12 Jul 2022
More pertinently do you remember the old Commercial Union advertising slogan? “We won’t make a drama out of a crisis”. With the significant and extraordinary volatility registered in sovereign bond yields recently, not a catchy strapline you’d apply either to the US Federal Reserve (Fed) or the European Central Bank (ECB) when, each to its own particular circumstances, both gave the impression of hitting the panic button this week.
First, the Fed. A three-quarter point rise (75 basis points in the lingo) is the biggest such leap in one single bound since 1994. Proportionately, this week’s increment from 1.00% to 1.75% (a 75% increase) is greater as a proportion than 28 years ago: in November 1994, the 75-basis point addition was from a starting-point of 4.75%, a mere 15.8% increase.
The hawks on the policy board, previously in the minority, had been whistling in the dark for such action since February; so what was it that prompted the rest, including a reluctant Chairman Powell, to fall into line to create such a momentous event? Answer: the May CPI inflation data, released last Friday.
For those who still fondly think that the Fed’s principal preoccupation is with Core PCE when considering the 2% average inflation rate as its target mandate (question: average over what period? How long is a piece of string?), Core PCE being the inflation rate defined (‘smoothed’) by the removal of ‘volatile food and fuel prices’, that notion can now be thoroughly debunked.
You may remember back in November when Powell was pitching for a second term in office, his re-nomination acceptance speech specifically addressed the burning issues of food and fuel as real costs of living in any normal household ‘normal’, that is, beyond the tidy minds of economists for whom the short-term volatility in those sectors was inconvenient to their spreadsheets. Essentially Joe Biden, Powell’s nominator, nobbled the aspiring two-term Chairman and told him to get a grip on inflation; if Powell failed to agree with the political interference, he would be fired and replaced with somebody on-message. Biden, facing the prospect of a thumping at the November 2022 mid-term elections, had absolutely no intention of addressing the hustings wearing a supporter’s scarf round his neck emblazoned with, “COST OF LIVING CRISIS! ON MY WATCH! AND ALL MY FAULT! YEE-HA!”. He may yet go down in flames, that remains to be seen. But notwithstanding that common sense says food and fuel price changes are important to consumers’ budgets, nevertheless this confrontation was where the realpolitik of Congressional maths and supposedly independent central bank policy met in a dark alley. The Fed was mugged.
To illustrate the point, Core PCE at 4.9% in April (May’s figure is released at the end of June) has actually declined steadily since February when it peaked at 5.4%. The May headline CPI rate including food and fuel, however, rose against economists’ estimates to 8.6% year-on-year from 8.3% in April. It reflected a 34% year-on-year rise in energy costs, worse than the month before, and 10.1% acceleration in food prices, the biggest year-on-year increase seen in any month since 1981.
If a year ago Powell was firmly narrating a story that saw loose monetary policy of zero interest rates and quantitative easing (QE) extending at least until early 2024, totally in sympathy with supporting Biden’s “we’re gonna go big!” fiscal expansion plan (and that of his Treasury Secretary, Janet Yellen who was Powell’s immediate predecessor at the Fed), markets were much more attuned to the incipient inflationary risk. They steadily pushed up bond yields in anticipation of the Fed, if not the government, needing to change course. Few, if any, with certainty could forecast a major war in Europe and the weaponization of energy and food staples through OPEC oil production quota-fixing, western sanctions against Russia and Putin’s economic warfare as we analysed in last week’s edition; nor more than two years after the start of the pandemic and 18 months after the introduction of the vaccines that thanks to China’s zero tolerance of the virus, Covid would still be playing havoc with global supply chains.
However, as we have argued consistently over the months in these columns, the rising geopolitical risks and the potential knock-on effects were already much in evidence, and should have been reflected in markets through a steepening of the yield curve. But the central banks, including the Fed, were significantly and sufficiently off the pace in response (let alone taking pre-emptive action) to the extent that they have now become as much part of the problem as part of the solution.
Already slowing thanks to supply-side dislocation and rampant inflation, economic growth forecasts are tumbling as what was billed as the ‘Recovery Trade’ fades away. Few economists see much if any growth in the US economy in 2023. The Atlanta Fed even forecasts zero growth in the US in the current quarter. Stagflation (stagnant economic growth combined with inflation) is rapidly becoming a reality, but the Fed anticipates several more doses of the same medicine to come. Far from being zero at the end of 2023, as it forecast a year ago, or 2.85% it estimated only 3 months ago, it now sees US interest rates peaking closer to 3.5% next year. Markets continue to worry that the Fed, now with the bit between its teeth, will kill the economy stone dead.
The evidence of the markets’ anxiety is visible in the US Treasury yield ‘curve’: less a ‘curve’ than a horizontal line, at 3.15% for the 2 Year bond, and 3.30% for the 30 Year, only 0.15% (15 basis points) separates the risk perspective over the intervening 28 years. The only thing in 30 years’ time the author can predict with total certainty is that he will be either approaching his 90th birthday or he will be dead; anything else is speculation.
A flat or inverted curve (as we see currently between the 5-Year Treasury and the 10-Year at 3.34% and 3.26% respectively) does not predict the inevitability of recession but it does point to the increased risk of it happening. Notwithstanding the lack of any notable long-term risk premium, the sharp increase in short-dated bond yields rings alarm bells about the financial costs suddenly being loaded on households, businesses and the government itself in an economic system both awash with debt and used to being bailed out with central bank liquidity at the first sign of stress. That facility is now in sharp reverse. This is a deeply unhappy, upside-down, counter-intuitive position in which to be, not at all what one would read as recommended policy in any orthodox economic textbook.
If the Fed is hawkish, in Europe the ECB finds itself in a familiar fangle all of its own, notwithstanding that for at least a year too long it was fighting the wrong fight, still convinced that deflation was the real enemy.
Confronted with the same global inflationary pressures but with even more immediate economic severity and vulnerability because of Europe’s direct entanglement with Putin and his oil and gas supplies, the complicating factor is the EU itself: 27 countries each with its own domestic fiscal policy, and eight of them still with their own monetary policies. The 19 members of the eurozone have a one-size-fits-all monetary policy through the single currency and a unitary interest rate, but with no coordinated or shared fiscal policy to bring economic coherence to the whole. A political construct, what has emerged is a fiscal Frankenstein, an economic monster. It functions (just) but it really does not work, constantly needing to find inventive means to keep the show on the road.
We have discussed on many occasions the dividing line between the fiscally conservative northern countries (Germany, Holland, Finland etc) and the fiscally incontinent south, including Greece and Italy. As we analysed last week, the ECB capitulated and announced that eurozone rates would begin rising in July. The consequences sunk in over the weekend and this week markets reacted violently: all eurozone national bond yields rose sharply, but those with the wobbliest economics, Greece and Italy (with debt to GDP ratios of 193% and 151% respectively) exploded, prompting fears of a re-run of the 2012-14 eurozone monetary crisis. The feeling of panic was exacerbated when the ECB announced an unscheduled emergency policy meeting. What was subsequently revealed was a proposal for an “anti-fragmentation instrument”: essentially, instead of pursuing a blanket approach to curtailing its bond purchasing programme as a precursor for a rising interest rate, it would stop buying the national bonds of those countries with the strongest economies, but would continue with QE for countries such as Italy and Greece (and no doubt others). Bond yield volatility has far from abated.
Looking down as God sees it, here is the lie of the land in Europe: 27 national governments are each doing their own thing economically with a plethora of outcomes but to a greater or lesser extent most pursuing Keynesian tax-and-spend policies geared heavily towards meeting carbon net-zero; supranationally, the EU is 11 months into its programme of disbursing funds from its €750bn Covid-recovery loans-and-grants fund to every country apart from Poland and Hungary both of which are on the naughty step with Brussels. The ECB, responsible for the monetary policy of 19 members, is proposing to raise interest rates for all, to jam the brakes on some but to have one foot on the brake and the other on the accelerator for those countries which are economically dysfunctional. And the ECB seriously thinks its latest oxymoronic “anti-fragmentation instrument” sticking plaster is a credible solution. Do you follow? Oh, please do keep up at the back.
As if this were not Alice-in-Wonderland enough, there is the serious question as to whether the ECB’s new proposal is in fact legal. Under its constitution, it is forbidden actively to manage yield curves and yet that is precisely what this new strategy is designed to do. It is explicitly there to prevent the yield differentials between Germany on the one hand, and Greece and Italy on the other, ballooning to dangerous levels (a spread of over 2.5% is judged unacceptable in overloading costs and undermining competitiveness for weaker countries and raising the possibility of investors arbitraging the difference to the point it creates a systemic risk). If the path to agreeing the Covid-recovery bail-out plan was tortured enough, the ECB’s proposal may prove every bit as controversial as it is thrashed out in national assemblies. A long history of precedent will suggest a solution will be found by fudge, compromise and much sweeping of inconveniencies under many carpets very late at night.
Finally, the Bank of England. Another 25-basis point rise in Base Rates this week as Andrew Bailey treads warily with inflation and the economy. His committee has its own hawks pushing for more robust action. Buried away in the accompanying statement which raises the prospect of inflation topping 11% in the winter when the next fuel cap rate change is implemented, Bailey hinted at the possibility of half-point increments in base rates in future. And to think it is not so very long ago he was flying kites about the Bank implementing negative interest rates. No wonder markets get confused.
As we have said before, everyone is feeling their way here. It pays to keep an open and enquiring mind, not to be prescriptive and, above all, not to panic. Volatility can be alarming, but it provides opportunity as well as challenging the nerves in a considerable downdraught. Real risk is the permanent loss of capital, something seasoned investors try very hard to avoid.
The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.
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