A modest interest rate cycle cometh…maybe

Central bankers have set out how they want to “normalise” monetary policy for some time. That process could start soon. The realisation of this has the potential to provoke some volatility in rates and equities. Yet the medium-term outlook is still benign. Unless policy makers get it wrong, rates will remain very low for some time to come. Some nuanced portfolio adjustments might be justified as we edge towards more of a mid-cycle environment – in what remains a very odd cycle indeed.  

How long is transitory?

The consensus view remains that the increase in inflation being experienced around the world is transitory. However, it must be acknowledged that collectively economists, investors and policy makers have been surprised by the speed and extent of the increase in inflation and the supply side disruptions that are behind it. That shows how complicated the world economy is. Who could have possibly foreseen just how the ongoing need for workers to quarantine because of Covid-19, disruptions in energy markets and shortages of heavy goods vehicle drivers – amongst other things – would have come together to impact on production and distribution? Equally I think we need to be somewhat humble about what will resolve these issues and how long it will take. All Covid-19 restrictions are unlikely to be completely lifted anytime soon. Changes in consumer and corporate behaviour will affect supply in labour and product markets and in services for some time to come. Shortages of all kinds of goods are likely to persist for at least a few months until firms can re-establish effective supply lines. Inflation might be transitory for some time.

Getting ready for higher rates 

For financial markets all of this can impact on the macro-economic data and undermine investor sentiment. Perhaps the most troublesome development would be a monetary policy mistake. Central banks might react to the rise in inflation above their targets by rapidly shifting to a more hawkish stance. Both the Federal Reserve (Fed) and the Bank of England (BoE) continued to prepare markets for the end of super-accommodative policies this week. Some observers have taken the BoE’s stance to suggest that rates could even go up this year! That is not our core view, but it reflects a massive switch in sentiment considering that it was not that long ago when negative interest rates were being considered. The Fed’s message was more nuanced but clearly pointed to an announcement about tapering coming as early as November. Asset purchases would then start to be reduced from the current pace of $80bn Treasury securities and $40bn of mortgage backed securities per month.  

But not dramatically

I wouldn’t want to get too alarmist about this. Instead of making a mistake, the central banks are most likely acting responsibly. They are not suggesting a very rapid move back to long-term “normality” (2.5% Fed Funds in the US?) and markets aren’t pricing in anything too draconian just yet. Equally the chances of a policy mistake in allowing inflation to run too high for too long is not likely. What is generating some angst in rates markets at the moment is changing expectations on the timing, not on the direction of extent of future rate moves.

What’s priced in is modest

On the basis of current market pricing the first Fed rate hike is priced for the end of 2022. The Fed funds futures contract does not have the policy rate reaching 1% before the end of 2023. For the UK, the first adjustment in the bank rate comes in Q1 next year with a second by September. Still, that would only leave the overnight rate at 0.5%. Interest rate futures contracts don’t price in a 3m sterling rate of more than 1% until the end of 2024.

Don’t fight the CBs 

For now we should go with the idea that the central banks have got it right. An early withdrawal from quantitative easing followed by rate increases would be something that could quite quickly be reversed if inflation and growth fell back quickly or financial markets reacted badly. Given concerns about global levels of debt, this is a realistic scenario. The “let inflation run” scenario is unlikely given just how long monetary policy makers have been waiting for inflation to pick-up. Surely, they have a good plan to deal with that.

Mid-cycle adjustments

Investors need to continue to acknowledge that this is an unusual cycle. However, there are patterns that are typical, and we seem to be moving from early stage recovery to something like mid-cycle. Demand is not the issue, but spare capacity is being used up and it is complicated this time by the supply side issues. The progress from recovery to expansion in a typical business cycle is usually accompanied by higher interest rates, steeper yield curves, more pricing power and rising inflation. For fixed income investors the immediate concern is again rising yields rather than rising credit spreads. For equity investors, mid-cycle tends to favour quality companies with stable long-term growth rather than the operationally geared cyclicals that do well in the first stages of the recovery.

But…

 Having said all this, I still worry about a risk-off episode in markets. I was concerned we might be seeing that unfold last week as attention focussed on the Chinese property sector and the potential for contagion to other sectors and markets. Yet by the end of the week yields were rising again and stocks were rallying hard. At least the usual seasonal pattern of higher market volatility around the Autumn equinox appears to be holding. Our teams did the usual quarterly review of markets last week and the conclusion on the bond side was that yields would rise a little into year-end given the inflation and monetary policy outlook. Yet something continues to niggle me. The US 10-year yield is at 1.44%. If it was inflation and the Fed that drove things, it should probably be higher. The weight of global capital that can flow into risk-free assets when things get worrisome should not be underestimated. I may be contradicting my more thoughtful considerations here, but the rout on Thursday which took US Treasury yields to 1.45%, Bunds yields to -0.22 and gilt yields to 0.96% might be a little overdone. We will see.

Bank’s bark worse than its bite?

The core view should probably be that we are moving to a modestly higher rate environment. It is interesting to note that the Bank of England has form when it comes to shifting the sentiment in global interest rate markets. In 2003, the Bank was some eight months ahead of the Fed in raising rates. Ultimately it tightened less than the Fed but got in there first. The pattern of US Treasury yields during that period bears some consideration. Yields bottomed for that cycle in June 2003 at 3.2% before rising quickly to 4.6% by September. They fell back to 3.7% by March 2004 but by then the Bank was two rate hikes in and the Fed eventually tightened in mid-2004. Yields then rose to 4.9%. Inflation was rising through this period – US CPI inflation wen from below 2% in early 2004 to 4% in 2005. History never repeats itself but there are echoes. We have had a sell-off in rates in Q1, a rally over the summer, and now what could possibly be another sell off in the making as central bank tightening (however mild) becomes a more immediate reality. The sobering message from this historical interlude was that the Fed eventually raised rates so much that tighter financial conditions eventually burst the credit bubble. The global financial crisis was the end-product.

Less risk

So for a number of reasons it might be prudent to reduce risk exposures in portfolios. In short, get prepared for a modest shift in the interest rate environment in 2022 which will be the beginning of a monetary tightening cycle.  I’m not convinced that bond yields go substantially higher but limiting bond duration might be something that fixed income investors find a prudent strategy in the short-term. Fundamentally, support for credit remains quite strong and technical factors suggest that spreads are unlikely to widen significantly, absent a shock. However, given where spreads are the total return outlook from credit is limited and, over the medium term, a modestly tighter financial environment could bias spreads wider. On the equity side, low volatility / quality and sustainability focussed strategies look attractive as a core holding. Growth will continue, earnings will be strong, but the peak rate of growth will have been seen in 2021.

Calm down and carry on Ole

Financial markets aren’t the only place where reactions to new developments can be somewhat overdone. I can’t believe the number of people calling for a change in manager at Manchester United after an away defeat in the first round of the Champions League and a loss in the EFL Cup, a competition that the club is clearly not prioritising. The team is joint top of the premier league on points, unbeaten so far in the league and doesn’t lose away from Old Trafford. There are new faces to fit in and some key players still out injured. I fully expect Ole to deliver a successful season.