BlueBay AM: Consequences of a badly managed policy exit

August 20, 2021

By Mark Dowding, CIO at BlueBay Asset Management

We are confident that the FOMC won’t mismanage its policy exit in the way the White House seems to have gotten things very wrong in Afghanistan.

Newsfeeds have been dominated by images coming out of Afghanistan over the past week. A badly managed exit by the US led to chaotic and upsetting scenes, which had echoes of the withdrawal from Saigon in 1975 and that may have important ramifications regarding the role the US plays in world affairs in the decade to come. 

Ultimately, there may not be too much surprise at the resurgence of the Taliban, given the US had earlier signalled its planned withdrawal. However, the way in which this has played out in recent days leaves much to regret and one can only hope for stability and order in the days ahead, to facilitate an exit for those seeking to leave in fear for their lives. 

Although these events may have limited direct bearing on financial markets in the near term, there could be a lesson here in terms of the consequences of a badly managed policy exit. 

In this context, it is possible to contemplate how the Fed and other central banks may expedite their own upcoming policy exits in a manner that minimises potential disruption. Clear communication and an orderly timetable would appear central to this.

From this standpoint, it has been interesting to observe Fed speakers coalescing on the idea of announcing a taper in the next couple of months and starting to reduce bond purchases later this year. 

An insightful article in the Wall Street Journal appeared to suggest that many in the Fed may then look to complete the taper by the middle of 2022. This is consistent with our own thoughts that a first move up in interest rates is likely by the end of next year.

Covid

In the short term, ongoing concerns with respect to the Delta variant may be weighing on consumer and business confidence. With the US and Europe largely vaccinated, we believe that these worries may be temporary in nature, as we learn to live with Covid. 

However, in Asia and Australasia, where governments are still trying their best to eliminate the virus and where vaccination rates are much lower, the Delta variant undoubtedly represents a larger problem. 

Impacts on supply chains have seen companies such as Toyota post plans for a substantial cut in production in September, due to ongoing semi-conductor shortages. 

This imbalance between demand and supply risks further price pressures on the upside, it would seem, whilst also creating downside risk to growth. In the US and Europe, we feel that further lockdowns and restrictions on economic activity remain very unlikely. However, weaker sentiment may give the Federal Reserve and other central banks reasons to pause before tilting away from dovish policies established during the height of the pandemic. 

In the short term, this may limit how far yields can rise, but it does not change our assessment of the outlook for yields being very much skewed to the upside, on a medium-term basis.

Europe

The upcoming German election could be swinging towards Olaf Scholz of the SPD as the next German Chancellor, as rival Armin Laschet continues to struggle for popularity. However, we doubt that the outcome in Berlin will be particularly significant for financial assets, though a more socialist coalition could favour a more relaxed revision to the EU Fiscal Compact, when this is discussed in Q4. 

Otherwise, we have a sense of some growing division between hawks and doves at the ECB, which could make the September meeting more interesting. Although in the grand scheme of things, this tends to be a quiet time of year on the Continent. 

Market round-up

Across the Atlantic, surprise snap elections have been called by Trudeau and we wonder if the experience of his father, who unsuccessfully waited until the end of his term in the 1970s before going to the polls, could have acted as a motivating factor.

Asian growth concerns have pushed yields lower over the past week, with equities weaker as the Vix spiked to 23 from 15 just a week ago. Credit spreads traded softer and in FX, the dollar posted gains, reflecting a slightly risk-off tone coming from the East. The risk-off tone also weighed on emerging markets. We continue to see scope for Chinese yields to fall and the renminbi to weaken, with China set to underperform the West, on a relative basis, over the next few months.

Looking ahead

We continue to look for worries relating to the Delta variant peaking in the US, as it feels it already has across much of Europe and the UK. Looking at data in terms of the number of days it took for the Delta wave to peak in India suggests that this should occur in the US (or at least those states which have been hardest hit), within the coming week. 

Elsewhere, we would observe that underlying economic data trends remain firm and we continue to look for robust progress towards labour market normalisation as generous benefits roll off, supported by record levels of job openings.

Markets tend to be thin over the summer months and this is unlikely to change much in the next couple of weeks. Ultimately, with liquidity remaining abundant there is plenty of cash that can buy the dip, so we doubt any correction in risk assets will run too far. Once we can look beyond the crest of the delta wave, there may be calmer waters ahead and so this seems like a good time to be building and holding positions, with an eye towards the medium-term rather than playing for the vagaries of shorter-term price action. 

We are confident that the FOMC won’t mismanage its policy exit in the way the White House seems to have gotten things very wrong in Afghanistan. At this stage, it seems Fed members are aware that the biggest risk could come from delaying normalisation too long and allowing inflation expectations to become unanchored. We are hopeful for an orderly exit. 

As for Afghanistan, one can only hope and pray the situation remains calm in the days ahead.