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Is the Fed in a Hole?

Aug 10, 2021

• Higher inflation and lower unemployment present a challenge to the Fed’s ultra-loose monetary policy
• Near-term rise in COVID cases may provide an excuse to maintain an easy policy stance – for the moment
• US bond yields rise but will still likely be range-bound in the very near term
• The upcoming Jackson Hole meeting of central bankers could be a seminal market-moving moment
• Equities maintain momentum with Europe leading from the front
• Asia ex-Japan equities continue to disappoint with India being the marked exception

The Fed excused higher “transitory” inflation until it was no longer transitory. Now they find themselves in a bit of a hole, with last week’s nonfarm payroll report showing a more vibrant labour market than expectations. Is the Fed about to shift gears?

Much higher-than-expected inflation has already put the Fed under pressure to rein in some elements of their loose monetary policy. However, Fed Chairman Powell has in recent weeks tried to deflect any discussion about a potential tightening in monetary policy by pointing to the still-high unemployment. However, last week’s much stronger-than-expected employment data quite literally puts the Federal Reserve in a fix.

The Fed has a dual mandate of maintaining stable prices (with inflation around 2%) and full employment. The last four inflation reports have been well ahead of market expectations; indeed, the latest data point was the largest increase in monthly inflation since 1982. Last week, the Labour Department reported that the rate of US unemployment had fallen to 5.4% from 5.9% in June. Although it was still high relative to the 3.5% in February 2020, it was a substantial improvement from an unemployment rate of 14.7% in March 2020 and 6.7% at the turn of the year. Also, there are apparent signs of wage inflation. Hourly wages grew at 4.0%, with hours worked also increasing marginally. The latest broad wage growth data already shows wage inflation running at a 10-year high.

Today, the Fed’s US monetary policy is set for an economic debacle. We believe the Fed is finding itself on a sticky wicket trying to justify such easy monetary policy when the US economy has materially improved. Were it not for the recent increase in COVID cases in the US, we suspect that the bond market would have already bolted to much higher yields. Last week, 10-year government bond yields were up 7.5 basis points to 1.298%. Only last Tuesday, the 10-year yield was down at 1.172%.

The resurgence of COVID cases in the US has probably stopped investors from marking government bond yields far higher. According to the CDC, hospitalisations due to COVID-19 have risen to 44,000, up 30% in one week and a sharp 300% from June. It is worth noting, however, that in January, numbers were far higher and hospitalisations touched 120,000.

Jackson Hole – a risk of market moving news
Another proverbial hole for the Fed is the Jackson Hole symposium hosted by the Kansas Fed and usually attended by central bankers from across the world. Due to challenges posed by the pandemic, this year’s symposium entitled, “Navigating the Decade Ahead, Implications for Monetary Policy” will be virtual. However, if central bankers keep to the topic, we could see some interesting, potentially market-moving speeches.

The story runs that Jackson Hole became the host of the annual event in 1982 because it was apparently the only way to lure avid fly-fishing enthusiast and the then Fed Chairman Paul Volker to attend. Interestingly, Paul Volker was the famous architect of an interest rate policy to crush inflation. Has the global economy gone full circle?

The title of the symposium raises many issues. Will any central bankers admit that the world is too hooked on monetary policy? Will there be any perspective on how the global economy will get off the drug of debt? Will quantitative easing be presented as a necessary evil or a sound policy tool to be used frequently in the future? Will there be any perspective on the role of cryptocurrencies in monetary policy in the future?

The Jackson Hole speeches may also give us a sense of where global monetary policy conditions are moving. The ECB recently made dovish noises about their inflation targets, implying lower longer for interest rates. Meanwhile, several emerging countries (Russia, Brazil, and Turkey) have tightened monetary policy to counter any potential currency volatility and keep a cap on any acceleration in inflation.

Rising US COVID cases dampening the rise in yields
With US COVID cases rising, we suspect that the rise in US government bond yields is probably complete for the moment. Yields were above 1.60% in May, but global economic data has not been surprising of late, and surging cases caused by the Delta variant are worrying the market. The Global Aggregate Index returned -47 bps last week, reversing a good measure of recent positive returns. Credit performed better, with lower average duration and some spread narrowing helping to cushion the losses. Global high yield bonds, for example, returned -15 bps, and E.M. debt +7 bps.

Equity markets take the news in its stride
Equity markets were able to take the volatility in the bond markets in their stride. After the employment report, the US equity market gained momentum, although the growth stocks in the tech-heavy NASDAQ index were down. At the margin, there are some signs of rotation within the global equity markets. European equities have continued to improve, at the very least matching the returns from the US. However, those gains are much less for dollar-based investors. The dollar has rallied 2.5% against the euro over the past three months.

It is still early days, but there were some signs of life in the Japanese equity market last week with returns that beat US equities without significant losses for the yen against the dollar. Encouragingly for Japanese equities, analysts have been quite busy upgrading corporate profit forecasts over the past three months. Estimates for current-year earnings for the Nikkei 225 index have risen by 7.5%, matching upward revisions to US S&P 500 earnings.

Investor sentiment in Japan should benefit from the success of the Olympics and a marked improvement in the percentage of the population that has had at least one dose of the COVID-19 jab. At the end of April, barely 2.5% of the population had had one dose of the vaccine. Currently, vaccinations are up to 45%; and 75% of the over 65s have now received at least one shot. The country is close to vaccinating at a rate of 1% of the population per day. Pfizer is due to supply the country with 70 million shots over the next two months.

On several points of comparison, the equity markets in the rest of Asia ex-Japan don’t look so impressive. Asia ex-Japan continues to lag in terms of vaccinations and, by implication, the ability of the individual countries to get on top of the COVID challenges and get their respective economies moving. The improvement in global growth has provided some benefits, but forecasts for corporate profits growth are barely moving. The current challenges in China with focussed lockdowns and still evolving regulatory reforms are not helping. Beleaguered Ibellwether stocks such as Alibaba, were down again last week. Tencent, after a brief rebound, was down at close to a one-year low. The stock is down 4% from its April high. Forecasts for Tencent’s 2021 earnings are down 10%; however, the degree of confidence in that forecast is extremely low. Unfortunately, analysts are still struggling to accurately analyse the impact of the hit to medium-term profitability from some of the regulatory changes.

In Asia, Indian equities are a positive stand out. The market rose 3.5% last week, and the Indian rupee continues to remain firm. In the first week of August, international investors turned net buyers of the market after some heavy selling in July. International investors invested approximately INR 1,210 crore (USD 163.0 million) in the first five days of August as against being net sellers of INR 7,273 crore in July. China’s problems appear to be benefitting the market.

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