A week on from the Federal Open Market Committee meeting that, as we discussed last week, will likely be viewed historically as the start of the normalisation process in the US, and markets have calmed. US 10y yields are broadly where we were going into the meeting (having been 10pts higher and 10 points lower). However, equities remain on the front foot as does the USD – at least relative to the rest of developed markets (DM). In emerging markets (EM), as is often the case, things are a little more complex.

When we consider the themes that have been at the centre of our macro thinking for some time now – a positive outlook for growth, US leading the growth recovery and a widening of the equilibrium growth rate to the rest of DM (and similarly China to the rest of EM), and a differentiated global recovery (as opposed to the synchronous global recovery from the global financial crisis) – it is clear that the process of global policy normalisation is not only likely differentiated (in both timing and magnitude), but that it also may have unconventional connotations for asset market correlations within countries.

In the US, for example, we have seen a recovery that has driven a higher, steeper yield curve and a higher equity market – consistent with our long held view that the increase in nominal yields likely remains less than the increase in nominal growth (exacerbated by unprecedented fiscal stimulus) and thus continues to facilitate bottom line growth in corporate earnings.

However, when we discuss the impact and implications of global policy normalisation, it is also important to gauge progress (hawkishness) relative to market expectations. Indeed, it is likely that the initial, uncomfortable, response from some markets (notably but not exclusively EM) to the hawkish implications of the Federal Reserve (Fed) ‘dots’ was more a function of the fact that the Fed had ‘forward guided’ the market into thinking that the Fed would remain deliberately behind the curve for an extended period (whether the market had extrapolated the Fed’s intentions correctly or incorrectly is another matter), provoking growth, encouraging inflation, and undermining the USD perhaps!

Thus, when the dots showed that the median (of a wide range of) projections indicated not one but two rate hikes in 2023, they were caught off guard. From our perspective, it was a hawkish surprise only relative to the prior stance of the Fed, not relative to the macro data. In essence, the Fed’s forward guidance was merely catching up to the vastly improved fundamental backdrop - a theme that was clearly apparent in the confident economic narrative of the statement and more notably the press conference.

This week, it was the turn of the Bank of England (BoE), who despite a further significant upgrade to growth forecast – another 1.5 percentage points since the May Monetary Policy Committee (MPC) Report – disappointed markets that had extrapolated the hawkish narrative of the BoE Chief Economist (in his last MPC meeting) and all nine members of the Times Shadow MPC that had expressed a preference for curtailing quantitative easing purchases a full GBP 50B short of the pre-announced total. GBP bore the brunt of market disappointment on the day, but the prospect of a rate rise in 2022 – contingent on continued economic reopening – remains.

Similarly, the Bank of Korea signalled the start of the normalisation process this week, but with less urgency than perhaps the market had anticipated, and yields sold off. However, we are increasingly of the view that KRW offers value at current levels as the central bank withdraws accommodation and government passes a further significant fiscal package - tighter monetary, loose fiscal should be a positive for a currency with positive underlying fundamentals.

Inflation is clearly the elephant in the room of this discussion, with a number of EM central banks having already embarked on their respective hiking cycles in order to counter the faster than expected threat of inflation (Brazil, Hungary, Czech Republic and now Mexico are four interesting cases). In the case of Brazil (where there are some idiosyncratic factors that have increased the urgency of the Comitê de Política Monetária, rates have risen sharply from a low of 2.00% to a current 4.25% and a market implied terminal rate this year of 6.5%. There is perhaps an argument to be made that the recent inflationary pressure is a function of global supply, pandemic transfer programmes and other external (and arguably transitory) factors, and that raising rates will not dampen inflation or inflation expectations but will tighten financial conditions. As we alluded to above, this complicates the traditional asset class correlation, and in this instance could well weigh on equities and the long end of the curve, while being more clearly supportive of the currency.

Overall, we retain our macro view that the global economic rebound remains intact, and that from a DM perspective, beyond the distortion of reopening rebounds, the US will widen its growth differential. Furthermore, there will be a clear differentiation (in both chronology and magnitude) of the normalisation process as the recovery takes hold. It is also our view that the US economy is stronger and more durable than the current Treasury curve suggests, but that other sovereign curves are priced more ‘optimistically’, adding complexity to the market reaction function.

Ultimately, it all comes down to growth... sustainable growth. Not the reopening rebound which is essentially backward looking as it is driven more by lockdowns than productivity.

The Covid crisis has thrown up a lot of issues that a remarkably resilient global economy has overcome thus far. The recovery will have its own problems, but as the President and CEO of the Philadelphia Federal Reserve Bank said this week “you can solve a lot of problems when you have a lot of growth”.