Last week, we discussed a market dynamic where the core focus (in the US) has shifted from inflation to growth and with it the dominant asset class has shifted from bonds to equities, with no reduction in volatility.

We have stated many times recently that this year has so far been characterised by complexity. Not just the individual shocks of Covid, inflation and the Ukraine war, but the complicated evolution of each shock having its epicentre in different economic regions (Covid in China, inflation in the US and the Ukraine war in Europe), thus market participants have had to weigh not only the intensity and implications of the shocks directly, but also the indirect or relative implications of different shocks in different regions.

What has made this multiple equilibria backdrop even more complicated is the fact that it has generated an environment where the inflation threat has removed the global safe haven asset (US Treasuries) from the equation. Furthermore, the different dominant factors for policy in different economic regions (on top of the implications of the commodity price shock) have altered the correlation between assets - meaning that historic risk hedges have not been as reliable as they once were. In short, there has been no safe haven for global assets. Global capital has thus flowed in and out of asset classes and currencies on a shorter term, more transient, less committed basis, depending on the dominant fear in global markets - further fuelling volatility and vol. of vol.

Nowhere to run to, nowhere to hide! Indeed, against this backdrop, even the huge cash glut (the Federal Reserve System (Fed) now attracts close to two trillion dollars of excess cash into its overnight reverse repo facility) is punished by a substantial erosion in real terms.

This problem has been exacerbated of late by the market shift in focus - inflation to growth. Increasingly, markets have been attempting to price a recession to various degrees across asset classes as the Fed (and increasingly other G10 central banks) has become increasingly determined to tighten financial conditions to rein in excess demand (or in the case of the European Central Bank (ECB) use the opportunity of higher prices to normalise policy back to more traditional - non-negative - settings. Reducing the financial stability risks).

Amid this complexity and volatility, central banks having to look through the current volatility and make judgements about the medium-term inflation trajectory.
This week, there was a further hawkish pivot from the ECB. Over recent weeks we have seen a notable shift in the rhetoric of governing council members, with the consensus shifting towards a 25bp hike in July (and by default of the ECB sequencing commitment this means ending APP very early in July or even at the end of June). Furthermore, the Dutch Central Bank Head Klaus Knot (presiding over his country’s 11.2% inflation rate) even raised the prospect of a 50bps - further consolidating the debate away from 0 or 25bps in July, towards 25 or 50!

This week was also notable for The ECB Blog - Monetary policy normalisation in the Euro Area, where President of the European Central Bank aimed to clarify the ECB reaction function. In many respects the narrative was just as you might expect, offering a recap of the normalisation process so far (End of PEPP and the staged wind down of APP) and a clear discussion of the uncertainties and risks to the (albeit more positive on many levels) growth outlook from the global supply chain and energy price shocks.

Also as expected the narrative outlined and re-emphasised the key pillars of the normalisation focus: Gradualism, Optionality and Flexibility. While these terms are familiar and expected, that is not to understate their importance in the likely complicated evolution of growth, inflation and potential fragmentation of the normalisation process (we await more information about the proposed new ECB tools to combat fragmentation or maintain the transmission mechanism of monetary policy - likely at the June meeting).

What was more interesting from my perspective at least was the comparative description of the inflation environment pre, and now post, Covid - prefaced by the clear statement that “monetary policy normalisation is not a predefined concept: it depends crucially on the environment we are facing and the nature of shocks hitting the economy”.

President of the ECB highlighted the low inflation complex prior to Covid as a function of persistent demand weakness (overhang from the global financial and eurozone sovereign debt crises), structural forces (such as globalisation and digitalisation) and sliding inflation expectations. With the genuine risk that the too-low inflation would become entrenched.

Post Covid the story is very different; the environment is very different and thus the monetary dynamic should reflect that difference. A series of shocks, indeed an unprecedented combination of shocks, have pushed inflation to record highs (i) shocks to energy and food prices (ii) shocks to both the supply and demand (pandemic and pandemic stimulus) of industrial goods and, (iii) the reopening shock and the rotation from manufactured goods towards services. A combination of shocks that has countered the demand weakness, the structural forces and inflation expectations - thus created a new environment, and a new decidedly more hawkish ECB reaction function… for now (likely defined as the next three meetings: Ending APP in June, and then raising rates 25bps in both July and September) at least!

In the US, the release of the minutes of the May Federal Open Market Committee (FOMC) meeting provided a clear and consistent message. However, there have been different interpretations of the dovishness or hawkishness of this latest Fed narrative. My take on this is that it depends on your reference point. In relation to the concern (prevalent until a week or so ago) that the Fed may need to shift to a higher incremental pace of rate normalisation - 75bps - to restrain out of control inflation, then this week’s minutes were relatively dovish. There was no discussion about 75bps and the narrative focussed on the next two meetings specifically in terms of 50bp hikes, leaving the door open to a more conservative hiking path beyond that.

However, relative to recent market expectations where the pricing of the September meeting went below 50bps ahead of the release, then the emphasis on continued upside risks to inflation, the explicit reference that “restrictive policy may become appropriate” and even the discussion of active sales of the MBS sector of the Fed balance sheet - all clearly more hawkish.

In the near term it is likely that the continued (and potentially self-fulfilling) fear of recession means that the fed hiking cycle is fully priced by the market (Fed Funds futures implying a peak of around 3.25%). From this point, while US Treasuries likely become more attractive (outside of the historically high volatility), rate differentials narrowing in favour of alternative currencies (EUR, AUD, GBP, CHF and even potentially JPY) likely undermine the USD - especially at its current elevated levels. Indeed, the case for a weaker USD is even more compelling in the EMFX space where there is significant yield pickup from Emerging Market (EM) central banks aggressive front loading of rate hikes through 2021 to date offers significant compensation for the higher volatility. Especially when the baseline level of vol across the spectrum of asset classes is also high.

In many respects I would argue that while the reaction function of the Central Banks is clear in the short term (next couple of meetings) it remains more complex beyond that. For financial instruments it is likely the other way round with more clarity likely beyond near term volatility. Either way, it remains a very complicated backdrop where for markets and for policymakers there are limited directions to run, and even fewer to hide!