Roger [00:00:00] Over the last couple of weeks, there has been a renewed bout of volatility across risk assets. Some people are blaming it on the new COVID variant, whilst others are pointing towards the Powell pivotal on rate hikes and quantitative tightening. But which of these will have the biggest impacts on markets going forward? Well, that's The Big Conversation.
Roger [00:00:20] I'll come straight out with it and say it's the Fed that matters the most. Now we can never be dismissive of the impact of the new COVID variant, but this is something that markets and policymakers are getting used to. This won't be the last variant that we have to navigate, but economies, policymakers and investors are now experienced at dealing with this uncertainty. The main impact will probably be the continued strain it places on the supply chains and the potential for the inflationary bottlenecks behind soaring producer price inflation to work its way into even higher levels of consumer price inflation and then wages. The pivot by the Fed, however, is something that markets are going to have to digest afresh next year. And this was something of a surprise given the general expectation for loose policy next year. The recent discussions that have been taking place with Lael Brainard, a renowned policy uber dove, about her taking over the Fed chair, well that suggested that the Biden administration wanted the Fed to move towards a looser, not tighter policy. Now, even though Powell was reappointed despite the recent Fed trading scandals, it was anticipated that these leadership discussions would have been conditional on and leaning towards a more dovish stance. Now, however, it looks like the pressure of higher prices for US consumers has been sufficiently worrying to force Biden to alter course ahead of next year's midterm elections, and that containing prices has become a priority. And this would be a very significant shift if it's confirmed in the coming weeks. The last FOMC of 2021 on December the 15th, is a key date for our diaries and should provide some clarity about where Fed policy is heading after the recent reversal back to the lows of the Fed Funds future for December 2022. It looks like it will break the recent lows, implying higher interest rates in a year's time. Given the first FOMC of 2022 is not until January the 26th, investors will be keeping a close eye on next week's meeting. But why should we care about a pivot? Markets had already started to think about tighter policy after the June FOMC meeting. US 2 year yields, which had been locked in a tight range for much of the previous 12 months, had finally started to move into and beyond that meeting. And we look at 2 year yields and funding levels because this is a time frame that tends to be sensitive to changes in rates expectations. Very short dated maturities are usually anchored to fed funds right up until the point that they change. But if anything, US 2 year bond yields had lagged Eurodollar futures, which first started pricing higher funding levels in January of 2021. Most of these moves in the 2 year space, were the market front running Fed expectations and the Fed had signalled over the summer that tighter policy was possible. But at the time they remained really focussed on prioritising growth, over price stability, meaning they were happy to tolerate higher prices and maintain a loose stance on rates, focussing solely on the speed at which they bought back bonds via their QE operations. The Powell pivot, however, suggests that the Fed has switched from being pre-emptive on growth to being pre-emptive on price. And the price stability is now more important than growth. And this could be significant for positioning, the investor consensus for 2022, was that the ongoing loose policy would support economic growth in which COVID would have a decreasing impact. This meant that value in cyclical plays were in favour, and it very much echoes the consensus that appeared heading into 2021, when the outlook was also for a rebound in global growth that favoured the reflation trade. Emerging market equities were overwhelmingly expected to outperform developed markets. And there was also this unanimous expectation that the US dollar would decline. Now, whilst we did get a rebound in growth, we didn't get reflation. The S&P significantly outperformed emerging markets and the dollar ground higher. This was because the pattern of global growth was extremely uneven. Demand side policies saw consumption of finished goods skyrocket in the US, even as service demand collapsed. And at the same time, China continued its pivot towards domestic rebalancing and away from the growth at any cost policies which it pursued for much of the previous 15 years. And most of the reflationary trades within the commodity space were due to supply chain issues and the shift in demand due to lockdown, and not unbridled global growth. Although today's consensus is not as pervasive as it was at the end of 2020, a rebound in economic growth is still a very popular view. Cyclical and value stocks are expected to outperform the tech stocks next year, and yet the Fed has potentially just pivoted towards a policy that could impact the engine of growth. In previous episodes of The Big Conversation we've outlined how the strong inflationary data and PMIs are actually disguising a US economy that is struggling to create organic, self-sustaining growth. If the Fed tightens, that growth, if that is indeed what it is, could be on very shaky ground. The U.S. yield curve has provided the first signs of the repricing of the outlook for growth. The 10 year versus 2 year portion of the curve has taken a significant leg lower. 2 year yields, reflecting the risk of higher interest rates, have moved higher, whilst the 10-year portion of the curve, an indicator of growth in sentiment, have dropped away from their key resistance level. This combined bear and bull flattening of the U.S. yield curve is generally taken as a sign that the US growth outlook has deteriorated. 30 year yields, which tend to reflect inflation and deflationary concerns, have also fallen sharply, suggesting that longer term disinflationary expectations are building. But just why are curves flattening, if there's now a greater risk of tightening? Well, if lower for longer was one of the main concerns fuelling inflation expectations, then a turn toward tightening now should rein in some of those excess expectations. And this has helped depress yields at the longer end of the curve. The problem for policymakers here is that monetary policy doesn't help solve the problem of supply chain issues. Monetary policy can help soften demand, which helps at the margin, but if supply chains remain impaired because of COVID restrictions, then monetary policy will have very little impact. Now it's true that these yield curves are still a long way from inverting, which has historically preceded a recessionary period. But the point for equity investors is that it's not so much about risk on vs. risk off, but about the right style mix for 2022. If investors are positioned in cyclicals for economic growth, then flattening yield curve suggests that these positions will underperform. Falling long dated yields are usually pretty good for big name tech stocks. These have significantly outperformed in recent years because of the decline in yields. Many investors are positioning for the relative performance of tech versus the broad market to return to the pre-COVID trend, but that's unlikely if long dated yields remain subdued. What's also remarkable is that if this is the peak in the US yield curve, then the peak was significantly lower than previous peaks. And what does that mean? Well, the US economy was not growing at a sustainable rate prior to the pandemic. Yield curves had already inverted and they weren't predicting the pandemic. Today, the US economy is trying to rebalance after the policy distortions that were implemented through the last 18 months, in which fiscal handouts accentuated a shift towards demand for finished goods. The gap between inflation and yields has now reached record levels. That could be considered a policy induced distortion, or it could reflect an underlying economy that's being impaired by inflation. Inflation without growth isn't sustainable, and if long dated yields remain subdued because of tighter policy then cyclical stocks will struggle. The ratio of banks versus the S&P 500 is almost the same chart as the US 10 year yield. When yields fall, banks underperform. But what are the implications of flatter curves for broad based risk? Well, outside of a flight to safety events, lower yields have generally been supportive of risk assets, especially U.S. equities, over the last few years. It's been a threat of higher yields, such as a spike that we saw in late 2018 that's been destabilising for equity markets. In fact, today's US equity market has become so distorted by passive flows that it tends to outperform during periods of weak growth and increased policy intervention. And this makes today's outlook something of a conundrum. Rate policy could tighten, but long-dated yields have been falling in response to that. So should markets take their cue from overnight rates or from those long-dated yields? Well, as long as 10 year yields don't break the key resistance level, which has the potential to create a significant VAR shock if it does, then risk assets should be broadly supported. But the 1.75% level is a key line in the sand. Risk assets are therefore very delicately poised going into 2022. Now there are elements of 1999 and the dotcom era. There's also elements of late 2018 and the potential for a policy mistake, and there remains a huge amount of inflation uncertainty. So how aggressive will the Fed be about being pre-emptive on price instead of being pre-emptive on growth? Well, we might find out at next week's FOMC meeting. But surely policymakers have learnt that they need to take a gentle approach to changes in policy. One of the key considerations will be the sequencing of change. Will rate hikes take place alongside the unwinding of balance sheets, quantitative tightening? Or will these be two distinct phases? Well in the next section I talked to FTSE Russell's Macro Strategist Michael Hampden-Turner, who has worked within the UK's Treasury Debt Management Office, as well as investment banks, about how policymakers may proceed with their tightening policy in coming years.
Roger [00:09:39] Policymakers are turning a bit more hawkish. But what does that mean? I talked to Michael about the various policy tools at their disposal and the speed with which changes could be implemented.
[00:09:49]
Roger [00:09:49] It's been an interesting couple of weeks, because it felt like there's a pivot from Powell, obviously we need confirmation one way or the other, but it's really brought into focus all this question of where are we in the sort of cycle of potential tightening for for future, better growth? Because obviously we've gone through quantitative easing, we've been talking about taper, but we've changed the talk now towards tightening, which is quantitative tightening or its rate hikes. Could you maybe explain what the sequencing is and how you see both tightening in the sense of rate hikes and of quantitative tightening itself?
Michael [00:10:21] Sure, what is probably probably worth remembering that as we speak now, quite a lot of economies are still in a quantitative easing easing mode, in other words they are still purchasing assets from month to month. So step one has to be to stop purchase of of assets. Because here's no point hiking rates if you're also purchasing assets. Step two then this is once you start purchasing access you tend to reinvest the proceeds, so you're keeping the portfolio level at a at a sort of constant level. And then the next step would be to start to sort of sell down that portfolio, either just not reinvesting the proceeds or actively selling the portfolio. And if you're not actively selling the portfolio, that means that you're probably having effect on on rates, you're adding extra supply to the market and you're pushing up gilt yields or bund yields or whatever.
Roger [00:11:11] How far down this road are we, let's say, in the U.S. versus the U.K. versus Europe?
Michael [00:11:16] Take the U.K. is an example. They signalled last summer that they sort of set out in advance what they were going to do. And what they said was, first of all, we'll stop purchases, then we will start to to to, but we will maintain the portfolio at a constant level, ie we will reinvest proceeds, and then we'll start to hike rates. When, when base rates get to 0.5, we will then start to stop and we will then stop reinvesting proceeds, so we will then allow the portfolio to sort of decline gradually. But that process for the U.K. will take over 50 years, so that's quite a long, long, slow process. So they've stated that when base rates get to one percent, they will get involved in active sales, so will actually start to to set a and an amount per month that they will sell every month, which will have quite a big effect all along the curve and probably for for equities as well. It may take quite a long time for, for base rates to get up to 1%. That could be, you know Mark's not predicting base rates to get up that level for over five years. So it could be that we, we have a long period of of sort of passive, quantitative tightening.
Roger [00:12:26] And what does it mean for yields and rates overall? Because obviously, you know, part of this is not so much where we get to, but it's the journey of getting there, what the market sees and feels is going to be the changes.
Michael [00:12:37] Well I think we're quite likely to get quite a lot of high volatility in the lead up to the first, first sale. Because essentially this is something completely new, the markets have never experienced it before, it's going to be, it's going to feel uneasy about about it. And also there's there's always this thing that markets want to get ahead of whatever the policy thing is. So they want to pre-position for, for the for the move. So I think that will mean there'll be rumours about how fast this can be unwound and this type of thing, rate hikes, you're going to see sort of a certain amount of volatility. And the reason why people are going to be concerned is that remember what happened in 2009? So back in 2009, you know, quantitative easing, was seen like a sort of some sort of silver bullet. It was a sort of a it lifted all boats, it lifted equities, lifted rates, lifted commodities, funds, even very illiquid assets, real estate, gold, silver, so it was a sort of magic, magic thing for markets, and they loved it and it raised prices of everything. So now if that's going to go in reverse, markets are going to be scared. They're going to think, how bad is this going to be? Perhaps I should set up position in other assets. I think therefore for policymakers, you know, when they when they see that sort of reaction, I think that that will speak to them is that they need just to go slowly. So I think we'll find that that rates rising very slowly, yields rising very slowly, so that will that will help to limit that limit the damage I think.
Roger [00:14:05] It feels like the comments from Powell have moved from being pre-emptive on growth and allowing growth to go kind of have a free rein, to now suddenly a few worries about price and now being pre-emptive on price. Does that mean that although if they go slowly, it changes the nature of how we should look at risk assets?
Michael [00:14:22] My personal feeling on this is that even the most even sort of aggressive policymaker is going to think it's not worth the risk of a stall speed. You know, because they're going to be afraid of of knocking the economy from from a fragile recovery into into something worse. And so I think they're likely to be cautious. And so therefore a cautious set of hikes and a cautious set of quantative tightening, I think will probably not affect that growth story, you know that growth stock story as badly.
Roger [00:14:51] Where do these rates eventually sort of top out, because it sounds like it's going to be quite shallow, but then doesn't that also have the issue that if they top out at a shallow level and then we roll over, then there's still no ammo to deal with potentially the next slowdown that we have?
Michael [00:15:08] So if we think of of of the sort of policy rate cycle back in the 80s, sort of 80s and 90s, we were seeing double digit sort of policy rates. Maybe the 2000s, we're seeing 7%, 8%, something like that, you know globally, and then say, say, 2009, we saw more like 5, 6% and this this recent sort of upswing 2018, 2019, which was interrupted by COVID, we saw about 2.5%. So it seems, you know, if if we were to go by that pattern then it would it would suggest a sort of policy rate sort of hike of about two and a half to two to 3% would be sort of in keeping with that, with that sort of descending cycle. And that really fits with with the sort of having an extra monetary policy tool because in a way you don't need to rely as heavily on, on policy rates to slow inflation if you're also doing quantitative tightening, and you've got a lot of quantitive tightening to do.
Roger [00:16:06] Should I be afraid of tightening or should tightening be something I'm happy with because it reflects better growth, which way round we should, should we be looking at those?
Michael [00:16:13] Europe is definitely going to be a laggard in this in this story. The Bank of England is already in full signalling mode, which suggests that they are imminently going to do something, but exactly, you know they've laid out the path. So a small rate hike is, seems likely in the New Year. And the U.S. and Canada have done the same thing that they looked, they looked set as well. So it seems likely that the U.S. and Canada will, will, will lead, UK may be simultaneously, or maybe just behind, and Europe somewhere behind that. China and other countries are different, on a different cycle. In rates terms, you have to think who's had the most benefit from quantitative easing? And you know, within Europe, for example, there's quite a difference between, say, Bund, German bunds and Italian BTPs. So Italy and Spain and periphery saw a huge advantage from the, from the quantitative easing programme, they saw their spreads relative to Germany compressed massively. This is quite likely to, it has already started to a certain extent, quite likely to accelerate as we, as purchases stop and that sort of support for those, those bond markets disappears.
Roger [00:17:22] So policymakers have been trying to keep a lid on asset price volatility for much of the last decade. And whilst a change towards a hawkish stance is eventually inevitable, the speed of that change will probably be glacial. Now obviously, much of that depends upon the nature of inflation, but Michael expects that policymakers will err on the side of caution, despite the current bout of higher prices. And that should broadly be supportive of risk assets. And if you've got any questions about this episode or the economy and financial markets, please put them in the comments section or send them to TBC@Refinitiv.com
