BlueBay AM: Policymakers feel the heat

11 februari 2022

Please see below for the latest weekly insight from Mark Dowding, CIO of BlueBay Asset Management. In this edition, he looks at the prospect of rate hikes from the Federal Reserve, UK inflation, as well as the ongoing tensions between Russia and Ukraine.

This week’s US CPI report saw a new 40-year high print for headline and core inflation. In the wake of this, inflation fears have continued to build, leading to speculation that the Fed may announce a hike of 50bp as early as March. We think that this outcome is unlikely and that we are close to the inflation peak. 

Although we continue to hold the view that it will be slower to fall than many expect, we look for the Fed to tighten policy at a measured pace in the coming months, in an echo of the 2004-6 monetary policy hiking cycle. We believe that a 50bp hike could do more harm than good as it could be seen by markets as a tacit admission of a policy error, requiring policymakers to jam the brakes on much more abruptly and raising recession risk in the quarters to come.

Given the Fed will seek to maintain the expansion in the context of its dual mandate, this advocates a measured response to policy normalisation. In this context, aggregate projections for nearly seven hikes from the Fed – taking rates to 1.65% at the end of 2022 – look appropriately priced, albeit we retain more upbeat projections for growth and inflation into 2023 and beyond, warranting an ongoing short-duration bias in US rates.

In Europe, ECB officials sought to push back against markets pricing early rate hikes and widening sovereign spreads in the wake of Lagarde’s hawkish comments following last week’s Governing Council meeting. 

Eurozone money markets have discounted over 130bp of rate hikes before the end of 2023. This trajectory infers a lift-off this summer, notwithstanding assurances that this would not occur prior to the end of active QE bond purchases – currently scheduled towards the end of 2022. 

Yet, in the wake of the last consensus-beating 5.1% print on eurozone CPI, there is a limit to how far the ECB can row back its hawkishness without losing credibility. Ensuring price stability is the mandate of the central bank and it seems clear that heavy forecast revisions at the upcoming March ECB meeting will act as a pretext for action to follow in the months to come. 

However, we are hopeful that incoming inflation data could point to a moderation in the eurozone relatively soon. Consequently, it is possible that data helps to bail out the ECB in the months to come and alleviates the pressure on it to act too aggressively. In our view, eurozone inflation expectations are more strongly anchored than is the case in many other developed markets, so pressure on the ECB may subside once CPI appears to be trending back towards target.

Notwithstanding this, we believe that the eurozone deposit rate will rise to 0% by early next year, as the ECB seeks to normalise policy. Yet, it may then only increase slowly thereafter, should inflation return to a level within the central bank’s target range.

On the back of this, we believe that money markets in the eurozone have moved to price an already hawkish scenario for the ECB. Risks are now skewed to the central bank under-delivering as many hikes as are priced. 

Therefore, we think there is more to be made from a tactical long rates position in the eurozone and have added duration targeting the front end of the yield curve.

The bigger problem for the ECB, however, is what will now happen to spreads as the central bank pivots in a hawkish direction. Those on the Governing Council seem happy to assume that stability of the single currency can be taken for granted these days, in the same way that price stability was taken for granted just a few months ago.

In this context, there may be an assumption that spreads will find a new clearing price, representing a market equilibrium, as the ECB steps back. However, there is danger in this and it seems Lagarde is blissfully unaware that she has given the market a green light to push spreads wider. As the periphery widens, so we think that a plan to solely use re-investments from PEPP redemption as the basis of a backstop is unlikely to be credible.

In a different world, the central bank may conclude that it would continue to maintain asset purchases in order to ensure smooth policy transmission, even as it raises rates. Yet this seems unlikely given how keen hawks are to end the era of asset purchases altogether. A new chapter of the eurozone sovereign crisis could come to pass if the ECB is asleep at the wheel, though this in turn may end up as a factor that lends support to Bunds on a flight to quality.

Elsewhere, we continue to look for UK inflation to surprise to the upside. In the coming months, many regulated prices will add to inflation. Much has been made of the jump in household energy bills, while food and telecoms are set to be the next drivers of higher prices. Meanwhile, many contracts with a pricing link to inflation are due to re-set even as the RPI index moves towards 10%. 

Inflation expectations are de-anchoring, wage demands are increasing and the only thing to prevent the Bank of England (BoE) jamming rates higher is the fear that growth will already be derailed in the wake of a cost-of-living squeeze. 

Nevertheless, whereas we think eurozone inflation will be at, or close to, target at the end of this year, in the UK it seems destined to remain above 5% heading into 2023. In that context, higher UK rates and higher Gilt yields look to be inevitable, regardless of the growth consequences.

The euro has gained in the wake of the ECB meeting. More broadly speaking, EMFX has continued to trade well since the start of the year, notwithstanding ongoing Russian risks. Although inflation continues to surprise to the upside in some countries, as was the case in Colombia and Chile this week, there is a sense that through 2021, many EM central banks have acted to raise rates quite aggressively, pushing real rates materially into positive territory, in contrast to negative real rates in many developed countries. This means that carry is attractive and there are greater hopes that inflation may have peaked. 

With investors under-allocated to EM currencies, this also suggests a positive technical backdrop. Consequently, it may still be a little early to get bullish on the asset class, but there seem fewer reasons to stay bearish than was the case for much of the past year.

Corporate credit spreads in Europe came under material pressure following BoE and ECB meetings last week. The prospect of an end to QE in the eurozone and corporate bond sales by the central bank in the UK saw investors look nervously to the much wider spread levels that had prevailed in the period before QE purchases commenced in 2018. 

The underperformance of credit spreads in the region means that spreads to underlying government bonds are now materially wider than is the case in the US market, and this should act as a stabiliser. 

However, it remains difficult to adopt too constructive a stance on spreads at a time when central banks globally are set to withdraw liquidity, which has helped inflate asset valuations in prior periods. 

Nevertheless, we also think it is inappropriate to maintain too bearish a view, given our underlying assessment that growth in the US and EU remains well supported and this infers a constructive backdrop for corporate earnings. Adopting a fairly flat stance and focussing more on relative value continues to make sense to us for now.

Looking ahead

We have flagged that the next couple of weeks could represent a quieter period in newsflow. With central bank meetings out of the way, the next obvious catalyst driving markets will be data releases at the end of the month and beginning of March.

In the interim, Russia-Ukraine remains a risk, with some conspiracy theorists advancing a view that Putin is delaying action until after the Winter Olympics as a favour to Xi. It’s difficult to take an informed view on the probability of conflict in the next few weeks, yet this geopolitical uncertainty is an additional reason to proceed with caution and not take too much risk. 

More broadly, it seems we are in a world where inflation is increasing pressure on policymakers globally and they are starting to feel the heat. At this rate, Trudeau won’t be the only one running for cover as the months go by.