Equity markets are showing signs of being more sensitive to real world economic conditions, though sometimes they seem confused as to what they want. Earlier this month US employment data showing only half the number of jobs created against the estimates prompted a negative reaction: the economy must be stalling! Two weeks later, the much higher than expected US inflation data caused another negative reaction: the economy is running too hot! Both cannot be simultaneously correct.
If equity investors are life’s natural optimists, even if prone to being swayed by sentiment and fashion, bond investors are the markets’ pragmatists, only preoccupied with whether they are being adequately compensated for the riskiness of their loans and, come redemption day, whether their capital principal will be returned on time and in full. In contrast to equities, US 10 Year Treasury yields remained largely untroubled having already re-priced the risk of rising inflation earlier this year and taking the view that little of substance had changed.
Markets re-evaluate eurozone inflation risk
As western world lockdowns start to relax, even on the Continent, despite the recent viral surge, as vaccination programmes catch up with those of the UK and the US, economic activity is noticeably picking up. Not only is it apparent in the real-time ‘fast data’ but it is now also evident in the official numbers, however historic they might be by the time they are published. And as activity recovers and there are reports of shortages of raw materials and appropriately skilled labour, the pressures are becoming evident in inflation data.
Consider announcements made in the past two weeks: referred to above, the annual rate of US inflation surged to 4.2% in April, up from 2.6% in March and 1.7% in February; less dramatically, the April annual rate of inflation in the UK rose to 1.5%, albeit double the 0.7% seen in March; in Germany this week, the latest annual producer inflation number (as distinct from the national headline rate) saw an acceleration to 5.2% in April, continuing its uninterrupted recovery from the 2.2% rate of price contraction seen in May 2020. Italy too reported a substantial improvement in industrial activity.
In contrast to relatively steady US government bond yields, eurozone yields are playing catch-up as economic prospects improve, and despite Christine Lagarde’s efforts to control the yield curve using extra QE to prevent borrowing costs rising. At the end of 2020, the 10-year sovereign bonds of Germany, Holland, France and Portugal were all negative; now, only Germany’s remains so. Perhaps the most interesting is the German 30 Year Bund yield: on December 14th at its lowest it priced at -0.25%; today it is +0.42%. Whatever the timing, markets are clearly expecting the direction of interest rates’ travel to be upwards.
The increasing complexities of modern central banking
Whether such consumer price momentum is transitory (as the central banks maintain) or is becoming enduringly above trend remains to be seen. In terms of monetary policy response and in particular the future trajectory of interest rates, the context is the mandates of those principal monetary authorities: for the Bank of England, the European Central Bank and the Bank of Japan it remains a nominal target of 2% inflation; for the US Federal Reserve, 2% as an average rate over an unspecified period.
Long-term Inflation rates have been falling since their double-digit peaks in the late 1980s amid a number of contributing factors: Margaret Thatcher’s and Ronald Reagan’s free-market economic policies, including helping break the stranglehold of trades unions in wage negotiations; oil losing its influence and its power to shock the global economy; the deflationary effects of globalisation and the digital revolution; the prolonged zombie economy supported by central bank liquidity (QE) and ultra-low interest rates since the Global Financial Crisis giving rise to surplus capital and labour depressing prices, to name but a few.
Political angle 1): employment
However, central banks are no longer merely concentrating on the core inflation rates for their economies as their principal concern; the picture is rather more complex. Under Mark Carney when he was Governor of the Bank of England, his Monetary Policy Committee decided that, in the absence of meaningful headline inflation, the unemployment rate should be a policy trigger. The 7%, 6%, 5% indicative trigger-points all came and went as the unemployment rate steadily fell, to which there was no response from the Bank, raising the question of what the point was in alerting markets to trigger-points if such milestones were then not acted upon.
In the US, the Fed is now also preoccupied with employment; many question whether it is the business of the US central bank to solve unemployment, given the extent to which unemployment is a social issue (and therefore a political concern) rather than purely an economic one (though one can argue that what is economics but the sum of all human interactions as measured in pound notes, or dollars or euros etc?); where there is the possibility of the Fed’s perspectives pulling in opposite directions is that in targeting full employment and thereby running the risk of actively stoking inflation in a rapidly recovering economy, this is in conflict with its core mandate of controlling the inflation rate.
Political angle 2): climate change
Since 1997 when the Bank of England was the last of the major central banks to be given full monetary policy independence, there has been the inference that central banks are free from political interference. However, here too the lines are increasingly blurred especially in the climate change debate. Whether by political decree or by personal inclination among central bank leaders, the alignment of central banks with their governments is now explicit on this score. Given the Paris Climate Accord is a legally binding obligation for its signatories, having the state and its central bank pursuing the same agenda in a coordinated fashion is entirely pragmatic, particularly when it comes to the central bank’s role to oversee risk management in the financial system arising from the knock-on effects of climate change. But at what point does that become a political judgement rather than simply a matter of risk oversight? Mark Carney, now the UN Climate Change Ambassador, was dangerously close to allowing his own preconceptions about climate change to influence his decisions when Governor of the Bank of England. Likewise, Christine Lagarde at the ECB, a politician to her fingertips, has faced similar accusations of bringing her own personal feelings on the subject (and others) to bear as a matter of policy. When it comes to the financing the decarbonisation of the economy via the issuing of green bonds, it would be unsurprising were there not to be strong political influence about what is and is not appropriate for support with central bank leverage.
There is nothing straight forward about modern central banking. It would be surprising if topics and tensions such as those discussed above were not central parts of the next annual central bankers’ symposium at Jackson Hole in August.
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