Markets have continued their wild ride since we last wrote. Global equities sold off heavily last week, clocking their worst week since March 2020. The S&P 500 entered bear market territory, down -21.8% from its early January YTD peak at the bell on 13 June. And in the wake of a May CPI print that showed US inflation continues to outpace expectations (+8.6% YoY), bonds too sold off, driving yields correspondingly higher. US 2Y Treasuries saw their biggest 2-day move since the fallout of Lehman’s collapse, while the yield on 10Y Treasuries hit 3.47%, its highest point since 2011. The USD index added another highwater mark, reaching levels not seen since 2002. But a lot has happened since last week. Yields have eased down somewhat (the US 10Y stood at 3.07% at the end of Thursday’s session) while the S&P 500 has climbed +3% over the 3 days midweek. At the time of writing, European equities are staging a rally and US futures are pointing upward. To be sure, though, volatility has remained high throughout and stocks are still well off regaining the ground lost this month (the S&P 500 is down -7.45% MTD and the Eurostoxx 600 -8.28% MTD by Thursday close). Troubling economic data continue to come in thick and fast, showing a global economy plagued by inflation and struggling to maintain the pace of growth enjoyed since lockdowns lifted.
Central banks have been at the heart of the action in the last fortnight, as they attempt a response to the shifting economic picture – no easy feat, as we noted last time: the economic problems at hand call for conflicting monetary policy responses. The Fed surprised markets by pivoting to a +75bp hike on 15 June, the biggest since 1994, disregarding its recent forward guidance of a +50bp move. Fed Chair Powell is hammering the message that the Fed’s commitment to squashing inflation is ‘unconditional’. It would appear the ‘Fed put’ is dead: no more will the central bank step in to undergird tumbling stock markets. Whether another +75bp hike will follow in July is very much an open question: Powell steered markets away from this, declaring ‘I don’t expect these moves to be common’, but in such an uncertain and changeable environment, central banks are hard put to steadily follow the lodestar of their forward guidance. Speaking in the Senate over the last two days, Powell has painted a gloomier – but, we fear, more realistic – picture, with a hard landing and recession (whether that be shallow or deep) increasingly likely.
The Fed is not alone in tightening policy. The Bank of England (‘BoE’) lifted rates +25bps the day after the Fed – a smaller increment than their American counterparts, as the BoE fully expects economic stagnation, despite a forecast of +11% inflation. The Swiss National Bank, too, unexpectedly joined in the hiking (+50bps) on 16 June, causing the Swiss Franc to gain +2.91% against the dollar and Swiss equities to fall on the day. As we flagged in our last newsletter, the ECB has also finally turned hawkish, having committed to a +25bp hike in July and the end of the Asset Purchase Programme stimulus tool in the same month. While the ECB had good reason to delay tightening, a widening gap with US policy and inflation at +8.1% proved too much.
But the ECB faces a much more complex path to tightening policy than its central bank peers, as markets reminded Frankfurt in recent weeks. Where others can focus more narrowly on tightening against inflation, the Eurozone architecture leaves the ECB more constrained. Although they share a common currency, the Eurozone countries each maintain their own fiscal policies and separate bond markets. Member states issue debt, but money is created supranationally. Investors might, justifiably, take quite different views of the attraction of different members’ sovereign debt – creating divergent market dynamics, or ‘fragmentation’ – even as the ECB seeks to shape monetary policy for the entire bloc. In central banker speak, this impedes ‘smooth policy transmission’. We have seen precisely that since the ECB signalled the move away from the ultra-loose policy of the last decade: yields on Italian and other so-called ‘peripheral’ members’ bonds shot up, stretching the spread relative to German 10Y bunds, which, though climbing, remain lower. As Italian 10-year BTPs gained a 4-handle for the first time since 2014, the spread over German debt widened to +236.67bps on 13 June. Determined not to repeat the traumas of the euro-crisis, the ECB has acted swiftly. At an emergency meeting on 15 June, the ECB’s Board granted itself ‘flexibility’ to reinvest redemptions from its COVID-era asset portfolio, and instructed its Frankfurt staff to design a new ‘anti-fragmentation instrument’ to be unveiled in July.
What might they come up with? No details have been offered so far but they will have to square the circle of tightening via rate hikes at the same time as loosening in the ‘periphery’ to prevent fragmentation. Bond market intervention could be as direct as selling down ‘core’ sovereigns (such as German and French bonds) while buying Italian and other debt. Alternatively, ‘sterilisation’ could come from offsetting measures to manage the money supply, such as higher deposit requirements. Whatever they opt for, this sovereign spread targeting will be new territory – and the risks will be real. ECB President Lagarde and other board members have stressed the Bank’s determination to keep spreads in the comfort zone – but markets are likely to test that determination. If the line holds, it could be a meaningful step towards common fiscal policy, via fiscal pooling and a de facto Eurobond. The policy announcement of work on the ‘anti-fragmentation instrument’ seems to have helped for now, bringing yields and spreads tumbling back down.
Meanwhile, off the other end of Eurasia, the Bank of Japan faces its own set of challenges. Even as its G7 peers have pivoted, the BoJ insists the current bout of inflation (Japanese CPI was +2.1% YoY in May) is transitory and is sticking to its ultra-accommodative guns. To maintain its ‘Yield Curve Control’ policy (pushing real rates down by controlling the full rate curve), the BoJ has dramatically expanded its Quantitative Easing asset purchases in recent weeks. The result has been a substantial fall in the yen’s value, as the USDJPY chalked a new low this century at ¥136.71 midweek. Market pressure against the policy is mounting – as, interestingly, is domestic opposition. In a fraying of Japan’s old political economy, where once its power-house exporters welcomed the boon of a cheap yen, after years of offshoring production, they now feel the sting as much as the rest of the home economy. A bit of sticky inflation is precisely the elusive goal the BoJ has been chasing for decades and it does not want to nip it in the bud now it seems finally in reach. Prime Minister Kishida has indicated his support, but if the levee breaks it could be dramatic.
For all this focus on central banks (and we, like all market participants, must follow these policy moves closely), much remains beyond central bank control. Powell was right this week to stress that monetary policy alone cannot guarantee that inflation will be pushed back down to comfortable levels. The threats to the global economy remain all to real: China continues to wrestle COVID towards Beijing’s hallowed ‘zero’, while Putin this week plucked one of the few cards left in his losing hand by throttling gas supply to Europe. Germany responded by moving one step closer to gas rationing, declaring the ‘alarm’ stage of its national gas emergency plan. Fears for the global economy’s health are mounting, pulling commodity prices back down (copper is at a 16-month low while Brent Crude oil was c.-11% off its June MTD highs at time of writing) while investors via the Fed funds futures market have expressed their doubts that the US central bank will be able to hike as planned in recent days. Reprising a theme from previous newsletters: this is a volatile, challenging market environment to navigate. Our answer is to keep exposures selectively diversified. Even as cyclical energy and industrial metals waver in the face gathering macroeconomic gloom, agricultural commodities and precious metals may gain. To date, we have steered clear of interest rate risk but the shifting outlook may soon open a door for profitably adding rate and credit-spread duration to benefit from peaking rates. Equities continue to respond sensitively to changing rates indicators – see swift gains this week amongst higher duration tech stocks as the rate hike outlook appeared to soften – but recent falls may have created pockets of value in oversold segments. Beyond that, cyclical equities may offer a path through as the cycle progresses.
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