Posted 10 January 2022
Overview: The déjà vu of January 2022
So far, 2022 has kicked off very much where 2021 ended, with central bank policy news triggering outsized bond market reactions – causing volatility in equity markets. However, compared to this time last year, a period marked by a second national lockdown in the UK and the storming of the US Congress by a violent mob of Trump supporters, last week looked comparatively ordinary. Despite COVID infection rates near double what they were a year ago, and the economic outlook looking far less clear cut, central banks appear more worried about an overheating economy (causing inflation) than a renewed stalling of activity levels. As a result, the higher market volatility of last week was largely predicated on the difficulties posed by balancing short-term versus medium-term risks.
Last Tuesday evening, minutes for the December meeting of the Federal Open Markets Committee (FOMC) were released, and the committee’s hawkishness was unmistakable. Even before this, yields in almost all major markets had been moving higher in the last days of the year. However, they moved sharply higher and closed the week having risen by about 0.25% in the US, Germany and the UK. So, the interest rate sensitivity of the US ‘mega-caps’, a decided boon for most of the pandemic period, has bitten hard. The beneficiaries were financials, especially banks. Moreover, European banks this time kept pace with US bank share price performance, aided by the fact that European yields have risen almost as much as US yields. The growth outlook for Europe now appears as strong as the US over the next two years, with fiscal stimulus more certain and valuation upside decidedly larger.
All in all, one could argue that December 2021 marked the turning point in global central bank policy – from emergency support to the post-pandemic normal. While the rapid spread of the omicron variant across the world could still complicate this picture, so far, central bankers seem determined to push through to the next stage of the transition. Should that play out, the heady returns of the last two years may prove difficult to replicate as tighter central bank policy means less market liquidity. In the best-case scenario, monetary support would be replaced by economic optimism spurring business investment, as the world transitions out of the pandemic. But even in that case, lower liquidity levels and higher yields are likely to create continued pockets of volatility.
Fed hawks soar to their peak
Perhaps words really can speak louder than actions. That was the experience of capital markets last week, after the minutes of the FOMC’s December meeting emerged. The meeting itself brought a significant pivot in Fed policy: policymakers announced a faster reduction of its bond purchases (QE) and three interest rate rises in 2022. Markets reacted well at the time, with equities climbing higher into the end of the year. Now that investors know what was said at last month’s meeting, though, things are markedly different. The minutes showed everyone how hawkish the Fed really is, and it sent a chill through markets: The S&P 500 fell 2% last Wednesday, while the technology-heavy Nasdaq fell 3.3%, its worst day since last February.
According to the minutes, FOMC members think the Fed may need to raise rates “sooner or at a faster pace” than previously thought, and officials are fully on board with reducing the bank’s bond purchases “relatively soon” after rates start rising. This is a significant change of tack from the Fed. Policymakers spent most of 2021 assuring markets policy would shift slowly, and that spiking inflation was only transitory. What has now spooked investors, though is the bank’s zeal for fighting inflation. In the minutes released last week, Fed Chair Jay Powell made it clear the Fed’s average inflation target has been “more than met”, while several members thought employment levels were sufficient to tighten policy. Some even suggested rates could rise before the US reaches full employment – a move Powell had ruled out when announcing the current policy framework in 2020.
On rates, the Fed’s plan is uncontroversial. It is clear policymakers feel they need to tighten more quickly to prevent inflation from becoming structural. But tightening faster does not necessarily mean tightening harder. Inflation pressures will subside eventually, and the longer-term path for rates will be determined by what the Fed considers the ‘neutral’ price of money to be. Bond investors appear to have concluded that the Fed is reducing its longer-term looseness. We suspect markets are misguided in this conclusion – and, in any case, there is not much evidence for a tighter longer-term stance. We think there is not much room for interest rates to go higher over the long-term – even if rapid tightening is needed now.
Even so, with the release of December’s minutes, the Fed has left a bombshell in capital markets – one that could cause a further sell-off and tightening of financial conditions. Powell and co will no doubt be wary of this, and we may well hear more soothing comments from them in the coming months. More dovish tones would not necessarily be inconsistent with the Fed’s message either. The December meeting was held before the omicron variant became the world’s main pandemic concern – and we still do not know how it will affect future growth prospects. Should conditions worsen in the short-term and/or inflationary pressures recede, it is very unlikely the Fed will tighten as aggressively as it suggested a month ago. It all depends on data over the next few months, but the Fed’s hawkish talk may well have reached its peak.
More energy crises in the pipeline?
Nowhere has the current inflation shock been as clear as in energy prices. UK households are facing a 50% rise or more in gas and electricity prices once caps are raised in April – which is expected to push overall price inflation to 6.8%. Similar price scares emerged across Europe last year, after supply threatened to leave large sections of the continent without power. Oil prices, meanwhile, soared by more than 50% in 2021, and the rally has continued into this year. Brent crude prices currently sit at nearly $82 per barrel. Yet again, the reasons are on the supply side – with traders concerned about further outages and unrest. Libyan oil producers just recorded an output of 729,000 barrels per day (bpd), significantly down from a high of 1.3 million last year, due to maintenance problems. Meanwhile, the uprising in Kazakhstan (an OPEC+ member) has sparked fears that the country’s 1.8 million bpd output could be hit. OPEC countries have already promised to increase output, and at $80 per barrel, there is a big incentive to produce more oil. This applies to US shale producers too, who could add more than 1.1 million bpd this year according to the International Energy Agency.
Natural gas is a slightly different story. Gas problems have arisen from supply chain disruptions in Europe and Asia rather than curbs on output. Stockpiles have been low in parts of Europe since the beginning of autumn, causing prices to surge. Europe, especially Germany, is reliant on Russian gas and Ukraine has become a major issue. European politicians have already clashed with Russian President Putin over his readiness to shut down the gas pipeline to Europe which crosses Ukraine. The use of commodity supply as a political weapon was deemed unthinkable up until 2019 (even the Crimea annexation did not prompt such a move in 2014), and things may still worsen in the event of a cold winter on the continent. The good news is that gas inflows to western Europe are already picking up. LNG tankers have begun to arrive in numbers at Rotterdam, and indications are that stocks are already expected to be back to at least last year’s level in a couple of weeks. That is evidenced by the sharp retreat in LNG tanker rates from the December record highs.
Supply problems proved surprisingly persistent last year, but they were always likely to filter through once producers had enough incentive to increase output. Current energy prices provide that incentive. Now in the middle of winter, energy demand – particularly for gas – is strong. But this mismatch in Europe and Asia is likely to dissipate as the weeks and months roll by. If production is still intact, that will inevitably lead to lower prices. Unfortunately, we suspect this will not be soon enough to lower short-term perceptions of inflation. Energy bills are one of the most visible signs of inflation, and as they bump up in the coming months, consumers and households will bear the brunt. It is unclear what effect this will have on spending, but it could lead to inflation expectations becoming ingrained. Ultimately, the question for policymakers is how this affects the labour market. Should rising costs push workers to demand higher wages, it will lead to more inflation down the line. The jury is still out on how this will pan out, but central bankers and governments will need to watch labour market developments closely.