1.5= 0.75%) and continuously reassess thereafter. If after three hikes, average inflation forecasts still remain at or above 2.5%, they would continue to normalise with another three or four policy rate hikes…until they reach their current 2.5% long-term policy rate estimate. If average inflation comes in below 2%, he would slow the pace of normalisation. Same for a drop of inflation expectations below 2%. For colour: Clarida’s reading is for very protracted policy normalisation that could easily take four years.
Today the market expects lift-off by early to mid-2023…and most strategists, as well as the bond market through forward rates, expect the FED to normalise policy towards the longer-run rate of 2.5% by early 2025. US rates are priced to an aggressive tightening sequence versus the March dots. The market exposes plenty of hubris in that respect. A less aggressive scenario, with first lift in early 2024, followed by 2-year tightening cycle would push 10-year US rates back below 1.5%. If one considers first lift in early 2026, followed by a similar tightening to target over next two years, we might see 10-year rates back below 1.00%. Staying at ZIRP would collapse the US Treasury rates towards Japanese rate levels.
The roar of the bond bear cannot be silenced. 10-year Treasury rates rose another 10bp over the past week, finishing at 1.73% after making a high of 1.75%. The 10 to 30-year rate differential was able to resist further steepening and closed at 73bp. We pay attention to the behaviour at the longer end of US government and corporate credit curves, as genuine institutional investor interest might signal an end to the bond rout. For sure, confidence by market-makers and speculators is high and various shorting strategies generate high rewards for participants with short-term mandates. Some of the ‘value’ estimates released in letters over past weeks have been left behind. Effectively, expected returns for the US Treasury market continue to rise rapidly. Our preferred 5-year Treasury rate 5-year forward closed at 2.64%…a formidable level, making an investment at 1.73% in the 10-year note very attractive. In US TIPS markets, the rise in break-even rates was NOT extended up to the 5-year point. However, 10-year inflation expectations rose 3bp towards 2.31% and 30-year break-even rates spiked 8bp towards 2.27%. The fight between cyclical versus structural inflation believers is firmly in place.
European Government Bonds (EGB’s) were not able to resist for another week and lost the ground they recovered over the previous week. The JP Morgan EMU government index lost 23bp, showing -2.48% on year-to-date performance. 10-year German and Spanish rates were the winners over the week, closing unchanged at -0.30% or up 1bp at +0.34% respectively. Portugal and Italy finished at +0.23% and +0.66% on their reference 10-year rate, both up by 4bp. Various European governments decided that new lock-down measures had to be put in place in order to protect public safety. At times, it becomes difficult to align with or understand the rosy expectations and level of optimism reflected across financial market indicators.
European investment grade (IG) and high yield (HY) corporate bonds looked the other way again. Both sectors have almost become immune to the rate tantrum. IG markets retreated 6bp, posting a -0.98% YtD result. European HY markets dropped a modest 11bp over the week, consolidating at +1.26% over 2021. Primary markets remain open for business.
The yield of the emerging markets local currency index (GBI-EM) rose 12bp to just above 4.90% this week.
The Emerging Market Currency Index gained 0.75% this week, whilst currency volatility remained close to the 10-handle. Turkish lira (+4.30% in EUR terms) was the star of the week, followed by Brazilian Real (+2.40%) and Mexican Peso (+1.60%). The Russian Ruble (-1.15% in EUR terms), Polish Zloty (-0.60%) and Hungarian Forint (-0.20%) ended the week with the most negative returns. Emerging markets local currency debt has been resilient to yield rises in the US. We believe additional value has been created at current levels.
The era of policy normalisation has started. We should probably call it the era of FRONT-LOADED TIGHTENING. Brazil delivered 75bp (from 2.00% to 2.75%) at Wednesday’s COPOM meeting, signalling a hike of the same magnitude in May, thus beating market expectations. Turkey’s Central Bank delivered a 200bp increase in its key rate (from 17% to 19%), beating market expectations by 100bp. The Bank of Russia increased interest rates by 25bp (from 4.00% to 4.25%) and signalled further hikes are likely and that the path would be gradual. BRL rallied 3.5% and TRY 4.5% after the announcement. Regular readers of this letter are familiar with our view. The gradual normalisation of monetary policies will have a positive impact on emerging currencies. During the pandemic, emerging central banks have lowered rates at an unprecedented pace in order to boost growth. They did not mind the pass-through from currency depreciation on inflation, given the historical low levels of inflation in many economies. We believe this era is over and that EMFX will take over the baton from rates as the main driver of performance. The combination of stronger currency returns and high carry will compensate investors for potential higher rates.
Chinese’s growth data for the first two months of the year came out strong even though this data helped by base effects. They mark an uneven recovery with high industrial output (+35.0% YoY and +8.1% on a 2Y average basis) driven by export growth outpacing domestic demand. Retail sales rose only +3.2% on the same 2Y basis (and +0.56% from January). The unemployment rate unexpectedly increased to 5.4% from 5.2% and the number of migrant workers fell by 5 million at the end of 2020, suggesting even more pressures on the job market than observed in official data.
Negative US rate momentum has taken world government bond markets into a tailspin. Spread markets resist well and the tightening tendency of credit spreads remains intact. Markets have decided to close an eye on the current negative pandemic news flow. Hope is blinding. However, the FED conducts ‘real politics’. Fed policy is based on real progress not forecasted progress. They also call on the public at large to go back to the study and have another look at what they decided back in September 2020.
The market is stubborn in accepting a central bank reaction function based on Average Inflation Targeting (AIT). The devil is in the details. I hope to have lifted some of the uncertainties related to AIT in this letter.