- US Federal Reserve signals rate hikes are not imminent, but is starting to discuss tapering asset purchases
- Fed ‘dot plot’ eased concerns they were ignoring inflationary pressure, reduced tail risk of policy mistake
- Vaccination progress continues, but delta variant becomes more widespread especially in the UK
- Outlook: No changes expected at the Bank of England; survey data likely to be larger driver of markets
US Federal Reserve signals rate hikes are not imminent, but is starting to discuss tapering asset purchases
The market was focussed on the US Federal Reserve meeting on Wednesday as investors continue to wrestle with nature of the recovery and the developing inflation picture. The debate centres on whether this year’s strong headline consumer price index prints are simply the natural rise of prices in the areas of the economy that are more sensitive to an economic recovery and may be facing supply constraints or, more worryingly, were indicating a more sustained rise in prices and a faster erosion of spare capacity than previously expected. If inflation is only transitory, then it allows the Federal Reserve to take more time moving to a more ‘hawkish’ stance. Therefore, they can gradually remove some of the extraordinary monetary policies in place. However, if inflationary pressures are more persistent then the Federal Reserve could be seen to be ‘behind the curve’ leading to higher market volatility as it tries to constrain inflationary pressure.
While the statement following the Federal Open Market Committee (FOMC) meeting was little changed from April, there were changes to the FOMC members' forecast for the evolution of policy rates over the next two years. This ‘dot plot’ indicated that seven FOMC members expected the first rate hike in 2022 (up from four in March) and thirteen members expected rates to be higher in 2023 (up from seven in March). Chair Powell, however, confirmed that although the FOMC was now discussing the timing surrounding a tapering of asset purchases, any discussions about raising rates would be “highly premature”.
Fed ‘dot plot’ eased concerns they were ignoring inflationary pressure, reduced tail risk of policy mistake
The initial market reaction to the Federal Reserve meeting was negative, with global equity markets falling and bond yields rising sharply. The sell-off was relatively short-lived however, with the market reversing course on Thursday. The Fed appears to have done enough for now, to reassure markets that they are not purely focussed on the return to full employment and continue to walk the delicate balance between leaving policy as accommodative as possible without making markets too nervous that they are losing control of inflation. Post-meeting markets have seen a net rally in longer-dated bonds, with breakeven inflation pricing lower and commodity assets highlighting the weakness in the ‘reflation trade’. The short-term nature of the market moves was not sufficient to drive significant changes in asset allocation or create sufficient volatility to improve the return profile of potential total return strategies.
Vaccination progress continues, but delta variant becomes more widespread especially in the UK
Vaccination progress continues to outweigh, in the markets' eyes at least, the significant increase in cases related to the delta variant which was previously known as the ‘Indian variant’. In the UK, this has led to a very sharp increase in cases, albeit from a low base, with some tentative signs of its growth in the US as well. With over 80% of the UK’s adult population having received at least one dose and other countries on a similar path, albeit several weeks behind, any delay in the easing of lockdown measures such as those seen in the UK this week are expected to remain modest in duration. There remains the potential for a different variant to render the current vaccinations less effective which could halt the reopening trend and have material growth implications.
Outlook: No changes expected at the Bank of England; survey data likely to be larger driver of markets
The Bank of England will follow the Federal Reserve next week; we are expecting policy to remain largely unchanged, especially as this meeting is outside of their quarterly rhythm of forecast updates. There are also public speeches by both Fed Chair Powell and European Central Bank President Lagarde.
On the data front, US housing data and a raft of PMI survey releases should help investors assess how the easing of lockdown measures are impacting the economy through May and early June. Towards the end of the week, the University of Michigan release should provide another data point on the inflation roadmap for markets to digest. The outcome of the French regional elections may also provide some more colour as to the potential shape of the presidential elections in 2022, especially if Marine Le Pen’s National Rally were to win one or more regions.
- US CPI print exceeds market expectations, however it may do little to convince the Fed that inflation isn’t transitory
- The European Central Bank to increase rate of asset purchases, despite improving growth and inflation forecasts
- Outlook: the Fed’s latest policy decision and hard data releases from both the US and China are of interest next week
US CPI print exceeds market expectations, however it may do little to convince the Fed that inflation isn’t transitory
We have not had to wait long to see evidence of the unique nature of the COVID-19 recovery bounce and the challenges that are accompanying it. Supply constraints are evident in lengthening delivery times amid reports of material shortages and logistical bottlenecks. In short, irrespective of the country in focus, the pickup in global demand is rippling through production chains. The key question for policy makers and markets is how transitory these pricing pressures are. With this in mind, all eyes were on the US inflation print this week. The headline CPI measure increased 5.0% year on year (vs. 4.7% expected), marking the largest increase since the Global Financial Crisis. Whilst exceeding market expectations, this print may do little to convince the Federal Reserve (Fed) that inflation is anything but transitory, which is supported to the extent that the bulk of rises have been in areas where price trends tend to be more flexible in nature. Indeed, the bulk of the price rises were in areas such as used cars and car rentals, rather than in areas that may be more associated with a sustained increase in inflation, such as shelter and medical.
The fundamental economic backdrop still appears conducive for risk assets, but recent asset price performance already looks good by historical comparison and, of course, should the pick-up in inflation be more than transitory, the investment environment could become more challenging.
The European Central Bank to increase rate of asset purchases, despite improving growth and inflation forecasts
The other area of focus for markets this week was the European Central Bank (ECB) meeting, with investors looking for a sense of how the bank intends to adjust monetary policy as Europe finally brings the pandemic under control. Interest rates were left unchanged, as widely expected by the market. The ECB committed to increasing purchases under the Pandemic Emergency Purchase Programme (PEPP) at a significantly greater pace in the coming quarter, relative to the first few months of this year. The bank’s new forecasts were upgraded across the board for both 2021 and 2022, for GDP growth and inflation. Growth this year is now forecasted to come in at 4.6%, an increase of 0.6% since the March meeting, whilst 2022 growth is now forecasted at 4.7%, vs 4.1% in March.
In the ensuing press conference, ECB president Lagarde made it clear that the bank intends to run very accommodative policy for a long time. It was also implied that the bank needs to do more (through supportive stimulus) to reach its inflation target in the long run, quoting on several occasions the unchanged 2023 inflation forecast of 1.4%, which undershoots the bank’s long-term target.
Outlook: the Fed’s latest policy decision and hard data releases from both the US and China are of interest next week
It’s an important week ahead with the Fed delivering its latest policy decision on Wednesday. Chair Jerome Powell has on several occasions reiterated the view that the Fed expects increases in inflation to be transitory, being associated with the reopening process, rather than a more permanent issue. However, with another higher-than-expected CPI reading this week, his words will be followed closely. Aside from that, the Fed’s dot plot and inflation targets should be of interest.
On the data front, retail sales, industrial production and housing starts prints from the US should provide markets with a sense of how the economy has performed through May, as well as retail sales and industrial production numbers from China. Finally, in the political sphere, the G7 summit continues over the weekend where some headlines of interest could surface.
- US non-farm payrolls increased by 559K in May, rising significantly more than in April
- Global PMIs continue to trend upwards, with strong readings in both Europe and the US
- Central banks progress the discussion around the timing of tapering, with the Federal Reserve unwinding its corporate QE programme
- Outlook: The inflation debate will continue to dominate headlines next week as we see the US CPI print for May and the ECB’s latest decision on PEPP purchases
US non-farm payrolls increased by 559K in May, rising significantly more than in April
Payroll growth is still increasing, with hiring up 559K from an increase of 268K last month. This was below the market’s expectations of 675K. Although accelerating, hiring growth appears somewhat constrained by the lack of labour supply. The labour force in the US has contracted by more than 5 million compared to the pre-COVID trend. Job openings are at a record high and continue to increase. There are several factors including enhanced unemployment benefits that are keeping people away from the labour force. Employers are becoming conscious of the fact that they need to pay more in order to drag people into the labour force. We are seeing this with US average hourly earnings rising 0.5% above the consensus expectation of a 0.2% increase. At the time of writing, the market reaction has been positive, with US equities strong (most notably in technology shares) and 10-year US real yields reversing all of Thursday’s 6bp move.
Global PMIs continue to trend upwards, with strong readings in both Europe and the US
There continues to be a positive flow of economic data, as global PMI figures continue to support our view that we are in an accelerating growth regime. In Europe, the composite PMI came in above expectations at 57.1, which marks a 3-year high. This was driven by a manufacturing PMI of 63.1 (vs 62.8 last month) and a services PMI of 55.2 (vs 55.1 last month). In the US, the composite PMI rose to 68.7 (from 68.1 last month), driven mainly by an extremely strong services PMI of 70.4. Strikingly, the US composite PMI was the highest reading since the series began in 2009. This data is driven by a backdrop of pent up consumer savings being released into the economy.
Central banks progress the discussion around timing of tapering, with the Federal Reserve unwinding their corporate QE programme
The Federal Reserve have conceded that the economic expansion has been “at a somewhat faster rate than the prior reporting period.” On this point, Philadelphia Fed President Harker said that it “may be time to at least think-about-thinking about tapering our $120 billion in monthly Treasury bond and mortgage backed securities purchases.” The Fed announced intentions to cut its pandemic corporate credit facility, selling its portfolio of corporate debt and ETFs over the next six months. Whilst the Fed have made no purchases since late 2020 and the size of the holdings are insignificant in a broader market context, this is still an important signal for the market. That being said, market reaction in both corporate and government bonds has been subdued thus far.
Outlook: The inflation debate will continue to dominate headlines next week as we see the US CPI print for May and the ECB’s latest decision on PEPP purchases
Next week’s US CPI data is highly anticipated following April’s 0.8% month-on-month print, which was the largest monthly gain since 2009. As investors continue to grapple over the extent to which inflation is transitory, this data will give further direction on the matter. In Europe, the decision from next Thursday’s ECB meeting will provide greater insight into the timing of tapering. More specifically, market participants will be focussed on the pace at which the PEPP purchases will be kept at. Considering the dovish commentary from the ECB of late, the base case is that these purchases will be maintained for the time being.