The Federal Reserve is reportedly preparing to begin reducing monthly asset purchases in November, ending its quantitative easing program by the middle of next year. The European Central Bank is gradually scaling bond buying back, with observers expecting Madame Lagarde to telegraph tapering plans in December. The Bank of England and Bank of Canada are already winding their balance sheet expansions down.
Markets don’t care.
Interest rates and yield spreads have held near historic lows since mid-June, with long-term Treasury bills becoming less sensitive to data surprises. Foreign exchange traders are incredibly calm – one-month implied volatility across the Group of Ten currency pairs has plunged to levels only touched three times in the last two decades – in 2007, 2014, and January 2020.
This seems somewhat mysterious. Historically, the mere hint of an incoming tightening cycle has often touched off a round of turbulence in the markets – with the 2013 “taper tantrum” providing a notorious example of the sort of extreme reaction that can occur when central banks attempt to normalize policy.
But – fully understanding that these are the four most expensive words in the English language: this time is different.
In contrast with the communication strategies deployed in previous cycles, central bankers are preparing to slow down the pace at which they add liquidity to financial markets, but are not threatening to subtract from the overwhelming tide of displaced cash that has flooded asset classes in all corners of the global economy. In speech after speech, policymakers have drawn clear distinctions between asset purchases and interest rates, while committing to keeping balance sheets stable for years into the future.
In essence, policymakers are not – to use former Federal Reserve Chairman William McChesney Martin’s metaphor – removing punch bowls before parties get started. Our monetary bartenders are still refilling glasses, while telling already-tipsy guests that the night is still young and closing time remains far, far away.
Central Bank Assets, Trillions USD
2000 January – July 2021
Sources: Respective Central Banks, Bloomberg, Author Calculations
And, in an ironic twist, highly-contagious variants of the coronavirus are helping to keep the bar open.
For many market participants, it doesn’t seem sensible to call an Uber until the Delta variant crests and economic momentum begins to return. As long as the liquidity keeps flowing and central banks remain largely coordinated, volatility expectations will stay depressed, and asset prices should continue to rise.
But timing is everything.
Warren Buffett’s letter to shareholders in 2001 seems apropos: “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities: that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
Currency markets may be trapped in limbo in the coming days, with ranges holding ahead of next week’s slate of elections and central bank meetings.
Regional Fed presidents will enter purdah before the central bank’s September 22 rate decision, removing a source of low-level volatility (in the form of wildly-divergent media interviews) that has repeatedly pummelled fixed income and foreign exchange markets in recent weeks.
The Biden administration may announce a decision on whether to renominate or replace Federal Reserve Chair Jerome Powell when his term expires in 2022. But prediction markets currently give Mr. Powell 89 percent odds of renomination, with his closest rival, Lael Brainard, garnering 8 percent – lowering the likelihood of a shock.
Shifting fortunes in the run-up to next week’s Canadian election are unlikely to have a major impact on the exchange rate. A weekend editorial in China’s state-affiliated Global Times – which suggested that Ottawa could face “counterstrikes” if a Tory government puts its hawkish policy recommendations into action – could have longer-term currency implications, but in the here and now, sovereign debt levels remain manageable, the two major parties are closely aligned from a spending perspective, and polling currently suggests that the victor will form a minority government. Major policy swings are unlikely.
On paper, the euro could be poised for upside ahead of an epochal post-Merkel German election – with Olaf Scholz’s Social Democrats in the lead, the political environment looks poised to lurch leftward, raising the likelihood of deeper European integration and more expansive fiscal policy. But with polls suggesting that up to 16 different possible coalitions could emerge after the 26th, directional bets on the common currency remain risky, to say the least.
And economic data releases will slow to a trickle, serving mostly to help market participants calibrate short-term expectations:
T U E S D A Y
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United Kingdom: Unemployment, July
After a rapid post-lockdown rebound, most observers expect the UK labour market to tighten at a slower pace in August. Consensus estimates have the jobless rate falling to 4.5 percent from the prior month’s 4.7 percent, while wage growth decelerates to 8.2 percent year-over-year – down from 8.8 percent in June. A big downside miss could colour expectations ahead of the Bank of England’s policy meeting on the 23rd, but last week’s unmistakably hawkish comments from Governor Bailey – in which he said that the minimum conditions for rate increases have been met – are likely to keep market momentum moving toward the 1.40 threshold.
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United States: Consumer Prices, August
August inflation data could play a pivotal role in setting the dollar’s direction for the week, with an above-consensus print helping to firm expectations for a preliminary tapering agreement at the Federal Reserve’s September meeting. Estimates currently suggest that headline prices climbed 0.4 percent in August from the month before, with the core measure up 0.3 percent – but last week’s jump in producer prices could augur a stronger increase.
W E D N E S D A Y
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United Kingdom: Consumer Prices, August
Last year’s restaurant discounts and tax cuts are likely to render year-over-year inflation comparisons meaningless, but traders will drill down into the monthly details to determine whether labour shortages, rising commodity costs, and post-Brexit regulatory checks are sustainably raising background price levels. Evidence of a sustained inflationary overheat could break a logjam among Monetary Policy Committee members, opening the door to future interest rate hikes.
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Canada: Consumer Prices, August
Headline prices are expected to rise 3.9 percent year-over-year in August, with the Bank of Canada’s preferred set of core measures running well above target. With an October tapering decision and two 2022 interest rate hikes fully priced into financial markets, an upside surprise is unlikely to prompt a violent exchange rate response – while a downside shock could deliver some volatility.
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China: Economic Activity Indicators, August
China’s economy slowed further last month as a resurgent coronavirus closed ports and forced lockdowns in several critical manufacturing provinces. Consensus estimates suggest that year-over-year growth in industrial output slipped to 5.6 percent from 6.4 percent in the prior month, while urban fixed-asset investment – a measure of investment in factories, railroads and real estate – dropped to 9.1 percent from 10.3. With consumer sentiment worsening and travel numbers plunging, retail sales are expected to slow further, from 8.5 percent to 7 percent.
Disappointing results could weaken the yuan and put pressure on commodity-linked currencies, but the risk/reward ratio might be skewed to the upside. Purchasing manager surveys often overstate month-over-month weakness (because participants are asked whether conditions are improving or worsening relative to the prior month), and other high-frequency data points seem to show a recovery in exports toward the end of August.
T H U R S D A Y
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United States: Retail Sales, August
Consumer sentiment surveys and mobility indices suffered a profound drop in late summer, setting the stage for a plunge in spending volumes at American retailers. Investors think overall receipts dropped -0.8 percent in August, following a -1.1 percent contraction in July. So-called “control group” sales – a measure that excludes autos, building supplies, and other highly volatile categories – are thought likely to fall by less – down only -0.1 percent after a -0.7 percent fall in the prior month. An unexpectedly large drop could put pressure on the dollar, but with the number of new coronavirus infections beginning to fall in many states, we think markets are prepared to discount any likelihood of a long-term diminishment in consumer appetites.
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United States: Weekly Jobless Claims
The rolling 4-week average number of applications for unemployment benefits is expected to continue trending downward this week. But August’s shockingly weak non-farm payrolls report could foreshadow some softness, with both demand and supply sides of the labour market facing turbulence as the Delta variant hits state economies. A headline number substantially above the 320,000 mark could trigger a modest dollar selloff as traders fade the likelihood of a tapering signal before November.
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Australia: Employment, August
There is little doubt that Australia’s job market sustained enormous damage last month as draconian lockdowns in Melbourne and Sydney brought economic activity to a screeching halt. Layoffs are expected to exceed 115,000, with the unemployment rate surging to 5 percent from 4.6 in July – and this pain is likely to persist through September and October, with losses mounting as slower-moving businesses jettison employees.
The data could leave the Aussie dollar unshaken, however – last week’s decision by the Reserve Bank of Australia to continue tapering is demonstrative of a deep level of confidence in a quick and decisive rebound once the current wave of coronavirus infections is brought under control. Investors might be inclined to agree, betting that this round of lockdowns will prove less economically damaging – and exchange rate weakness less sustainable – than episodes experienced elsewhere over the last year and a half.
From Trevor Charsley – our London-based lead technical analyst – market levels to monitor in the days ahead:
Notes: A support level is an exchange rate at which demand is thought strong enough to stop the currency pair from falling any further. The rationale is that as the exchange rate falls and approaches support, buyers (demand) become more inclined to buy and sellers (supply) become less willing to sell. A resistance level is the opposite – a rate at which supply is thought strong enough to stop the currency pair from rising higher. As the exchange rate rises and approaches resistance, sellers (supply) become more inclined to sell and buyers (demand) become less willing to buy. When a resistance or support level is broken, its role can reverse. If the exchange rate falls below a support level, that level will become resistance. If the exchange rate rises above a resistance level, it will often become support.
Carefully-curated long reads to kick your week off properly:
“53% of Germans fear that the government will permanently raise taxes or cut services and benefits because of the debt burden from the coronavirus crisis… In contrast, the fear of serious illness – also from being infected with coronavirus itself – ranks only 14th on the angst scale”
⁃ Deutsche Welle: What Do Germans Fear the Most?
“For years container shipping kept supply chains running and globalisation humming. With shops’ shelves fully stocked and products from the other side of the world turning up promptly on customers’ doorsteps, the industry drew barely any outside attention. Shipping was “so cheap that it was almost immaterial”, says David Kerstens of Jefferies, a bank. But now, as disruption heaps upon disruption, the metal boxes are losing their reputation for low prices and reliability.”
⁃ The Economist: A Perfect Storm for Container Shipping
“A series of deep crises – beginning in Asia in the late 90s and moving to the Atlantic financial system in 2008, the eurozone in 2010 and global commodity producers in 2014 – had shaken confidence in market economics. All those crises had been overcome, but by government spending and central bank interventions that drove a coach and horses through firmly held precepts about “small government” and “independent” central banks. The crises had been brought on by speculation, and the scale of the interventions necessary to stabilise them had been historic. Yet the wealth of the global elite continued to expand. Whereas profits were private, losses were socialised.”
⁃ The Guardian: Covid and the Crisis of Neoliberalism
“During 1986-2021, the S&P500 index has appreciated at nearly twice the rate of GDP growth while earnings have beaten GDP by about 35%. We can see this gap widening over the past 20 years as earnings grew at nearly twice the clip of GDP. Over the past ten years, the index’s gap over GDP has widened immensely, almost all due to multiple expansion.”
⁃ Emerging Markets Investor: America Sucks Up Global Capital
“Hamilton was very cognizant of the thin line he must tread with these purchases, as he wanted the market to know the Treasury was stepping in to support prices, but also wanted to avoid investors expecting the Treasury to step in and support the market every time prices fell (in Richard Sylla’s words, a “Hamilton Put”)”
⁃ Investor Amnesia: Panic Series, Part 1
“…the sense that government action had been liberated from the tyranny of finance was illusory. The interventions triggered in March 2020 were not free acts of creative political will. The central bankers were not buying government debt to help finance lockdown life-support checks. They were acting to rescue financial markets from melting down. “Too big to fail” has become a systemic imperative.”
⁃ New York Times: What if the Coronavirus Crisis Is Just a Trial Run?
“Over their full life, only a minority (49.2 percent) of common stocks had a positive lifetime holding period return, and the median lifetime return was -3.7 percent.”
⁃ The Evidence Based Investor: Most Stocks Are Duds
“Since 1984, oil intensity has fallen every year in an almost perfectly linear fashion: the amount of oil used per dollar of global GDP has dropped by roughly the same amount each year. Wars and revolutions, booms and busts, OPEC successes and failures, and every other monumental event in the last 35 years left their imprint on oil markets but didn’t alter oil intensity’s steady, downward crawl. This kind of regularity is very rare in any long-time trend, in economics or in energy.”
⁃ Columbia University: Oil Intensity: The Curiously Steady Decline of Oil in GDP
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