The main price determinants behind the sustained rally in risky assets during the first half of the year have been primarily the improving COVID-19 data trends, namely falling case growth rates and vaccination rollouts across regions, and secondly, the ultra-loose financing conditions adopted by the major central banks’ two-pronged approach of low policy rates and a sustained increase in money supply through quantitative easing programmes.
In view of the underpinning factors of abating virus risks and the promise of cheap money for longer, asset valuations appreciated, given the higher earnings growth outlook and very lower discount rates.
However, a key debate is the unsolved conundrum on whether the recent surge in inflation is attributed to the temporary forces underlying short-term demand-supply imbalances, coupled with pronounced base effects, or the result of a more structural shift in macroeconomic variables.
On the one hand, an increase in price levels that is consequential to a cyclical upturn is generally a positive sign displaying normalising economic conditions. On the other hand, a persistently high rate of inflation may indicate overheating economic conditions which would lead to a sharper tightening reaction by central banks. This could be disruptive for both financial markets and economic output.
Following the clean break in economic data series as the pandemic brought global activity to a halt, each data release today bears a higher significance in determining the trajectory and speed of the economic recovery. The sequentially positive economic data prints during the first half of the year broadly supported the optimistic prospects of high economic growth rates which, combined with the reassuring commitment of an extended accommodative monetary policy, reinforced the market conditioning of ‘buying the dip’, producing an environment where markets have continued to reward higher risk-taking.
The signs of elevated market exuberance seem to attract little concern among investors, indicating the general disregard or underestimation of the downside risks to the economic outlook or the implications of an eventual withdrawal of central bank market intervention.
The movement in US inflation breakeven rates has been particularly relevant
The US Federal Reserve is among the first major central banks that are expected to moderate their easy stance by tapering asset purchases and raising policy rates. At the last FOMC meeting on June 15, members indicated that they expect the policy rate to be increased by 0.50 per cent (equivalent to two rate hikes) in 2023, bringing forward their projections of the first rate hike from 2024 as forecasted in March.
Despite the widely accepted assumption of an earlier move by the Fed, the market reaction to the hawkish outcome exposed the vulnerability of complacent market positioning and what one would reasonably expect from an eventual shift in central bank tone towards a normalising, or tightening, monetary stance. It also gave more definition to the inflation debate and the expectations thereof.
The movement in US inflation breakeven rates has been particularly relevant. This is the spread between the yield on fixed rate US treasury securities and the yield on inflation-linked treasury securities which represents a measure of market inflation expectations. Following the concurrent rise in the five-year and 10-year breakeven rates since the start of the year to an eight-year high in May, the five-year breakeven rate has held steady at 2.50 per cent, whilst the 10-year breakeven rate declined to 2.33 per cent after the announcement.
This gap shows that the market is attributing a higher probability that inflation will remain at elevated levels in the medium term, but it is expected to moderate over the longer term. At the same time, there has hardly been any movement in the expected short-term rates, which represent market pricing of future policy rates.
The hawkish FOMC outcome also led to an uncharacteristic rally in long-dated US Treasuries and a correction in equity markets led by a decline in value stocks while growth stocks outperformed. The move in US Treasuries goes counter to the original concerns that the withdrawal of central bank support will lead to a sell-off in US Treasuries (a reverse taper-tantrum maybe?). The short-lived change in leadership in equity market performance could also indicate the first signs of fatigue in the crowded equity rotation trade, which may be mostly relevant for the US stock market at this stage.
The pullback in the 10-year breakeven rate is interpreted as a sign of temperance in the over-anticipation of inflation expectations and the growing acceptance that inflation could indeed be transitory.
The risk-on market sentiment quickly resumed when the Fed chairman Jerome Powell gave a reassuring speech in front of Congress the following week that much more progress needs to be achieved before the central bank considers reeling back monetary stimulus. Nevertheless, the momentary jitter in financial markets following the first noteworthy adjustment in the Fed’s forward guidance has uncovered important underlying dynamics which may very well become more prominent once greater visibility on the economic outlook and the gradual return in employment is achieved.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
Matthias Busuttil, head of Investment Strategy & Research, Curmi and Partners Ltd