- Tough calls on interest rates and tapering loom for central bankers
- Fixed-income investors still face a challenging hunt for yield
Life doesn’t get any easier for the Bank of England monetary policy committee (MPC). Walking a tightrope between inflation and protecting a precarious economic restart, the escalating crisis in gas prices comes on top of a spectacular rise in CPIH figures. As inflationary pressures mount, the voices on the MPC that favour raising interest rates will become louder.
Although relatively new, the consumer price index plus owner occupiers’ housing costs (CPIH) measure of inflation caused alarm when the year-on-year figure for August was, at 3 per cent, 0.9 of a per cent higher than the July number. The retail price index (RPI) measure jumped to 4.8 per cent year on year and core inflation rose to 3.1 per cent.
Analysts at Société Générale qualify the rise, pointing out that year-on-year figures are influenced by base effects such as the impact of the government’s Eat out to Help Out scheme and VAT reduction last year. Looking through the alarming headline figures, there is an argument the MPC will be more swayed by other economic data and hold off hiking rates.
Last week, SocGen noted that UK gilts underperformed on the inflation surprise but emphasise signs of slowing consumer activity: “UK 10y interest rate swaps closed above 1 per cent for the first time since June but weak retail sales temper expectations for a hawkish BoE next week.”
Gas prices are a curve ball for policymakers, however. It’s hard to see how rate rises can keep being put off as shortages in carbon dioxide (essential for food production and packaging) exacerbate supply constraints caused by the lack of road haulage drivers. Food and energy bills look certain to go up.
Better news came in the form of UK payroll figures for August hitting pre-Covid-19 levels. This does add credence to the view that conditions are being met for easing off monetary stimulus, however.
Keeping control of economic narratives has become as much a part of central bankers’ jobs as managing the money supply. Being seen to be in control of the resurgent inflation beast and remain accommodating to growth is a struggle and analysts at Swiss bank UBS foresee a slight divergence in monetary policy from major central banks that could create opportunities in government bonds.
Christine Lagarde, chair of the European Central Bank (ECB), was at pains to frame tapering of its pandemic support asset purchases as a recalibration and key interest rates were maintained. Although monetary policy is set to remain ultra-loose around the world by historic standards, UBS sees the US Federal Reserve and the BoE as potentially becoming relative hawks on rates, with the ECB and Bank of Japan the doves.
Avoiding having to shut down economic activity again due to the delta variant or another new strain of Covid-19 is a caveat, but UBS suggests that should the “hawks versus doves” narrative play out, it will favour demand for US dollar- and sterling-denominated assets. This week the world will be watching the US Federal Reserve’s next move.
Expectations for tapering of the Fed’s asset-buying programme could be set, with potential for a taper tantrum in markets. Perhaps even more important will be the indication for the timetable for raising target interest rates. The so-called dot plot, showing the range of views of the Federal Open Market Committee (FOMC) is a barometer for future policy.
The composition of the FOMC is also under scrutiny with changes to be announced. Although the chair, Jay Powell, is expected to stay on two members are due to step down. Whether the replacements favour more rapid tightening or looser policy will have a major bearing on asset markets.
Corporate bonds have been a relatively stable asset class this year, but the scope for high returns is limited given the tightness in spreads between investment-grade (IG) and even high-yield (HY) corporate credit and government bonds in developed markets. There are interesting developments in different sectors, reflecting the perceived creditworthiness of companies in industries especially damaged during the pandemic.
Data from risk analytics firm Credit Benchmark highlight that Travel and Leisure businesses make up 12 per cent of their sample of companies that have been downgraded from investment-grade to high-yield credit status. Overall, Credit Benchmarks shows the number of ‘Fallen Angels’ in all sectors continues to grow.
Interestingly, there has also been growth in the number of Rising Stars, which are going in the other direction, from high yield to investment-grade. There is a nuanced picture developing for the leisure goods sector, which figures prominently amongst Fallen Angel and Rising Star companies.
Although there are subtleties in credit for fixed-income fund managers to exploit, the risk-to-reward trade-off could be better elsewhere. In its Q4 outlook, UBS advocates private credit, senior corporate loans and direct real estate investment as alternative means of yield generation.
