"Like a tiger defying the laws of gravity"
Last week, we discussed the global bond sell-off and the potential implications for sentiment, risk assets and, through the lens of global economic differentiation, currencies. Central to our position within this debate is the origin of the drivers of this change in sentiment – most notably expressed through the global bond sell-off: greater optimism about future growth prospects. There are, of course, some clear caveats, in that the debate is not just focussed on the prospect of growth normalisation (in the case of the US we see greater potential for the new normal to be a faster pace of equilibrium or potential growth), but also policy normalisation, amid significant debate about the pace and sustainability of inflation as a function of significant (and sustained) policy stimulus.
In this regard, there have been a couple of interesting narratives this week. Firstly, on the prospect of – and even ultimate trajectory of – US monetary normalisation through the army of Fed speakers and most recently the Fed Chairman. And secondly, the prospect of fiscal normalisation, as tentatively highlighted by the UK Budget this week. I have some thoughts.
Going into the Fed Chairman interview this week, markets had grown expectant (if not hopeful) of a dovish narrative with expectation that the Chairman would hint at the potential for Yield Curve Control or even a form of ‘Operation Twist’ to suppress the long end of the US yield curve. Instead the Chairman was clear and concise: “the current policy stance is appropriate”.
With no new news of the path of the US fiscal stimulus (and hints that an infrastructure bill is near the top of the Biden Administration’s to-do-list), and thus no reason not to expect a $1.7-1.9 trillion fiscal injection, US 10y yields broke back above 1.50% on the Chairman’s comments. This once again triggered nervousness in equities, emerging markets (EM) and broader risk sentiment.
However, the Chairman remained consistent in his attempts to push back the near-term prospects of any monetary tightening (even if he disappointed some at the long end). He noted that while the Fed expect progress over coming months, that it would still take some time to achieve ‘Substantial Further Progress’ (SFP), and effectively linked the attainment of SFP with the clear communication of the Fed’s intentions on tapering its asset purchases – communication that will be made “well in advance” of action. Essentially the Chairman pledged to maintain near term policy accommodation in the face of rising growth expectations. From my perspective, it matters that it is driven by expectations of significant acceleration of growth and it matters that this growth (excluding some supply slippage and thus inflation slippage, through higher exports and thus a weaker current account) will be US-led.
In the UK, the Budget announcement was something of a mixed bag. Rising corporation tax (from 19% to 25% starting in 2023) and a freeze in income tax (IHT, Pension allowance, and CGT) thresholds were clearly aimed at the long-term sustainability of UK finances. While the significant further fiscal expansion was a nod to the substantial (and ongoing) fallout from the pandemic, there was also a more positive tone on future growth prospects – not just the updated OBR forecast for 2022 of 7.3%, but the growing confidence that the vaccination programme paves a way out of lockdown restrictions more permanently.
Further, there were a compendium of measures aimed at boosting near term investment and productivity from a corporation tax ‘Super Deduction’ on investment expenditure of 130%, freeports, visa simplifications (aimed at science, research and tech talent), the ‘Help to Grow’ scheme and also changes to pension fund investment rules and UK listing rules (as per the Lord Hill Review). Ultimately a Budget targeting growth.
The more sanguine approach from the Fed Chairman, and the more fiscally responsible approach from the UK Chancellor, are clear reminders that when growth returns, so must fiscal and monetary prudence.
From our perspective – with the important caveat that a rapid pace of adjustment can appear disorderly and thus have negative risk contagion connotations if left unchecked (as the Fed Chairman stated, had the market repricing had “caught [his] attention”) – we remain of the view that while the rise in growth forecasts remains significantly above the rise in nominal yields, then the overall impact should be positive for equities and the broader US economy.
There was no direct reference from the Fed Chairman in the interview to the circular link between rising US yields and the implications for US growth at the policy relevant forecast horizon (1-3 years). In this regard, any tightening of financing conditions could reduce growth expectations and thus reduce the pace of policy normalisation.
For the USD, this is likely a key factor. Rising yields may have been driven by sharp upward revisions in US growth (and inflation) expectations, but they are not limited to the US bond market. Indeed, yields in the UK, Australia and New Zealand have for significant periods risen faster. Herein lies an issue. If rising yields can dampen growth expectations in the US, but global growth is led by the US, then the negative economic implications of rising US yields are significantly larger outside the US, where the reopening, fiscal boost and growth prospects are much weaker.
Ultimately, while we are acutely aware of the negative risks of a rapid or disorderly rise in US yields – particularly in the EMFX and equity space – we remain more sanguine than the market about the financial implications of higher rates per se. If monetary (and indeed fiscal) normalisation comes in response to a sharp rise in future growth expectations and the magnitude of those higher growth expectations remains significantly above those of the adjustment higher in nominal yields, then equities and risk sentiment can likely remain supported overall. However, as the growth/yield link becomes more familiar with markets, so too will the divergent implications for global economies, as recovery rates vary. In FX, this likely means that the USD can, contrary to the consensus view, outperform – particularly if, as we expect, the US economic data (and most notably, labour market data) resume their outperformance...
… Provided that yields don’t continue “travelling at the speed of light...”
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