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The Big Conversation

Episode 129: A serious time for central banks 

This week Roger Hirst looks at the problems facing the world’s central banks. The ECB has convened an emergency meeting, the BoJ has re-iterated yield curve control, and the Fed is debating a faster pace of rate hikes. Something will have to give when defending a bond market in a time of high inflation. With a new 40 year high in US CPI, it’s time to get serious. In the Chatter, LSEG’s Catherine Yoshimoto outlines the major liquidity event of the Russell Index Reconstitution that takes place on June 24th.

  • Roger [00:00:00] This week has already seen some incredible price action across financial markets, with stocks, bonds and FX all having big moves on Monday after US headline CPI re-accelerated to a new high last week. But what does the Fed need to do to get this under control and will a further fall in stocks give them time to breathe? That's the Big Conversation.

    Roger [00:00:24] On Monday we saw the US 2-year yield reach the highest level since 2007, anticipating that the Fed will have to be more aggressive still. Many hope that CPI is now close to a peak. But even if that's the case, higher prices continue to shift from discretionary items into essentials such as food and fuel. Furthermore, the Fed will want to see inflation fall significantly, rather than just peak. And the move in yields saw the US 2-year to 10-year portion of the curve invert once again. Many investors have focused on the inversion and re-steepening as signs of a recession in the past. But, if we go to the inflationary period of the 1970's and early 80's, the yield curve continued to invert into the recession. Monday also saw the dollar index, the DXY, make a new high. Of note were the performance of commodity currencies such as the Aussie Dollar and Norwegian Krona. These also fell sharply, even though many commodities held up. Additionally, we saw the Italian 10-year yield reach its highest level since 2014. The widening spread between Italian and German 10-year yields is a reminder that higher rates in Europe have consequences for debt-ridden governments and corporates. And as we are going into film this, the ECB had called an emergency meeting to start talking about some of the issues that were appearing in Europe. But perhaps the biggest unknown for the markets today is the potential outcome in Japan. With every other central bank looking to hike rates, often aggressively so, the Bank of Japan is still operating its yield curve cap at 25 basis points on the 10-year government bond. And you can see the distortion when compared to the 30-year, which is move significantly higher. 10-year swaps in the cash market have significantly widened out compared to the government bond yield, indicating that many traders believe the 25 basis point cap won't hold. Now, a weaker Yen should be the release valve for yields capped at 25 basis points, but with the US Dollar-Yen approaching 140, policy makers have started to get nervous. It's unlikely they can control both. So which one are they going to choose? If Japan takes off its yield curve cap, then domestic yields should race much higher. But that would also put upward pressure on other global bond yields because these are all relative positions. On the flip side, if they ended yield curve control, then the Yen should surge. But this is not a position for the faint hearted, it's quite asymmetric, it's because with the yield curve cap in place, the Yen should weaken and it can do quite quickly, but it will be a gradual move. If they walk away from yield curve control, then we could see a massive gap back to higher i.e Dollar Yen, weakening Yen, going stronger. So this is an asymmetric risk which is very, very difficult to control from a risk management perspective. But one of the knock-on effects, if the Yen does continue to weaken, could be a weaker Chinese Yuan in order to maintain competitiveness. The point here is that Japan is one of the world's leading creditor nations and any tremors within this market can have massive repercussions elsewhere. But what about the Fed? Will the Fed be willing to rein back current rate hike expectations if markets wobble further? Well, I think that's probably unlikely, and if anything, the markets are clamouring for faster hikes and it actually could be a more hawkish intent to provide relief to the market if it indicates the Fed really means business this time. Now, the FOMC takes place after we film this episode. Although Fed policy appears to be via the interest rate and QE/QT channels, what they're really trying to adjust are financial conditions. Currently, financial conditions appear to be loose, roughly at the average of the last 20 years, and nowhere near the inflation fighting levels of the 1970's and 1980's. Inputs for financial conditions are things like bond yields, credit spreads, levels of equity and the US dollar. If the Fed wants to fight inflation, they need much, much tighter financial conditions. And of all those inputs, the dollar and yields have already moved quite a way. In fact, the year-on-year percentage speed of change in yields is very pronounced given the low starting point, but it suggests that financial conditions may have tightened more than that index implies. Credit spreads are below recent peaks but are starting to move into tightening territory. But US equities, despite this year's drop, are still much higher than the long-term trend because of the magnitude of that post-COVID rally. If the Fed is serious about fighting inflation, they may need a drop in the equity market to really help slow things down. Of course, a widening of credit spreads could take the lead, and that would also be a negative for the stock market. Also, a further rise in bond yields would also have a negative equity impact. Perhaps the rally in the US dollar can continue. Now the Fed has historically tried to keep a lid on the dollar because of it's negative impact on global growth. But in a world of globalisation, policy makers may be less concerned about this. A stronger dollar normally has a negative impact on commodities (and vice versa), although that hasn't been the case in recent months. A stronger dollar would help reduce imported inflation into the US. However, it would still have a negative equity impact via the large cap exporters. But so far, the ISM above 50 suggests that these companies are not quite yet under pressure. It's the consumer and small family businesses that are really feeling the pinch and they account for a larger portion of the US economy. Consumer sentiment has fallen to an all-time low. These are levels that have historically been associated with prior recessions, although many assets are already well on their way to pricing that risk anyway. US Real wages have been falling, consumers are using record levels of credit to maintain purchasing power, household savings are unequally disputed anyway, and these savings are significantly dwarfed by the losses across bond, stock and crypto markets. Therefore, inflation remains a greater threat to growth than a declining stock market. If the Fed reverses course now, inflation could have yet another leg higher and impact the US consumer and small businesses even more. The Fed would then still need to tighten financial conditions. But will they do that by targeting lower equities, a higher dollar, or letting yields just run free? It may come naturally through credit spreads, but that could be a lengthy process. And in the very short term, Friday's options and futures expiry should be on the radar. One of the largest on record, it is probably impacting the performance of the US equity market. It's worth noting, however, that we have seen major lows on the days after the expiry in both 2018 and 2020. Now, we shouldn't be looking for a major market low yet. Financial conditions need to be much tighter to cap inflation, and nearly all roads, whether its higher yields, wider credit markets or a stronger dollar. Well, they all lead towards weaker equity markets. But inflation impacts everybody and the equity market doesn't. The Fed is just starting its heavy lifting.

    Roger [00:06:58] And another major technical event that's on the near horizon is the US Russell Indices Reconstitution. Many investors will have to rebalance their portfolios through this process, which is explained by LSEG's Catherine Yoshimoto in the next section.

    Roger [00:07:15] Hi Catherine good to see you and in this sort of in a world where there's so much going on in markets, it's often easy to forget that there are some incredible things going on which are sort of more technical, and the one I want to talk to you about is the the 'Russell Rebalancing'. So could you just sort of talk about what's happening? When it's taking place? And at the very basic level, what is a rebalancing?

    Catherine [00:07:35] Great. Thank you. Russell Reconstitution or Recon is the annual rebalance of the Russell Indexes, essentially the membership of the indexes, such as the large cap Russell 1000 and small cap Russell 2000 is reset. Membership in the Russell Indexes is based on the size of the company and where it ranks relative to other eligible stocks in the US market. So it's important for Russell Indexes to capture changes that have occurred, and to add new companies that have become eligible to enter the indexes since the prior reconstitution. We like to call Russell Reconstitution, one of the most anticipated and orderly index rebalance events. Because of the transparency that we provide into the methodology that we use, and the communication that we provide to the market into what's changing. In 2022 Rank Day was May 6th and preliminary membership changes were announced on June 3rd. Recon is final after the close of June 24th and this schedule was communicated to the market in the first quarter of 2022. In terms of why people should care, it is a big annual event for Russell Indexes, there's approximately $12 trillion tracking the indexes, of that, 2 trillion's passive, and we do anticipate that a lot of those funds will rebalance at the close of reconstitution in order to keep the tracking error low against the benchmark. And so you know the past, if you take an average of the past five reconstitutions, there is an average of $119 billion traded across UX exchanges at the close of Russell Reconstitution. So it is one of the biggest trading days in the US equity markets and so therefore we do anticipate a lot of activity around that date. However, again, we do anticipate it to be an orderly event because clients are expecting, the market is anticipating, this event in advance.

    Roger [00:09:23] And you mentioned there you know, the reason why people should care.I mean, could you maybe explain what this means to to passive fund managers if we just focus on that segment and we'll come to on to others later?

    Catherine [00:09:32] Sure. I mentioned that passive funds, there is approximately $2 trillion tracking a Russell Index. So those passive funds will want to replicate the indexes, you know, they typically do want to replicate the positions in order to minimise the tracking error against the benchmark. So they're mandated to actually track the benchmark as closely as possible. So that's why we do anticipate that those passive managers at the close of Russell Reconstitution will be trading into the new index memberships and weights on June 24th.

    Roger [00:10:07] So so the passive guys really do aim, aim for that specific date, but it's also of interest as well to the active management community because in some ways they're the ones who get more excited because the passive guys are quite functional, but you're active guys and the quasi index trackers they're also get very excited about this, too.

    Catherine [00:10:25] Yes, absolutely. So because Russell Reconstitution, the new membership is communicated from starting this year, June 3rd, you know, well in advance of the reconstitution date. So active managers and traders may choose to trade ahead of reconstitution Friday and position their portfolios in anticipation of stock moves. Some of them may try to generate Alpha out of this event, but some may even wait to trade until after the reconstitution's final.

    Roger [00:10:52] And then in terms of the, you know, people get excited about these things, but what are the sectors because normally, there's often sort of a bias in sectors because obviously what's the performance of the last year or last six months or whatever, but what are the sectors that you think are going to see the biggest impact, as it were, or the most involved? And also, are there any stocks that are interesting as well?

    Catherine [00:11:12] Sure. So sector weights for the Russell Indexes are an outcome of the companies being re- ranked and reassigned to the new indexes. We use a framework called ICB Industry Classification Benchmark. For the Russell 1000 index, the sector shifts are relatively minor, with a modest decrease in technology and modest increase in basic materials. However, with energy a standout performance over the past year with its total return, more than 60% as of the one year period ended the May 6th rank date for the Russell 3000 Energy Index, it's no surprise that 6 energy companies will be moving up from the Russell 2000 into the Russell 1000 Index. And Terra Resources, Chesapeake Energy Ovintiv, PDC Energy Range Resources, Southwestern Energy and 4 consumer discretionary companies will also be moving up to the Russell 1000 Index from the Russell 2000 Index. AMC Entertainment, Avis Budget Group, BJ's Wholesale Club and Macy's.

    Roger [00:12:12] Brilliant, so just to finally re-cap this, it's obviously it's on the 24th, that's the Friday of the 24th is when the rebalancing is done effective that goes live, I guess on the following Monday. What was, there's a couple of dates before then that is where things are finalised, is that right? What are those last two days? So we just got that time-line just to finish off.

    Catherine [00:12:28] Sure. I'll just mention that after the June 3rd announcement date, we had a week of query week, but now this week we're into lockdown. And this Friday, June 17th, there will be another update to the Russell 3000 and Russell MicroCap lists on the Russell,  FTSE Russell.com website on our reconstitution landing page. So watch for that update on Friday and then reconstitution is final on the following Friday, June 24th at the close.

    Roger [00:12:57] Great. So so it's something it's a it's a technical event, but it's a liquidity event, so as as a result of that, this is an event that a lot of institutional investors will be looking at quite closely.

    Roger [00:13:07] And if you have questions about this episode, financial markets or the economy, please put them in the comments section or send them to fmt@LSEG.com