Monday digest
Posted 11 April 2022
Q2 begins with QT top of the agenda
Global markets have managed a reasonable bounce since the onset of Vladimir Putin’s invasion of Ukraine. Indeed, the awfulness of the news from the area has ceased to impact markets greatly. Investors have, by and large, returned to worrying about the resurgence of COVID-19 in China, along with its impacts on the global supply chain and on overall global growth, which itself is compounded by concerns about the US Federal Reserve (Fed) and its plans for quantitative tightening (QT).
Last week saw the release of the minutes from the Fed’s March meeting. They showed officials were finalising plans to reduce the bank’s $9 trillion balance sheet by shedding bonds – a process that could start as early as May. The Fed will allow “run-off”, whereby it stops reinvesting proceeds from maturing bonds, to take billions off its balance sheet in the coming months; the pace mentioned in the minutes was of $95 billion per month ($60 billion in treasuries and $35 billion in mortgage-backed securities), which possibly would be phased in in the beginning.
QT is hardly going to be a positive for financial asset prices. Of course, other positive factors, such as earnings growth momentum, can still mean that overall, financial markets stay in a positive mode. Nevertheless, in a cyclical set-up, QT will likely oscillate between being a neutral to negative factor. The longer QT lasts, the more liquidity gets drained from the financial system, and the more likely this is going to be negative. Structurally, some may even argue QT is needed to connect financial assets more with their fundamentals. There remains the possibility that as the Fed shrinks its balance sheet, the actual withdrawal of liquidity gets buffered by current excess liquidity being released back into the market. We expect more insight will arrive in May, when the Fed is expected to formally announce QT.
Behind the (yield) curve
Although the yield curve is nothing more than a plot of the fixed term yields on government bonds at different maturities, it is probably one of the most viewed graphs in the financial industry. In the past, an inversion of the curve – where short-term bond yields go above long-term yields – has been an astoundingly accurate predictor of economic downturns. Last week, the yield on ten-year US Treasuries sunk lower than the yield on two-year coupons. Every time that has happened in the post-war period, a recession occurred in the next 15-24 months.
That such a closely watched warning signal has started flashing is understandably making investors nervous. The reason it has now turned negative is once again the interplay between growth, inflation expectations and central bank policy. Runaway inflation in the developed world has forced central banks to dramatically tighten monetary policy – the Fed chief among them. Meanwhile, the supply shock and ensuing cost-of-living squeeze has brought down growth expectations.
Yield curves can be very informative, but in the short-term the more useful takeaway is what it says about expected interest rates that have been priced-in by the market. The implication is that the Fed will need to engineer a slowdown in growth by raising rates above short-term growth. As many commentators have pointed out, the Fed’s rapid tightening path seems to be a recognition that monetary policy was “behind the curve” in terms of controlling inflation – which now requires a heftier readjustment. Markets now expect the Fed to raise rates hard and fast – increasing its policy rate to more than 3% next year – which they hope will succeed in bringing down inflation and see a return to the pre-pandemic economic environment. That gives the Fed an all-important role in the global inflation fight – no other central bank is seen as needing to achieve a positive real – after inflation – rate of return on cash to control prices.
The current debate is whether the Fed can engineer an economic soft landing, or whether its efforts to bring down inflation also causes a recession. But beyond those cyclical considerations, longer-dated rate expectations have been relatively stable lately – at least when considering the disruption such a policy reversal could have caused. Although bond markets have had a tough time this year, things would have been much tougher if they thought the Fed was not in control.
In that case, long-term rate expectations would be much more volatile, and investors would have to increase their risk premium – potentially destabilising the financial system. While this has not happened yet, it certainly could. It is worth noting that longer-term real rate expectations are extremely low by historical standards, presumably because markets expect central banks to be structurally more dovish than before the pandemic. If that changes, bond markets could have a very hard time. For now, the yield curve tells us that the Fed will bring down growth and inflation – with less reflection on structural shifts in the global growth and inflation trade-off.
Enigmatic emerging markets give investors pause for thought
After a sharp recovery last month, Russia’s rouble is no longer the world’s worst performing currency this year. Far from it, in fact, having erased virtually all the losses sustained since the invasion of Ukraine. The ‘worst in class’ moniker now goes to the Sri Lankan rupee, which has sunk an incredible 32% since the start of the year. Most astonishingly, the collapse has come entirely in the last month, after more than a year of stability in exchange markets.
Sri Lanka is facing its worst economic crisis since its independence in 1948. A fall in tourism revenue caused by the pandemic, a large foreign debt pile and an inability to service it with foreign capital has led to a financial and economic crisis. Facing runaway inflation and shortages of food, power and medicine, Sri Lanka is looking to the International Monetary Fund (IMF) to stave off default and further disaster. Whether it can get more funding remains doubtful. Moreover, if Sri Lanka does default on its large sovereign debt pile this year, it will likely not be the only emerging market to do so. Despite the recent improvements in the rouble, the growing list of sanctions on Russia push the country ever closer to default.
Last Monday, the US Treasury said it would no longer allow Russia to make dollar payments on its debt through American banks. President Biden talked up the effects of the new sanctions, saying they would cause the Russian economy to “crumble”. Such pronouncements from Washington are to be expected, but there is no doubt Russia will find it increasingly hard to meet debt payments on dollar-denominated bonds. There is some debate about what constitutes a ‘default’ in debt markets, but governments missing payments is not good news – whatever you call it. And when risks pile up, it tends to spell trouble for emerging markets (EM) more generally. This is not so much because of direct financial contagion, but rather the effects on investor confidence and the wider global system. EM investors can be easily startled – particularly in the current environment. With high and rising input costs, slowing global growth and a hawkish Fed, EMs face a challenging backdrop.
Some are rising to the challenge, however. Despite the above difficulties, the Latin American Index is up around 25% year-to-date. This performance is particularly impressive when you consider the S&P 500 has sunk 6.6% so far this year, while the MSCI world is down 6.9%. Commodity price rises are a big part of this outperformance. Brazil is one of the world’s largest producers of oil, iron and soya beans, while other EM nations produce more than their fair share of hard and soft commodities. The disruption caused by Russia’s invasion of Ukraine – from oil and gas sanctions to Ukraine’s mining and agriculture – has boosted demand for LatAm goods. But not all LatAm countries are commodity exporters, and even Chile and Peru – big oil importers – have fared well this year. This is not to say things are all rosy for the region, let alone for EMs more generally. Much still depends on the general outlook for global growth. If the world can muddle through this slowdown relatively unscathed, EMs – particularly LatAm – are well placed. If not, they are at risk. As the crises in Russia and now Sri Lanka demonstrate, things can go horribly wrong, but LatAm’s outperformance suggests a few bad apples do not always spoil the barrel.