Uncertainty has fallen: central banks are heading towards removing accommodation and the asymmetry is for earlier starts; the Delta outbreak is easing and Evergrande is unlikely to have significant financial contagion.
It was an extremely busy week in global markets. Volatility was elevated due to key central bank meetings, concerns about negative global growth affects from the Chinese property slowdown, and spillovers from the Evergrande situation. Risk assets were whipsawed, with sharp falls in global equities and interest rates in the earlier part of the week before a strong recovery due to falling risks relating to Evergrande and the passage of key risk events.
The key central bank meeting was the FOMC, which resulted in a moderately hawkish outcome relative to expectations. In sum, the FOMC and Chair Powell believe the conditions for tapering have been met, that tapering is to commence this year and that they want to follow “a gradual tapering process that concludes around the middle of next year”. This is a more rapid taper than what had been expected, and is a significant change from the dependency associated with tapering in the period 2013-14. Alongside this, the median “dot” is now evenly split for the first hike coming in 2022.
This monetary policy stance is internally consistent. The Fed wants to complete tapering as soon as it is practicable to open the possibility of a hike next year. In addition to this hawkish development were upward revisions to where the FOMC anticipates the policy rate to be in 2023 and the first data relating to 2024 where the median expectation was for the policy rate to be at 1.625%, above market pricing.
Regarding other policy decisions, the Bank of England meeting was also hawkish, signaling the committee is losing some confidence in the idea that the inflation pressures experienced in the economy are transitory, especially with respect to the labor market. The minutes suggested that there is even a possibility of a 2021 rate hike. In contrast, the South African central bank held rates unchanged in a unanimous decision. While their forward inflation and rate path projections were revised higher, this decision raised the bar for rate hikes this year and contributed to the South African Rand falling by 2.5 weekly stdevs vs the USD in the last two days of the week.
Overall, the Fed and BoE clearly stated that key central banks are on a pathway towards tighter policy stances. Furthermore, the Fed’s relative lack of equivocation with respect to the start of tapering and the speed of the presumptive timeline reduces uncertainty about the Fed’s policy stance. The takeaway being that due to inflationary pressures, as long as growth data remains relatively supported, the asymmetry is towards incrementally tighter policy.
Therefore, even though PMI data disappointed this week, the steady fall of Delta variant related risk premium combined with falling Evergrande contagion risk premium allowed interest rates to move higher following this week's central bank meetings. Indeed, after a long period of consolidation over the summer it was this week that saw a sustained break higher in developed market interest rates. A market backdrop of rising rates and higher rate volatility is not a positive environment for credit and indeed, the high yield credit complex came under substantial pressure this week.
However, what does perform in a high inflation, rising rate environment are shorts in fixed income and ultimately, longs in cyclical assets. We continue to have shorts in Bunds and US Treasuries as well as payers in Polish rates which performed this week. We are also looking at adding to longs in European and emerging market financials, where higher long end rates can be a cyclical tailwind. More broadly, a reduction in uncertainty with the Fed risk event now behind us is a good thing for markets, and we now have answers to some key questions. The path is now clearer heading into the 4Q.