This week we have seen an interesting paradox. Bond market yields have retreated significantly, indicating investors do not perceive an immediate or even medium-term risk of rising interest rates to deal with potential structural inflation; simultaneously in Europe, the Bundesbank (Germany’s national central bank) is warning that unlike Monty Python’s Norwegian Blue parrot, inflation is not dead, not even resting, it is alive and kicking. Can both perspectives be correct?
Bonds: leading the witness gently by the nose
Sovereign bond yields have a strong correlation over the long-term with central bank interest rates. Short-term however, fluctuations around the trend line indicate investors’ differing opinions from those of the authorities about future economic prospects. It is a truism of forecasting that however sophisticated the economic soothsayers’ models are, their propensity to stir the chicken’s entrails to predict further and further into the future means the more likely they are to be wrong (not confined to economics: many expert forecasts for Covid cases have been wildly off-beam). Arguably the value in such models is not the absolute number they deliver as a predicted output, so much as the sensitivity of that output to changes in key variables.
Two other behavioural factors have to be borne in mind: first, nobody makes money from static prices, investors are always seeking to find what they perceive as mis-priced assets, to sell those over-priced and buy the under-valued (again a matter of opinion: what represents good value in an asset to one investor may be poor value to another); second, there is a constant game of bluff particularly in fixed income markets between investors and central bank policy makers as both try to massage and condition each other’s opinions and actions, the central banks through ‘forward guidance’, investors through driving yields in a direction which might prompt the authorities to change tack (a good example was the Federal Reserve in 2018/19 when markets forced Jerome Powell to reverse Fed policy on interest rates, what became known as ‘Powell’s Policy Pivot’).
Economic prospects: seeking reassurance or wanting to be spooked?
As we have discussed in these columns recently, investors’ preoccupations have focused on whether inflationary pressures as evidenced in reported economic data are transitory or are becoming embedded. They have also become increasingly concerned that the risk is rising that President Biden’s $6 trillion fiscal stimulus packages may not be implemented in full ahead of the US mid-term elections in November 2022 with the knock-on ramifications to longer-term economic momentum.
More immediately, those looking for evidence that economic recovery is potentially losing steam point to the June US jobs data where new jobs growth slowed against expectations, and the June purchasing managers’ index which, despite being still well above 50 (indicating economic expansion), at 60.6 was below the 61.2 recorded in May and market estimates of 61. Oil prices have weakened too, after a period of considerable strength.
Given the linkages between economic activity, labour markets and inflation, the ‘transitory’ inflation camp currently has the upper hand over the ‘runaway train’ believers on the back of which bond yields have weakened significantly. US 10 Year Treasury yields fell sharply this week as low as 1.26% having been 1.58% less than three weeks ago, and it was only in March that some pundits were expecting yields to breach the 2% level. In Europe, a similar reversal: German 10 Year Bund yields fell from minus 0.1% three weeks ago to minus 0.33% at the time of writing; a month ago in the eurozone for however brief a time, only Germany maintained a negative yield on its 10 Year sovereign bonds, but this week it is re-joined by the Netherlands, while France’s 10 Year bond has been flirting with a yield below zero again. In equities, style has shifted away from the economically sensitive ‘value’ sectors in favour of long-term ‘growth’ companies as concerns about the duration of the ‘reflation trade’ mount.
Central banks on differing paths
As for the central banks, the smoke signals are in all shades. Complexity is increased and confused by political and social additions to mandates relating to employment and climate change, both sitting uneasily alongside managing growth to a pre-determined inflation target. But underpinning all the debates is one simple question: at what point on the economic recovery path is it not only inappropriate but wrong for central banks still to be stoking the economic boiler, particularly if governments are weighing in from a political angle with significant fiscal measures of their own?
Open to the charge of dithering, the Federal Reserve is still ‘talking about thinking about’ when to begin tapering its bond purchasing programme, a pre-requisite to raising interest rates. The Bank of Japan, one of the most persistent employers of quantitative easing particularly using it to manage bond yields to a target rate, has stopped its asset purchases. The Australian and Canadian central banks have reduced the rate at which assets are purchased, so too the Bank of England. It is important to note that ‘tapering’ (slowing the rate of asset purchases) and ‘tightening’ are often used interchangeably but are in reality quite different: ‘tapering’ is still economically stimulatory, merely less so than before; ‘tightening’ is when the central bank withdraws the stimulus (whether that be through shrinking liquidity, or raising interest rates, or both sequentially) and applies the brakes to the economy.
The European Central Bank (ECB) has its own problems. Not content with having to deal with the economic fall-out of the pandemic and the appropriate mitigating policy to pursue, ahead of the German federal elections in September domestic politicians and policymakers are demanding a return to fiscal probity in the belief that inflation is a major threat (and given Germany’s history, an acute sensitivity). Germany also looks at it from the point of view that were there to be another economic or fiscal shock posing a systemic financial risk to the eurozone, Germany would once more be expected to fulfil the role of underwriter. Jens Weidmann, Chairman of the Bundesbank, is among others including campaigning politicians demanding the restoration of the German debt brake under which government budget deficits are limited to 0.35% of GDP. They also want the complete restoration of the EU Stability and Growth Pact under which national deficit to GDP ratios are limited to 3% and national debt to GDP cannot exceed 60%.
However dogmatic in pursuit of the established rules, German policymakers are pushing water uphill. In military parlance they are hampered by the reality that while a certain geographic point might be the objective to attain, you won’t do it from here except at grievous cost. Italy’s new technocrat government led by appointed prime minister Mario Draghi (former President of the ECB) recently presented a budget projecting a deficit of 12% of GDP. The debt to GDP ratios for the Club Med countries defy the limits: France 116%; Italy 156%; Spain 120%; Portugal 133%; Greece 205%. If the remedy is austerity measures which would be politically suicidal, the quid pro quo is that thanks to all its structural asymmetries and fundamental weaknesses, Europe remains chronically vulnerable to systemic risk from sharply rising interest rates should Herr Weidmann’s prophesy of enduringly high levels of inflation prove correct.
Next month’s central bankers’ annual fishing trip to Jackson Hole will provide yet more material for markets to ponder as the policy cross-roads approaches. As the great ‘Yogi’ Berra said, “when you get to a fork in the road, take it”. But which fork?
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