“We think cracks are more likely in the foreign exchange or sovereign markets than in credit,” we wrote here three weeks ago.
It’s fair to say we didn’t expect those cracks to appear quite as quickly and visibly as they have. Last week, we saw days in which U.K. index-linked gilt yields soared by more than 60 basis points, as well as double-digit whipsawing in normally staid German Bunds. What‘s going on?
In short, as Joe Amato put it recently, we think that a world of high inflation is making bond investors stand up for themselves against policymakers, reminding them that “capital is not free.”
Where policy is consistent, we believe government yields could be close to their cycle peaks and ready to trade in a range. But where policy is inconsistent, we see markets now standing ready to punish. This rigor is now being applied to developed sovereigns just as it would be in the emerging world—and, as we’ve seen, it can mean historic levels of volatility.
Policymaking can be inconsistent in two ways: within a sovereign, between the fiscal and monetary authorities; and among sovereigns.
It looks like the U.K. has volunteered to be the poster child for internal inconsistency.
As the Bank of England tightened monetary policy against inflation, a new government announced billions of pounds of tax cuts. Arguably, they were poorly conceived (being unfunded, inflationary and regressive) and definitely poorly communicated (with some tax cuts revealed at the last minute, with no input from the official budget watchdog, and no thought for consequences in the gilt market or the U.K.’s highly exposed pensions industry). In the midst of hiking rates and quantitative tightening, the central bank had to start a new round of emergency asset purchases, itself characterized by inconsistent messaging.
Inconsistency Among Sovereigns
Look across the English Channel for a good example of inconsistency among sovereigns.
Europe is facing a potentially hard winter of energy shortages due to the war in Ukraine and Russia’s cessation of gas supplies. In response, Germany rolled out a €200bn plan to help shield its own consumers and businesses from the impact—just as the European Central Bank (ECB) was talking tough on inflation and European Union energy ministers were on their way to Brussels to bash out some kind of joint strategy.
“It is an act which undermines the reasons for the union,” fumed an advisor to Italy’s new government. Italy will likely be criticized by other Eurozone members, and disciplined by the bond market, should it have submitted even a mildly expansionary draft budget to the European Commission over the weekend.
When COVID-19 hit, the Eurozone response was surprisingly unified, and reports of German support for an issuance of common Eurozone bonds to finance energy-crisis loans may signal a willingness to maintain solidarity. That said, we think the Eurozone remains a source of market tail risk on inflation and growth, particularly if policy becomes more inconsistent.
Europe isn’t the only place beset with policy inconsistencies.
Back in May, we highlighted the increasing inconsistency of the Bank of Japan’s (BOJ) monetary policy given rising inflation and inflation expectations. With the BOJ maintaining negative rates and yield curve control policies, the yen has felt the brunt of the adjustment and has since fallen to a 24-year low against the dollar, exacerbating inflationary pressures. The Bank of Japan’s December meeting could be one to watch for a very long-awaited change in stance.
And while the U.S. has so far largely avoided such policy inconsistency, November’s mid-term elections may determine the future path. Some would argue that parts of the Inflation Reduction Act are somewhat misnamed, for example, and it is difficult to see how the Department of Labor’s recent proposal on classifying “gig workers” would be disinflationary should it find its way into law.
Discipline Is Hard
We see plenty of evidence that policymakers in the developed world still think we are in the environment that prevailed between the Great Financial Crisis and the COVID-19 epidemic, then. But, in our view, we’ve moved into new territory. The bond market appears to see it that way, too, and is increasingly prepared to reprice sovereign rates higher.
As Joe wrote, that is ultimately a good thing for economic stability and sustainability. But discipline is hard, and it is likely to entail more volatility—especially if policymakers take too long to learn the lesson.
In Case You Missed It
- U.S. Producer Price Index: +8.5% year-over-year, +0.4% month-over-month
- U.S. Consumer Price Index: +8.2% year-over-year, +0.4% month-over-month (core consumer price index +6.6% year-over year, +0.6% month-over-month)
- U.S. Initial Jobless Claims: +9k to 228k
- U.S. Retail Sales: flat at 0.0% month-over-month
- University of Michigan Consumer Sentiment: +1.2 to 59.8; 1 year inflation expectations +0.4% to 5.1%
What to Watch For
- Monday, October 17:
- Empire State Fed Index
- Tuesday, October 18:
- NAHB Housing Market Index
- Wednesday, October 19:
- U.S. Housing Starts
- Thursday, October 20:
- Philadelphia Fed Index
- U.S. Existing Home Sales