“In another perfect light… We run”
Foo Fighters, Run
Wikipedia defines a Mexican Standoff as “... a confrontation in which no strategy exists that allows any party to achieve victory. Any party initiating aggression might trigger its own demise. At the same time, the parties are unable to extricate themselves from the situation without suffering a loss.” This feels a little bit like the current dominant dynamic in the global macroeconomic space - the self-reinforcing as well as self-defeating trade off (standoff) between inflation and growth!
Last week, we noted the complexity of the current macroeconomic environment and re-emphasised the different dominant factors in the major economic areas in the world (COVID/Ukraine/inflation on China/Europe/US); thus, the policy responses across different parts of the world have been driven by different objectives and different (potentially conflicting) priorities. By extension, we have recently expanded this comparison of multiple policy drivers and objectives to a global macroeconomic backdrop of not just multiple equilibria, but also of different probability distribution functions for growth across different regions. This is important for 2022.
As the situation in Ukraine continues, albeit after taking a marginally de-escalatory turn over recent weeks, some of the risk premia attached to the front oil contracts has dissipated. Furthermore, the very substantial SPR release from the Biden Administration, and prospect of Iranian supply coming back online (unclear) have taken some of the pressure out of the energy market - and perhaps, if this can be sustained, will do the same to inflation over coming months. However, at the same time, the continued COVID wave in China, against a maintained ‘zero-COVID policy, has led to the exacerbation of supply constraints across the region - keeping bottlenecks and supply chain inflation pressure front of mind.
Last week, we stated our view that uncertainty does not necessarily imply risk-off against this backdrop – especially when There’s Effectively a Real Exiguity of Suitable Assets (TERESA!). We maintain this view - that there are some assets that remain well placed in the current uncertain backdrop due to the size of the cash balance, the threat of inflation and the scarcity of securities or asset segments that provide effective inflation hedges and or a sufficient carry dynamic. This week, we have a few further thoughts.
In recent sessions, we have seen sharp reactions from financial markets to the official statements on The Federal Reserve System (Fed) balance sheet reduction first from the Vice Chair and subsequently from the March The Federal Open Market Committee (FOMC) meeting minutes. Both the Vice Chair and the Minutes provided a narrative that to all intents and purposes was likely the central market expectation for some weeks now - a capped, passive (i.e. to take place through the reaching of maturity of assets held under QE, rather than the active selling of assets to the market) of around $100B per month. There was perhaps some hawkish concern going into the minutes, that the urgency of Fed action may have led to a faster tapering in the balance sheet run-off Quantitative Tightening (QT). In the end, the three-month run up to a monthly cap of $95B per month (modestly below expectations on the MBS side - likely as a function of a longer duration asset holding) was broadly as expected.
Some may argue that the urgency of the narrative from the Vice Chair was significant, from a policy maker who has traditionally been at the dovish end of the spectrum (although this is likely countered by the open political affiliation and the partisan ramifications of inflation in the US). However, it is not clear what new information was offered by the Vice Chair or the minutes. It is not clear what the impetus for a further repricing at the front end of the yield curve is. In fact, in some respects, we could argue for a reduction in the inflation risk premium at the front end of the US yield curve going forward, and thus lower short end rates.
By extension, the rally in the US yields, this time led by the longer end, has a couple of interesting connotations. Firstly, risk assets have wobbled. Essentially this is a function of market concern about growth, which brings us back to the Mexican Standoff. Overall, we retain a positive view on the global growth backdrop, although as we outline above, there is likely to be some differentiation globally with respect to growth, and its susceptibility or relationship with inflation. In the US, with significant excess demand, a historically very tight labour market, fast payroll gains, strong household and business balance sheets and latent post COVID demand and/or investment, we remain comfortable with a positive growth dynamic, and do not subscribe to the late cycle assertions of some.
Strong growth may drive stronger inflation pressures and weak growth can weigh on inflation through the demand channel - the Mexican Standoff - BUT there is one important factor that may offer growth the upper hand, and that is the fact that inflation itself is elevated by uncertainty and by extension the inflation risk premium weighs on growth expectations. Therefore, any reduction in uncertainty over time (whether that is improvements in the COVID situation in China, positive developments in Ukraine, or reduced energy of input pressures), improves the balance of risks for growth. We remain glass (more than) half full.
Markets are concerned that persistently high inflation and the monetary response to regain control could lead to a collapse in growth. There is a line of thinking from the minutes that we think is key in this regard, where the Fed discussed the importance of communication in tightening financial conditions. In other words, it is important for the Fed communication narrative to be at least as hawkish as they think may be necessary, and to likely go even further, such that the actions of the Fed to not have to outdo its own rhetoric later in the cycle. This would have more serious connotations for growth.
Lastly, the European Central Bank (ECB) minutes from the March meeting, also released this week, were also more positive on growth and on the necessity and prospect of rate normalisation. Since the release of the two sets of minutes, there has been a (modest) narrowing of the EUR vs. USD 2y yield differential, which we think makes some sense.
The macro backdrop remains complex, with the Mexican Standoff between inflation and growth at the heart of the debate, but we maintain the view that complexity need not mean risk off, and ultimately we retain a positive bias towards (US led) growth, and a select few risk assets.
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FOMC March Meeting minutes: - https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20220316.pdf
ECB March meeting minutes: - https://www.ecb.europa.eu/press/accounts/2021/html/ecb.mg210408~46b9deaa4a.en.html
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