Central banks have returned to centre stage over the past few weeks as inflation expectations have continued to rise sharply and investors have started pricing in swifter adjustments to monetary policies. Central bank rhetoric of a “transitory inflationary environment” and their patient stance regarding future monetary action is being challenged by market participants, given the observable data. Why are policymakers sticking to their surprisingly dovish convictions given the macroeconomic context, and what can we expect over the medium term from major central banks?
Surprise, Surprise
What Happened?
Macro trends remain unchanged
One thing that has not changed recently is the dynamics of macro fundamentals: inflation keeps on pushing higher and growth continues to stabilise above trend levels in developed economies. In the US, recent CPI numbers released for October came out stronger than expected (yet again): headline inflation jumped 6.2% year-over-year, the highest rate since December 1990, while core CPI surged 4.6%, more than twice the Fed’s long-term target of 2%. The latter is particularly alarming as the forces at play in this core measure are less volatile, stickier, and will consequently take longer to resorb than the headline measure, driven by cyclical elements such as energy prices. Shelter, the biggest component of core inflation measures – and the largest expenditure for most average citizens – once again posted an above average rise in October, highlighting that the trend remains strong and durable.
Figure 1: Shelter Inflation Is Alive and Well
Source: Bloomberg, Unigestion, as of 11 November 2021
Our proprietary Inflation Nowcaster, which measures the risk of inflation surprise over the medium term, correctly spotted an increasing likelihood for rising prices to become both a surprise and an issue early in 2021. The fact that the indicator has not yet come down from extreme levels and continues to push higher makes us believe that investors (and central bankers) could be surprised by the length of the current inflationary environment.
Central banks are surprisingly dovish
The outcomes of the most recent monetary policy meetings held by the Fed, the BOE and other central banks were a surprise to investors. Indeed, investors had started exhibiting high expectations of increasingly hawkish forward guidance. However, the Fed, despite delivering the much anticipated tapering of asset purchases, maintained its soft stance on inflation while the BOE did not hike interest rates even though it was supposed to be a done deal. Markets had already priced in future rate hikes and yield curves had adjusted accordingly, creating a window of opportunity to take a step further toward a less accommodative stance without shaking investor sentiment – a missed opportunity.
Yet investors remain defiant and in the case of the US, are still pricing the first rate hike to happen as soon as tapering is over, i.e. mid-2022.
Figure 2: Market Pricing for Rate Hikes Remains Elevated
Source: Bloomberg, Unigestion, as of 11 November 2021
If one considers that credibility is the most important asset for central banks, they have definitely incurred losses on this front.
Figure 3: Yield Curve Reactions to Central Banks
Source: Bloomberg, Unigestion, as of 11 November 2021
The market is becoming ever more sceptical about the transitory nature of the current inflation shock, and the longer policymakers take to acknowledge the genie is already out of the bottle, the longer price pressures will stay with us without efficient counter measures. Even though the initial market reaction has been positive, as pushing forward the moment to tighten monetary conditions is good news for the investment community, their perceived complacency on inflation is negative over a slightly longer time horizon.
Figure 4: Changes in Hike Expectations Week-on-week
Source: Bloomberg, Unigestion, as of 11 November 2021
Medium-term consequences could be difficult to manage
The increasing divergence between economic reality and central bank patience could have negative consequences for both Main Street and Wall Street. Investor sensitivity to inflation numbers has sharply risen over the past couple of months and so has market volatility, especially in the bonds space. The MOVE index, which measures the implied volatility of 1-month options on a variety of tenors, is at its highest level since March 2020, buoyed by the rising risk of a monetary policy mistake. Fundamentally, the current levels of growth and inflation combined should (historically, in a pre-QE world) grant a sharp rise in interest rates, which in turn could be detrimental to risky assets. For now, only the inflation element has been priced: breakeven curves are now at multiyear highs while real rates remain at multi-year lows, deep in negative territories.
Once rates stop being maintained at artificially low levels by central bank asset purchase schemes, a recovery in real rates would be a good omen for risky assets, suggesting an improvement in growth and/or a decrease in inflation. On the contrary, risk assets would be negatively affected by a surge in yields, driven only by the inflation premium.
Figure 5: US Bonds Volatility: MOVE Index
Source: Bloomberg, Unigestion, as of 11 November 2021
Indeed, a purely systematic assessment of the macro forces at play should prompt a defensive stance on government bonds as the probability of seeing yields normalise is elevated due to the inflationary pressures. This would likely be accompanied by a cautious yet positive tilt to growth-related assets thanks to the benign growth environment.
We can interpret the surprisingly dovish central bank stance as testament to the seemingly imponderable equation they need to resolve: contending with inflation without derailing the post-pandemic recovery. This is the reason they have all been putting forward to justify their wait-and-see approach. They are taking the risk of spiralling inflation to make sure growth has become self-sustaining and achieve full employment, hoping that the supply disruptions driving surging prices will naturally reach an equilibrium point soon before fading away.
Positive as long as it lasts
Right or wrong, the surprisingly soft stance of central banks has given legs to the rally. Considering that monetary accommodation remains the key factor driving asset returns, above even the sacred fundamental factors, we believe it is still time to take advantage of the situation and remain exposed to both risk and real assets. History has demonstrated that trying to anticipate the actual change in financial conditions from an accommodative to a tightening situation usually yields disappointing results. We continue to scrutinize the specific factors that could indicate a rising risk of central banks adjusting faster than anticipated, which will be the time to turn more defensive.
Unigestion Nowcasting
World Growth Nowcaster
World Inflation Nowcaster
Market Stress Nowcaster
Weekly Change
- Last week, our World Growth Nowcaster ticked down slightly due to a lower European growth impulse.
- Our World Inflation Nowcaster moved slightly higher driven largely by higher readings out of the US and China.
- Our Market Stress Nowcaster moved modestly higher as volatilities rose and spreads widened.
Sources: Unigestion, Bloomberg, as of 12 November 2021.
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