Central banks now face the predicament of prioritizing inflation over growth. Last quarter, we discussed in ‘Czech Mate’ that central banks faced an unenviable dilemma amid higher and more persistent inflation, following the Russian invasion of Ukraine. It seems that many central banks have now resigned on the question of growth, prioritizing the need to bring inflation down to target.
Some games, however, are simpler than others. Whereas the Fed face a two-dimensional challenge of sacrificing growth on the Volcker-esque altar of inflation control, for other central banks, the challenge appears in 3D. The ECB for instance also have to play the anti-fragmentation game, as the stresses of tighter monetary policy reawaken concerns over periphery debt sustainability, bringing back the ghost of crises past from 2020, 2018 and 2011-12.
The ECB now have five weeks to design a legally compliant, market-effective crisis tool to once again save an ever-more indebted periphery. For the PBoC, there is the macroprudential game, given the extreme level of corporate sector debt and large and growing cracks over the past year in real estate, besides lingering Covid challenges. The BoJ face a unique mix of macroprudential risk and JGB market liquidity, amid the traditional face-off between central bank market pegs (in this case the peg of yield curve control) and market forces, as their prevailing policy is now openly questioned.
With inflation broadening – across CPI basket items, and countries – and with the year-on-year peak still elusive despite favorable base effects, relief from aggressive rate rises, and the associated market volatility, still seems far off. In only one week, the Fed has delivered the largest rate hike since 1994, the Swiss National Bank have hiked 50 bps, and the ECB have felt compelled to hold emergency meetings before even executing their first rate hike in eleven years.
For bond markets, this means we remain in the ‘taper regime’ that has dominated H1 2022, whereby real yields rise at the same time that credit spreads widen, and with a stronger dollar to boot. In recent times, a positive correlation between government yields and credit (i.e. yields higher, spreads wider) was previously only seen for a matter of one or two months (the taper tantrum of May-June 2013, the Bund tantrum in April 2015, or the brief but sharp US credit sell-off in Q4 2018).
2022 has offered a much more prolonged period of taper regime, not seen since the 1970s. We noted in late 2021, in ‘Pricing sigma’, that volatility was picking up, “after nearly a year and a half of an expensive and generally dull landscape in fixed income, with opportunities mainly on the short side”. Well, say that again. This means still few places to find shelter in bond markets on the long side, other than perhaps Chinese government bonds, amid deeply negative benchmark, passive and ETF returns.
It also means a need in our view to remain patient and judicious about when to get long each of rates and credit. The good news is we think we will see nominal bond coupons at among their highest for more than a decade before the year is out and, with each week of abrupt moves, the necessary repricing is underway.
At the start of 2022, the Fed dot plot anticipated just 4x25 rate hikes for a total of 100 bps for the year. As of 20 June, we have already had 150 bps delivered and, with a potential 1x75 and 1x50 at the next two Fed meetings, Fed funds could easily be at 3% by the end of September. Once Fed funds rates are higher than 2-year Treasury yields, another current red light for duration longs could – in due course – be turning amber to green.
We discussed rising recession probabilities three months ago already. One view that seems prevalent in markets currently is the idea that recession is still a few years out, based on the lags of monetary policy, strong prevailing growth, high household cash savings, low unemployment and the traditional time lags from yield curve inversion to NBER recessions.
Market price action in early June, besides the year to date, suggests the pendulum of opinion is starting to move, with many market participants now scrambling to wake up to the risks. For too long, amid too much cheap money, many investors have blindly chased returns in cryptocurrencies, SPACs and all manner of the latest bull market synthetic product creations, reminiscent of investment trusts of the late 1920s, profitless dotcom stocks of the late 1990s or CDOs of the pre-2008 era. The profitless and questionable were awarded extraordinary, but historically all-too-familiar, valuations. That is now changing. But it does not yet mean that recession is priced.
As we wrote in March, “Critically, from current levels of inflation, the Fed has never tightened just enough to make inflation come back down to target without causing a recession. Commodity strategists already talk of ‘demand destruction’ as the central scenario for wheat and energy prices to come back down in due course. For the likes of Fed Chair Powell and the BoE’s Governor Andrew Bailey, who are facing an unwelcome policy version of zugzwang, the path shown by CEE curves and the historically unlikely challenge of pulling off the feat of dampening inflation without causing recession, it might just be Czech mate”.
Fast forward to June, we stand by our words. We note the Fed, the BoE and a growing number of central banks have now given up on the game of trying to save growth. Controlling second-round effects and inflation expectations is the priority now, while growth is the casualty: the next chapter of 2022 is the inflation game.
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