Stephen Miller

Not unexpectedly, and resilience in the labour market notwithstanding, US activity data appears to be responding to Fed policy rate hikes and the recent hawkish tack from Fed officials.

Market pricing of the policy rate also appears more aligned with that Federal Reserve (Fed) communication, suggesting a peak close to 4.60 per cent in the first half of 2023, not that different from the current Fed “dot plot”.

The 10-year bond yield also appears to have reflected the vigour of Fed communication.

That begs the question as to whether bond yields are at a turning point.

I suspect that rather than a turning point, bond yield will plateau in the around 4.00 per cent.

That said, the risks to that view appear skewed to the upside even if the bulk of the cyclical move upwards in yields would now seem to be behind us.

First, as Bloomberg noted this week many of the big buyers of US Treasuries are in retreat. The most obvious is the Fed itself which has upped the pace at which it is running down its portfolio to $US60 billion per month. Furthermore, Japanese pensions and life insurers and foreign central banks and US commercial banks have stepped away from the market.

Second, I suspect that 10-year yields are a little too optimistic on the rapidity with which inflation can get back to around 2.5 per cent given recent indications of the momentum in measures of inflation ‘pulse’ and ‘breadth’.

Clearly Thursday’s US September US CPI report will be critical.

There is little sign of a much-vaunted Fed “pivot”. Overnight, Minneapolis Fed Chief, Neel Kashkari reaffirmed policymakers’ commitment to the current policy rate trajectory, saying the bar for a pivot away from monetary policy tightening is “very high.” Nevertheless, that trajectory does involve a step down in the policy increment at some stage. On that note, there has been at the margin some perceptible shading of Fed rhetoric this week. Fed Vice Chair Lael Brainard acknowledged a case for caution given that previous policy rate increases were working their way through the economy. The Fed’s FOMC minutes from the 20 – 21 September meeting, released overnight, also revealed that some members argued it would be important to calibrate the pace of hikes to mitigate adverse risks to the economy.

Nevertheless, as mentioned above, measures of the inflation ‘pulse’ continue to show extraordinary momentum with no meaningful evidence of retreat from historically high levels. On a 3-month annualised basis, the Cleveland Fed measures of median and trimmed-mean inflation in August were running at 8.3 per cent and 7.7 per cent respectively – in the case of the former, at a four-decade high, and in the case of the latter only a little off that. The same measure of the Dallas Fed trimmed-mean Personal Consumption Expenditures (PCE) price index is, at 5.6 per cent, also running at a four-decade high. This suggests a broadening of inflation pressures. That is also reflected in the ongoing elevated levels in the price’s component of the Services ISM Purchasing Managers Index (PMI).

Should the September Consumer Price Index (CPI) indicate some turning point in these 3-month inflation ‘pulse’ measures that may open the door for some further shading of Fed rhetoric and perhaps a reduction in the size of the policy rate increment, but that is a “big if” and it would need a highly visible turning point for bond yields to meaningfully navigate a turning point.

Coming up: Bank of England gilt backstop due to end on Friday

Speaking in Washington on Tuesday afternoon, Bank of England (BoE) Governor Bailey appeared to scotch hopes of an extension of the BoE backstop to the Gilt market. His message to pension funds sounded unequivocal: “…you’ve got three days left … you’ve got to get this done.”

Subsequent press reports had BoE spokespeople walking back those comments suggesting that in an emergency the backstop might temporarily endure.

The current crisis in the Great British Pound (GBP) / gilts was motivated by asset management practices within the Liability-Driven Investing (LDI) pension sector. But it came on top of a series of prior policy missteps from the BoE and lately the UK Government.

At this stage, it is difficult not to see a continuation of volatility in sterling and gilt markets:

• The BoE is behind the curve and has a lot of catching up to do.
• Brexit looks to have been mismanaged. Indeed, apart from lofty rhetoric, little effort appears to have been expended into any management of the consequences.
• Finally, despite some minor backtracking from the Government, fiscal policy is pulling in the opposite direction to monetary policy.

Clearly the BoE intervention was only ever going to be, at its very best, a short-term palliative and to extend the support indefinitely represents de-facto easing of monetary policy (following what looks like a substantial easing of fiscal policy). That would simply fuel inflation at a time when it is at a 40 year high. That would ultimately send the GBP lower and gilt yields higher.

Bailey clearly wishes to end the gilt backstop at the scheduled time on Friday. In that context the tough talk makes some sense but his tone appears to leave limited room for manoeuvre in the event that LDI pension funds continue to confront problems that threaten systemic financial instability. Although, as mentioned, subsequent press reports have attended some equivocation to the Bailey comments.

His comments come at a time when there is little sign of any near-term prospect of a resolution of the policy vacuum afflicting the UK. The UK Government is expected to bring forward by a month plans to unveil a medium-term fiscal statement but that will not be until toward the end of the month. Meanwhile, the BoE is not scheduled to meet until 3 November, with markets pricing a hike well in excess of 100 basis points.

It looks to be the case that a series of prior policy missteps from both the BoE and the Government has already ‘baked in’ confronting economic circumstances for the UK.

The BoE might break the vicious circle of a lower GBP / higher gilt yields with a serious hike in the policy rate (circa 100 basis points or more with more foreshadowed) but its previous less-than-deft execution of monetary policy, combined with the likely downdraft in activity attendant on monster rate hikes, may mean that markets place little faith in the BoE and the Government negotiating anything other than a highly disruptive path through the economic morass in which case volatility in sterling and gilts may endure.

NAB Monthly Business Survey points to upside risk in RBA inflation forecast – Some “awkward optics” ahead for the RBA?

In opting for a 25 basis point increment the Reserve Bank of Australia (RBA) Governor in his Statement following the September meeting cited two key factors.

The first was growing uncertainty in the outlook for the global economy which it described as having “deteriorated recently”.

The second was how household spending in Australia responds to the tighter financial conditions. The implication being that the RBA Board would like to gauge the full effects of higher interest rates on household spending.

The Governor’s Statement appeared to indicate that the difference between 25 basis point and 50 basis point was a fine judgement and while a surprise to many, including this writer, the Board decision is certainly defensible.

The Statement reiterates that “the Board expects to increase interest rates further over the period ahead” and further that it “remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.” In other words, the Governor was keen to signal that the Board remains vigilant and has not taken its eye off the (inflation) ball.

Further, the greater frequency of RBA Board meetings compared with their counterparts elsewhere may have afforded the opportunity of lesser 25 basis point increment in October. The RBA meets monthly, as opposed to every 6 weeks like most of its developed country counterparts. A 50: 50: 25 basis point sequencing of rate rises over three consecutive meetings would be virtually equivalent to a 50:75 sequencing over two consecutive meetings in other developed country central banks.

As the Governor noted in his Statement, the path to returning inflation to the 2-3 per cent target and keeping the economy on an even keel “is a narrow one and it is clouded in uncertainty.” It is arguably appropriate that given the global outlook, and given the lags in monetary policy effectiveness, that the RBA exercise a little caution to mitigate the risk of a recession.

However, while acknowledging that the downshift may have been a fine judgement, and is certainly defensible, the Board may have opened itself up to some “awkward optics” if the extraordinary momentum in high-frequency price and wage measures show up in an outsize increase in the September quarter CPI, forcing the RBA back to a 50 basis point increment in November.

For just as recession is a risk, so is a premature declaration of victory over the inflation threat.

Tuesday’s NAB September Monthly Business Survey indicated some easing in cost and price pressure from the July peak (around the time oil prices peaked and the Fair Work Commission minimum wage increase took effect). Still, costs have been elevated across the quarter and the evidence seems to indicate that firms have continued to pass these pressures onto their customers.

Using price measures gleaned from the Monthly Survey, NAB economists construct a simple ‘nowcasting’ model of the trimmed-mean CPI. That model suggests trimmed-mean CPI could be as high as 2 per cent (quarter on quarter) in the September quarter (the Australian Bureau of Statistics release September quarter CPI data on 26 October). That would see core CPI running at over 6 per cent (year on year) for the September quarter, indicating significant upside risk to the RBA forecast of 6 per cent at year-end. It should be noted that NAB is not, however, forecasting trimmed-mean inflation as high as 2 per cent quarter on quarter opting for 1.6 per cent).

The momentum in the high frequency data indicates a danger of the emergence of the sort of inflation inertia that was last experienced on a global scale in the late ‘70s / early ‘80s. It lasted a little longer in Australia.

In this context, the RBA Board might be grateful with “awkward optics” to be the extent of its challenges over the coming period.

By Stephen Miller, investment strategist 

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