Last week, I was lucky enough to present to several different clients and to also address a group of business school students. Questions and conversations with them this week have helped to shape what’s been on my mind, especially regarding the “silver linings” I’m seeing in some concerning issues. Below, I discuss a few of them.
A “melt up” in global yields
The issue: Developed marketgovernment bond yields are on the rise, especially on the long end. Hawkish central bank speak in recent days is having an impact — especially comments from Fed Governor Lael Brainard as well as the Federal Open Market Committee (FOMC) minutes released last week. Brainard has traditionally been perceived as a “dove,” but she appears to have turned into a “hawk” because of inflation, and her comments about balance sheet reduction “at a rapid pace” were noticed.
The FOMC minutes provided more details on the Federal Reserve’s (Fed) plans to reduce the size of its balance sheet, indicating that the monthly cap on the passive roll-off of the balance sheet (allowing securities to mature and not be replaced) would probably be $95 billion. In addition, they talked about the potential for the Fed to start actively selling some of the mortgage-backed securities (MBS) on its balance sheet once runoff is “well underway.” And it’s not just the Fed — the Bank of Canada is widely expected to begin quantitative tightening (QT) soon and it is already underway for the Bank of England. However, the bold move forward with QT for the Fed seems to be having a particularly significant impact, especially coupled with growing market expectations of several 50 basis point rate hikes in the offing, starting at the May meeting.
Where do I see a silver lining? The fact that central bank speak is already causing a tightening of financial conditions has a silver lining, in my view: The Fed (and perhaps other central banks) may not need to tighten as much as many expect. As I have said before, I believe they would prefer to speak loudly but use a smaller stick. In the meantime, the Fed has helped reverse the temporary inversions seen in parts of the Treasury yield curve, which might cause some jittery investors to breathe easier given all the attention that has been given to the recent inversion of the 2-year/10-year Treasury yield curve (which as of this writing has reversed and is actually at 25 basis points).1
The future of Europe
The issue: Last week, European Union leader Ursula von der Leyen toured some of the destruction caused by Russia’s invasion of Ukraine. Reflecting horror and outrage, she denounced the actions of the Russian army and pledged to expedite Ukraine’s application for membership to the European Union. She shared her vision for the future with Ukrainian President Zelensky, “Russia will descend into economic, financial and technological decay, while Ukraine is marching towards the European future, this is what I see.”2 But what is the European future? Some of that will be decided by the French presidential elections underway, given Emmanuel Macron’s emergence as something of a “de facto” leader of Europe now that Angela Merkel is no longer Germany’s chancellor.
Market fears had risen in recent days as challenger Marine Le Pen gained in the polls. Spreads widened last week between French and German government bond yields3 — the increase in borrowing costs for the French government indicated the market’s concerns about a potential change in leadership. The first round of the election was held April 10 and, as expected, Macron and Le Pen garnered the most votes and are advancing to the second and final round later this month, just as they did in 2017.
Le Pen’s rise in the polls is a result of the drop in popularity of a candidate farther to the right, whose pro-Putin stance has negatively impacted his popularity in the face of Russia’s invasion of Ukraine. At the same time, Le Pen was able to focus on domestic issues including inflation, which is top of mind for many disgruntled French voters (and a cautionary tale for U.S. mid-term elections). Conventional wisdom suggests that Macron should eke out a narrow victory, but I would expect spreads to widen and volatility to increase between now and then.
Where do I see a silver lining? As my colleague Paul Jackson pointed out, “a Marine Le Pen presidency would initially take France down a very different path (more isolationist, more assertive, anti-EU/U.S. and fiscally expansive). Though we think the reality of office could soften the approach, we fear that financial markets would react negatively in the first instance, with French and other peripheral Eurozone assets suffering.” But it is that visceral market reaction that could force a Le Pen presidency to soften more radical elements of its platform, just as it did with the François Mitterand presidency in the early 1980s.
COVID in China
The issue: There are waves of COVID emerging around the world right now, but investor concerns appear centered on China given that the policy response has been a significant level of lockdowns. Looking at the issue from an economic perspective, this could obviously contribute to short-term supply chain disruptions and create headwinds for the economy in the short run. However, as I have said before, I believe fiscal and monetary stimulus should help spark a re-acceleration in Chinese growth in the second half of the year.
Where do I see a silver lining? The lockdowns are causing a short-term reduction in demand for oil, helping to exert downward pressure on energy prices at a time when the world can use all the help it can get in terms of lowering oil prices.
Demand delay and demand deterrence, not demand destruction
This week, some key data points will be the U.S. Consumer Price Index (CPI) — consensus expectations are for 8.4% year over year,4 and I wouldn’t be surprised to see it at that level — as well as CPI readings for France and Italy. But I believe there is even a silver lining in high inflation. Higher prices have a way of solving for higher prices since they can cause a reduction in demand. In addition, the Fed and other central banks are also helping to reduce demand through monetary tightening. For example, mortgage rates in the U.S. have risen very substantially in just a few weeks, which should help to cool the red hot housing market.
The fear is that this so-called “demand destruction” will send developed economies into recession. Demand destruction is a dramatic term; I would describe what I am seeing thus far in the U.S. not as demand destruction but a combination of “demand deterrence” and “demand delay.” For example, we are seeing demand deterrence in that some consumers are reducing driving when possible and are switching to generic brands for some staples to reduce costs. And we are seeing demand delay in that consumers seem to be foregoing “big ticket” purchases that they don’t need immediately, such as delaying an auto purchase until next year — although I suspect that any material drop in prices in the near term would bring them back into purchasing mode rather quickly. Demand is not being fully destroyed, as it is being supported to a substantial extent by the tight labour market and more sound household balance sheets. In my opinion, the ability to engineer a “soft landing” will depend in large part on achieving demand deterrence as opposed to demand destruction.
Looking ahead, I will be following ZEW Economic Sentiment for Germany. Germany is under enormous pressure to sanction Russian energy, which would be an enormous burden given Germany’s great reliance on those imports. I suspect significant pessimism about the near term will be reflected in the sentiment reading, which could signal more disappointing economic activity in the near term (especially reduced capex spending). Finally, I will be looking at preliminary consumer sentiment data from the University of Michigan to get a sense of where the U.S. consumer is — and what their current expectations are for longer-term inflation.
1 Source: Bloomberg, L.P.
2 Source: Reuters, “EU chief promises speeded up process for Ukraine to seek membership,” April 8, 2022
3 Source: Reuters, “French government bond yields extend rise, peripheral spreads widen,” April 6, 2022
4 Source: Bloomberg, L.P.