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“I’m afraid monetary policy can’t increase the supply of gas… or increase wind speed"

- Bank of England Governor Andrew Bailey

If last week’s comment was entitled ‘Inflation, Inflation, Inflation’ then this week’s could well have been called ‘Reaction, Reaction, Reaction’, as attention shifted first to the Reserve Bank of Australia (RBA), then to the Federal Reserve (Fed) and the Bank of England (BoE). Last week, we outlined the dramatic shift in the inflation landscape that has evolved over recent weeks, and also the dramatic shift in market expectations that has seen significant repricing at the front end of global rate curves. This week, while the markets were likely disappointed by the central bank responses, the narrative has clearly turned more hawkish.

The Reserve Bank of Australia

Nowhere has the front end adjustment been as dramatic over recent weeks as in Australia, where the global effects of surging energy prices, continued supply chain disruption and strong demand were exacerbated by a surprise jump in Q3 inflation and a significant liquidity event (position liquidation at the front end of the Australian curve – where rate pricing was contingent of YCC, until it wasn’t!). This week the RBA abandoned their Yield Curve Control (YCC) target, citing “economic improvement” – although it is very possible that the move the previous week had been so significant in terms of position adjustment, and so substantial in breaking the ‘credibility’ of the YCC forward guidance pledge, that the real reason it was abandoned is that they had very little choice. Indeed, the RBA Governor suggested that the RBA board “didn’t think they could get the yield back to target” and later suggested “I don’t think we would do yield targeting again”.

Next up was the Fed

In many respects, the November Federal Open Market Committee meeting (FOMC) was the most potentially consequential for global markets. The concept of a Fed taper had been tainted by the ‘Taper Tantrum’ of 2013, where arguably poor communication from the Fed led to a sharp back up in US yields, capital flight from emerging markets (EM) and a period of global instability. This time round the plan from The Fed Chair et. al. was clear: market stability at the outset of Fed normalisation was paramount – especially given the absolute level of global monetary settings and sovereign indebtedness – the world could not afford a taper tantrum.

That said, the backdrop this time round was very different. EM interest rates had already built a significant buffer relative to the US; positioning was much lighter; and the communication that a Fed taper was in train had been flagged many months in advance.

While the global backdrop was dominated by the threat of inflation and the central bank reaction function to the prospect of de-anchored medium term inflation expectations, it quickly became clear that the Fed Chair had one thing in mind for the November FOMC meeting: to announce a tapering of Fed quantitative easing purchases in a manner that generated the smallest footprint in terms of market volatility. In that sense, EM currencies and the USD breathed a modest sigh of relief post Fed.

That is not to say that we think the Fed will remain dovish; merely to say that it was the desire of the Fed Chair to disassociate the process of tapering with the process or attainment of criteria for rate rises. Indeed, the Chair did his very best to avoid the debate around the prospect of de-anchored inflation expectations and the reaction function of the Fed throughout the Q&A. In our view, that debate comes alongside the new Summary of Economic Projections (SEPs) in December and the updated rate forecasts (the ‘dots’). Under the proviso that the current Fed Chair gains re-nomination by the December meeting, we are of the opinion that December witnesses a distinct hawkish pivot from the Fed.

Last, it was the Bank of England

Over recent weeks we have been consistent in the view that while we agree with the ‘direction of travel’ of UK monetary policy, we disagreed with the lift-off in November. We have cited:

  1. labour market uncertainties around the end of furlough and unclear skills friction;
  2. recent energy price rises and fiscal tightening on near-term domestic demand as well as the uncertainties over:
  3. Covid;
  4. Brexit, and
  5. supply chain / inflation transience as factors for patience.

This week, the BoE listed all of those factors and disappointed market expectations of a rate hike.

The BoE provided a number of projections – as is the norm in a Monetary Policy Report (MPR) meeting. While they were keen to acknowledge that the Bank rate “will have to rise over coming months” to meet the inflation target, under the conditioned assumptions, using market expectations of rate hikes (~90bps by the end of 2022), the inflation projection at the forecast horizon was below target – perhaps suggesting that BoE rate may not get above the pre Covid level of 75bps (again something we have referenced over previous weeks). Admittedly, the BoE did make it clear that much of this is still very dependent on the energy price trajectory over the period and the Governor was also clear to point out the additional uncertainties surrounding second round effects – which increase the longer inflation remains elevated.

Ultimately, we think there are some important indicators that have emerged from this week

Firstly, there has been a regime shift in the uncertainty surrounding the medium-term prospects for inflation and thus there is heightened uncertainty about the anchoring of medium-term inflation expectations (which increases over time, as inflation remains elevated). By extension, we feel that this increases the acceptance of central banks (perhaps is even encouraged by central banks) of increased risk premium in the respective yield curves. Central banks are less likely to push back on market pricing that is contingent on uncertain inflation expectations.

Secondly, the narrative of central bankers has shifted from containment of rate expectations to an acceptance that rates will need to rise, in response to inflation. Further, that the extent of the response is dependent on the extent of the supply disruption duration (unclear), the resultant second round effects, the de-anchoring of inflation expectations (correlated to the duration, and thus unclear), and the absolute level of current accommodation. In the words of the RBA Governor, “there is a genuine uncertainty around inflation”; but the direction of travel on rates is now clear.

Lastly, and most importantly for us, differentiation. If the direction of travel is clear then the most important factor is the speed and/or the trajectory, not just in relation to the capacity of central banks to tighten, but also in relation to what is already priced. Here we feel there are big differences in developed markets.

On the basis of many metrics, we consider the Fed insufficiently hawkish. However, they are more hawkish than the market. For much of the developed markets, the situation is reversed: the markets are far more hawkish than the central banks (the RBA and the BoE).

Central bank governors may not have the tools to “increase the supply of gas… or increase wind speed”, but they are governed by their inflation mandates. From our perspective, given the uncertainty of the extent and duration of inflation and the potential central bank reaction function, at least on a relative basis, the US stands out. Therefore, USD continues to stand out.

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