Soyez patient, soyez payé
Central banks are far from declaring victory over inflation. They need demand to slow. They need a recession. The bond market believes inflation will fall eventually, but the message is clear. Short-term, rates are still going up and picking the top is a bit of a gamble. Best to restrict risk exposure and benefit from higher yields at the short-end. The risk rally – or at least one that has real legs – is in the future. Be patient until the rate cycle tops out.
Higher and higher
Never try to call the top or the bottom in markets. It should be one of the golden rules of investing along with taking a long-term view and being diversified. It applies equally to rates, bond yields, credit spreads, equities, commodity prices and currencies. It also applies to central banks. Jerome Powell’s Federal Reserve (Fed) has again forced higher the collective market expectation about where the Fed Funds rate peak will come. The US central bank raised rate by 75 basis points (bps) on 21 September and basically said that until real rates turn positive and there are signs of the unemployment rate moving higher, the Fed will stay hawkish. Yields across the curve have risen again, blowing through the June high. The hurdle rate for the Fed pausing, let alone turning more dovish, has been raised.
In the last few days the Fed, the Swiss National Bank and the Norges Bank raised policy rates by 75bps. The Bank of England opted for 50bps, but three members of the monetary committee voted for a 75bps hike. The European Central Bank did 75bps last time out and could easily do that again on 27 October given the hawkish rhetoric floating around through Eurosystem. Global monetary policy has been tightened massively this year. As a guide, the yield on the Bank of America/ICE 1-3 year global aggregate bond index is up more than 300bps. There is more to come because evidence of inflation moving lower is not there yet.
Short-end yields good enough for now
I’ve blathered on about value in bond markets for months. It’s only natural for a fixed income person when you see prices for government and other investment grade bonds in the low 90s. But the macro factor is pointing to higher rates still and that also means that sentiment is remaining negative. So patience is necessary. And that is even more the case in riskier assets like high yield credit and equities. You can get paid for being patient today. Interest rates on bank deposits are slow to move up but short-dated fixed income or Treasury bills are a good place to put money until sentiment shifts and the time comes to buy cheap credit and equity assets. Don’t worry too much about not getting the absolute bottom. Two-year US Treasuries yield above 4%. One can get around 5% in UK Treasury bills. Yields in Euro money market instruments are creeping up now that the European Central Bank (ECB) is back in positive territory.
The fight goes on
Central banks are clear. The argument that they can’t control inflation that is the result of energy and COVID shocks has become somewhat irrelevant in practical terms. They want to see demand come down to be more in balance with the constrained supply side. If there are not enough available workers to fill vacant jobs, the central banks want to crush the demand for labour. We have been meeting with economists and strategists this week for our quarterly strategy meetings. A clear message is that the US economy remains strong, and it will take time and more rate hikes to trigger the process of negative momentum. Consumer and business spending needs to slow but balance sheets are still in good shape. Eventually demand for labour will slow as firms respond to slower sales and profits growth. Then the vicious cycle of rising unemployment and slowing spending kicks in. That could be months or quarters away still. Meanwhile the Fed might take rates as high as 5%.
US vs Europe
The contrasts between the US and Europe are stark. The US is probably in a healthier position regarding growth right now compared to Europe. The ECB is behind the Fed and its policy seems to be being driven by the need to squash inflationary expectations, even when there are clear downside risks to activity. The energy situation is different also. The US is self-sufficient, Europe is struggling to adapt to not having Russian gas. The plan is also to reduce Russian oil imports to zero early next year, which could exacerbate the energy crunch. It bodes badly for growth in Europe. That also means weaker corporate sectors relative to the US where balance sheets and leverage remain comfortable.
If it wasn’t for the Fed’s hawkishness then US corporate assets would look great right now. There is no credit stress, at least amongst large cap companies. Their funding is not dependent on bank lending or floating rate loans on the whole. Corporate profit margins have not deteriorated significantly. The Q3 earnings season will be important to see whether the decline in equity prices and multiples has been sufficient for now. I suspect that as soon as we get a better number on core CPI, the US equity market will rally like crazy.
I think a road map forward is to recognize that there is value in many parts of the markets but not to jump in to being fully invested just yet. In parts of fixed income yields are at multi-year highs. Buying high yield bonds in the 3-5 year maturity range with 7%-8% yields attainable looks attractive if you think inflation is going to fall from its current levels. Returns should be higher than inflation over the maturity of the investment. But, short-term the Fed is in play still and is playing hard. So it might be wise to wait and get paid somewhat lower yields with less risk, or by still owning short-dated inflation linked bonds to receive the inflation that is higher than we thought it was going to be just a few months ago. The other take-away is to remain long US dollars. The dollar index is at a 20-year high but, apart from the Japanese, no-one really cares. There’s no Plaza Accord around the corner.
Away from the core story of waiting for the central banks to declare victory over inflation, there are some other things to watch. There could be a turn in fortunes in the Ukraine-Russia conflict given the recent pronouncements of the Russian President and signs of popular dissent becoming more visible. Foreign adventurism can often be undermined by domestic opposition. Also, are we seeing the beginnings of change in Iran? The dynamics on the oil market would change if Iran, under a different political arrangement to today’s, was brought more back into the fold. Geopolitical events don’t always need to contribute to risk-off.
Buy high, sell low?
Finally for this week, markets are struggling to understand the implications of Quantitative Tightening (QT). The Fed has already allowed Treasuries that it held on its balance sheet to mature without the proceeds being re-invested. This is termed passive QT and leads to a gradual reduction in the size of the balance sheet. The Bank of England announced it was actively going to start selling bonds held, which does re-introduce duration back into the bond market and might need some participants to re-balance their holdings accordingly (and perhaps re-price). The ECB has yet to finalise its approach. In all forms it constitutes some form of monetary tightening even if the effects are not well understood and may differ. The process is probably not just a mirror image of Quantitative Easing (QE) but will, other things being equal, contribute to some upward pressure on rates or yields somewhere on the curve. I can’t help noticing though, that during QE, central banks were buying bonds when they were expensive (yields were low) and now they are selling bonds when they are cheap (yields are higher). That is not a profitable trading strategy!