Rate expectations shot up in October. We may get a small rate rise in the UK this week. The shifts in market views have pushed short-term bond yields higher and flattened yield curves. The ball is now in the court of the central bankers. They have a tough job to do in convincing market players of the appropriate path for policy rates in the next couple of years. If they fail market rates go higher and growth prospects will come down. And for a view on COP26, go to the end.
Central banks have lost (or are very close to losing) control over interest rate expectations as evidence increasingly suggests that post-pandemic rise in inflation risks being more pervasive than thought a few months ago. Since early September, market pricing of where short-term rates will be in 18-months’ time (a window of time typically covered by central bankers’ attempts at forward guidance) has risen sharply across a range of markets. Bond yields have broken above their immediate pre-pandemic levels and rate expectations in Europe and the UK are suggesting the pandemic-era monetary policy settings will be fully reversed by early 2023. We are on the path to normalisation of the interest rate environment.
The risk here is that markets take interest rate expectations higher. Inflation expectations have become un-anchored. Market participants don’t have much collective memory of central bank reactions to higher inflation because they have been conditioned by low and sticky inflation for many years. Now the inflation cat is peaking out of the bag, the incumbent framework for setting rate expectations is perhaps inadequate. It is noteworthy that attempts by central bankers to reverse market expectations have been absent or ineffective in recent weeks. It’s almost as if central banks want the market to do their work for them. The US Federal Reserve (Fed) and the Bank of England (BoE) are openly discussing ending asset purchases. The European Central Bank is struggling to convince the market that the market is wrong on rate expectations and to articulate what will happen to asset purchases next year.
All eyes on the Fed and BoE
This week is very important as both the Fed and the BoE have the opportunity to re-assert some control over rate expectations or at least provide some guidance as to what is an appropriate path for rate hikes in the coming two years. An interesting thing to note about the Bank of England is that in its inflation forecast, to be published on Thursday, it will have used higher market rates as an input. That, ceteris paribus, would mean a lower inflation and growth forecast. This in itself could provide a natural break on how far further UK rate expectations can rise.
Pricing in low growth
The violence of the moves at the short-end of rate curves has had some collateral damage. Yield curves have flattened and the gap between what inflation markets are pricing in for the short-term versus the longer-term has widened. The 10-year versus 2-year US Treasury yield spread narrowed by over 20bps through October. While being careful not to over-dramatize these moves – I will leave that to other commentators – these developments do represent a lowering of market growth and inflation expectations.
Rate and energy shock not good for household incomes
It’s easy to see why. A rate shock and an energy shock will hit household incomes. This poses a risk to the outlook over the next 1-2 years. So far, risk markets have not got the growth scare. Perhaps credit and equity markets reflect the view that what their friends in the rates market are re-pricing is just a return to monetary conditions as they were in 2019 before anyone had heard of COVID-19. Real interest rates are negative and if lots of economic agents are benefitting from higher nominal growth (wages) then the rise in the cost-of-living might not be so damaging.
There is also the possibility that the central bankers are right on inflation. My view is that we do settle at a higher rate of inflation than has been the case in recent years. However, the very high rates that have printed in recent months are more related to base effects and COVID-19 related supply. Even the shocking 1.3% increase in the US employment cost index could be partly related to the end of furlough and emergency unemployment benefits and companies paying up to entice workers back into employment. That is not necessarily a permanent state. Elsewhere the September reading on the core PCE deflator was back down to 0.2% m/m. If it stays there, the Fed has won the game. In conversation with our equity fund managers, a number have cited an easing in supply chain issues, particularly in SE Asia. Recently the cost of shipping – represented by the Baltic Freight Index – has come off as have prices for copper and natural gas.
Waiting for the sirens call
The rate shock requires central banks to respond. They did a great job in keeping market expectations stable throughout the pandemic. Exiting the pandemic was always going to be tricky but the expansion is at risk if markets push rates up more. Monetary policy can’t do anything about oil prices other than force a collapse in demand and I am sure that is not on anyone’s agenda. But what they can do is send a message saying rates do need to rise but in a controlled way and not as aggressively as some market pricing suggests. If they can do that, the risk of a market rout in bonds and equities will be reduced.
Still at the wheel
I’d like to thank the board at Tottenham Hotspur Football Club for getting ahead of the game in creating an opportunity for the appointment of a new coach. Hopefully they will do it quickly and thus remove one of the potential candidates for taking over at Old Trafford should Manchester United also seek to change its manager. I didn’t fancy Antonio Conte in the Reds’ dugout. Actually, I am still willing to see Ole succeed and the second half display against Spurs suggests that the potential is there. That has to be carried forward in games against Atalanta and Manchester City this week. I just hope the two old boys up top can keep on doing the business.
My last point is about COP26. Have we lost control of the climate? The answer seems to be yes, and the pre-summit noise is not encouraging about Glasgow delivering more aggressive agreements to change that conclusion. But that doesn’t mean we give up. Investors have a central role to play in mobilising finance to support companies and governments that are contributing to a net zero future. More and more needs to be done. The MSCI believes that only 10% of listed companies worldwide have plans that are consistent with a 1.5-degree temperature rise and only 43% with 2 degrees. Glasgow should accelerate the pressures that investors – as owners and creditors – bring to bear on companies to get more of them to pledge to make their business models consistent with a 1.5-degree world. As such, we need to keep doing the analysis on companies from an ESG point of view to understand where they are at and where they are going, we need to stop financing the worst polluters and we need to engage even more actively to get companies to do the right thing in a material and intentional way. We might not get back control, but we can stop the worst-case scenario happening.