This market review comes from Jamieson Coote Bonds
The recent US Federal Reserve (US Fed) meeting has elicited discussion about a possible US Fed ‘pivot’ in interest rate policy and how that might support asset markets. Given global financial markets take their lead from the US, it is worth considering what we might look for to confirm this pivot.
Central Bankers around the world have been madly rushing to return monetary policy settings to neutral in order to quash inflation that has been turbo charged by the Russia/Ukraine conflict, and Covid-19 related supply chain issues. Central Banks also made a subtle shift to reduce ‘forward guidance’ suggesting they will now be more data dependent in future policy moves. Markets are expecting a return to ‘bad news is good news’ in expectation of less restrictive monetary conditions, to help reclaim lost performance from earlier in the year. We do not believe this is the ‘pivot’ moment, as there are several important factors that do not align correctly to generate such an outcome.
Positioning is primarily responsible for the sharp rally in many asset classes, which have ironically taken their lead from a rally in Government bonds. Government bonds performed well during the month as markets shifted their focus to a sharp decline in growth, with a large global recession now the base case for economic expectations. With risk allocations very low after the brutal market moves of June, the scene was set to regain some lost performance on a reduction of tightening expectations. This ‘flight to quality’ move for Government bonds is due to weakening economic conditions and has been misinterpreted by markets expecting to operate on the Central Bank safety net dynamics of the last cycle. This may be a false start on the road to a policy pivot in a world of higher secular inflation due to energy shortages.
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Inflation needs to observably peak and then fall rapidly to provide comfort for Central Bankers. This is currently in play as most commodity markets are now lower in price from where they were on the outbreak of the Russia/Ukraine conflict in late February. Goods inflation has already peaked, services inflation is sticky for now, but the important swing factor of energy and commodities is falling under expected lower growth. We cannot expect a pivot to neutral or accommodative policies that would underpin a long bull market for assets if inflation falls were only slight from their lofty levels of 9.1% in the U.S economy. We believe inflation would moderate quickly if left to its own devices, but the highly influential energy components are out of our control.
Energy remains at the behest of Vladimir Putin. Europe is having an energy crisis and cannot stockpile energy reserves needed to see out the freezing winter months ahead, instead continuing to draw across all energy inventories. Vladimir Putin has the western world cornered in energy dependency through the short-sighted energy policies of dependence on Russian oil and gas. It’s expected that Russia will cut off European energy flows into the winter months as Europe literally freezes. This type of exogenous energy shock would badly derail inflation normalisation by triggering a deeper global energy issue.
Deeply inverted yield curve – warning signs for the economy and markets
Government bonds remain the canary in the goldmine as they often lead in predictions on the macroeconomic landscape. The deep inversion of the yield curve suggests that the market is concerned for forward looking growth, however expects further rate hikes from the US Fed to complete its inflation fighting task. A hyper inverted yield curve suggests significant recession risk is ahead with lower growth almost a certainty as the year progresses due to tightening policy. Risk markets need to closely consider the shape of the Treasury curve to illicit the correct signals for consumer health and corporate profitability. When the Treasury bond curve starts to steepen from the current inverted levels, the ‘pivot’ will likely be upon us.
Markets have been conditioned to expect continued support from policy makers who have papered over every systemic financial crack since the GFC. Today’s unstable geopolitical world makes that safety net increasingly difficult to produce without restimulating inflation. Sadly, for investors, the much anticipated Central Bank ‘pivot’ for a clean and certain bullish run is some way away. Volatility and heightened uncertainty will likely remain, and investors should maintain their defensive mindset in the months ahead.
