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“We’re under control"

- Calvin Harris & Alesso, Under Control

With very little top tier data on the calendar this week there was a distinct shift in the focus of markets. Central banks and credit drove sentiment, with geopolitics offering an interesting side show. Today we focus on the Bank of England (BoE) and the Federal Reserve (the Fed), as both err further towards the hawkish end of the spectrum.

Ever since the recent parliamentary testimony of the BoE’s internal members, there has (quite rightly) been speculation about the hawkish pivot of the BoE. The focus then being that four members of the Monetary Policy Committee (MPC) considered the conditions for withdrawal of monetary stimulus “had been met” (including the three most senior members, Bailey, Broadbent and Ramsden). This week, the minutes went a ‘hawkish’ step further, suggesting that this framework was “no longer useful”.

This week, the BoE kept rates on hold, at 0.10%, and voted to maintain the current quantitative (QE) target ‘stock’ at GBP 875B (with two dissents - both in favour of curtailing asset purchases at the current 840B). The minutes stated that there was agreement across the committee that recent developments had strengthened the case for a modest tightening through the forecast period.

Perhaps most strikingly, the minutes suggested that "any future initial tightening of monetary policy should be implemented by an increase in Bank Rate, even if that tightening became appropriate before the end of the existing UK government bond asset purchase programme". In theory, this could free the MPC to raise rates this year, before the pre-announced GBP 875B asset purchase programme has been completed (mid-December). In practice, while this is likely intended to bolster the Bank’s inflation fighting credibility (amid heightened price risks from the current energy price crisis), we see little prospect of ‘lift-off’ while concurrently easing through QE. Or indeed, before the February MPR (Inflation Report in old money) - this is where market pricing is concentrated.

A further reason for delay comes from the uncertainty surrounding the end to the furlough scheme in the UK. Currently, the Office for National Statistics estimates that around 1.3-1.6 million people are furloughed and it is unclear how many of those will be reabsorbed into the workforce in their previous roles when the scheme expires at the end of this month. It is, however, clear that there are record numbers of job vacancies (>1m) and rising wages to facilitate the transition; and with signs of further normalisation in economic activity and mobility, a tight labour market and inflationary pressures could both become more persistent. Thus, to paraphrase Margaret Thatcher, The (Old) Lady (of Threadneedle Street) is for Turning!

The Federal Reserve

Perhaps more consequentially for global financial markets, this week also saw a hawkish pivot from the Fed. In many respects, it was less of a pivot and more of a continuation down a well flagged path of ‘gradual’ normalisation. However, it marks a significant step in the process.

Going into the meeting, the market focus was on a couple of key areas; firstly, the new Summary of Economic Projections (SEPs). Markets expected the growth forecast for 2021 to be reduced (on the recent delta wave and supply chain bottlenecks) and inflation to rise (largely for the same ‘transitory’ reasons). The Fed marked lower their median SEP growth forecast for 2021, broadly in line with expectations, but also raised subsequent years (through 2024) more than anticipated. Similarly, inflation was marginally higher in the new Fed forecasts through the forecast horizon.

The second key focus for the evolution of policy was the language around the ‘taper’. On this topic, Powell was as clear as he could have been. The statement noted that a reduction in the pace of asset purchases may soon be warranted, and in the press conference, Powell went a step further in effectively declaring the goal of “substantial further progress” attained - “in my thinking the test is all but met”. Further, he stressed that the committee deemed ending the “gradual” tapering process around mid-22 as “appropriate” - consistent with a tapering pace of USD 15B per month (not the more cautious ‘per meeting’ approach that many commentators had favoured).

And then there were the ‘dots’. The September update to the dots now provides a median Fed projection of 0.5 hikes in 2022 (an even split among members of the prospect), with 3 in 2023, and a further three in 2024, taking the Fed Funds rate to 1.75% by the end of the forecast period. Significantly, this is substantially higher than the rate priced by Fed Funds futures, and the government curve. It is also significantly higher than the 10y yield at this point in time. For us, this continues to support our view of higher US yields and a clear shift from the Fed towards the hawkish end of the spectrum, and ultimately a higher USD.

Furthermore, the Fed forecasts continue to see a period of supply chain blockages (“into 2022”), that likely keep price pressures elevated in the near term, but ultimately acute price pressures remain transitory. If we also add the additional ‘transitory’ implications of the recent Delta wave, and expectations of a “tight labour market” and a fast return to maximum employment (which may indeed be higher now than pre-covid in both the UK and the US), then we likely have a backdrop that remains supportive of growth, US rates, the USD and (due to the gradual pace from deep in accommodative territory) even US equities and risk assets.

China

This week has also been complicated by the China credit backdrop and specifically the liquidity of property developer Evergrande. Positive news in this regard has boosted risk assets and likely damped the USD reaction to what we see as a hawkish (if linear) pivot from the Fed. On Evergrande, I have little to say other than our view that Beijing remains in control and we do not expect a contagion event. As for the Fed and the Old Lady, they too are “under control”.

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