Stephen Miller

Powell signals Fed to begin tapering this year…

In a much anticipated speech on Friday, Fed Chair Powell gave his strongest signal yet that the Fed will begin to taper its bond purchases this year, declaring that the U.S. economy has met the central bank’s test of “substantial further progress” toward its inflation goal and that it has made “clear progress” on the labour-market front. While Powell stopped short of nominating when the Fed might set out a tapering roadmap, it seems that should the August employment report (to be released on September 3) come in close to the current consensus of an increase of circa 750k, such an announcement could come as early the September 21-22 meeting, although that remains very much open to conjecture.

No taper tantrum…

Markets took the announcement with equanimity as bond yields retreated somewhat from earlier highs and equity markets eked out impressive gains to close at an all-time high.

So much for a dreaded ‘taper tantrum’ such as that when then Fed Chairman Bernanke canvassed a similar paring of bond purchases back in May 2013.

The difference this time around might be attributed to three key factors:

• First, such a move had been well-telegraphed by the Fed Chairman in contrast to the “drive-by” announcement from then Fed Chair Bernanke back in May 2013. It also helped that Fed hawks had softened up the markets prior to Powell’s address by indicating their preference for an early start to tapering.
• Second, Powell was careful to give the Fed the requisite flexibility to tweak both the timing and nature of any tapering saying that the Fed “will be carefully assessing incoming data and the evolving risks”, particularly given uncertainties attaching to the spread of the COVID delta variant.
• Third, Powell was at pains to emphasise that any tapering should not  be interpreted as a sign that increases in the policy rate might soon follow, emphasising that “the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate lift-off, for which we have articulated a different and substantially more stringent test.”

Fed’s preferred inflation measure remains elevated…Fed Chair maintains inflation is transitory…

Powell’s comments came just a short while after the Fed’s preferred measure of inflation showed an increase of 3.6% over the year to July, the highest since May 1991. On a 3-month annualised basis, that translates into an increase of 6.2% which would be the highest since September 1982. At its March meeting, the FOMC had a median core PCE projection of 2.2% for 2021. That was revised to 3.0% at the June meeting but the July result means that inflation in the first seven months of 2021 is already at 2.8% which almost inevitably means that the Fed will have to revise again its forecast at the September meeting.

Powell maintained at Jackson Hole that inflation was essentially of a “transitory” nature driven largely by temporary supply bottlenecks. Moreover, Powell asserted that structural factors such as aging populations in the United States and elsewhere, along with globalization and advancements in technology, are pushing down on prices globally and that these forces will reassert themselves quickly as the impact of the pandemic passes. That is a sentiment that seems to find acceptance within the bond market given the apparent disconnect with the current inflation pulse and bond yields. Obviously some of that is explained by the Fed’s bond purchases but even allowing for the impact of such purchases, a disconnect is apparent. Powell – implicitly at least – seems to think that disconnect is resolved by inflation drifting lower in 2022 and beyond.

Some commentators question Powell’s sanguine inflation view…

However, that sanguine view on inflation is under question from a number of economists, most notably Obama-era Treasury Secretary Larry Summers, who on Friday maintained that Powell’s remarks on inflation amounted to a “serene” depiction of inflation that is potentially a fundamental misreading of the upside risks. For good measure, Summers added that that it’s “bizarre” for the Fed to still be pumping liquidity into markets with bond buying, which to his mind is producing “toxic” side effects.

Others question whether inflation simply reflects temporary supply bottlenecks.

They point not only to historically high levels of monetary accommodation but also to the notion that fiscal stimulus appears to have been a multiple of any measure of the output gap. Household savings are also still high (although off their peak) and buoyant equity and real estate markets are a strong tailwind to demand.

The Powell assertion that structural forces will continue to suppress inflation is also contestable. Former Bank of England Monetary Policy Committee member and former London School Of Economics Professor, Charles Goodhart, maintains that there are structural currents driving inflation arising from the reversal of the two great structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply and baby boomer workforce participation. Add to that a backlash against globalisation of markets, re-regulation as well as ongoing supply chain constraints, it may well be that structural forces are no longer as powerful in keeping inflation dormant perhaps offsetting structural inflation suppressors such as technology and demographics.

Still others point to inflation sustained by its own momentum: “the inflation genie gets out of the bottle” and once that occurs, it is a difficult process getting the genie back inside the bottle. That is precisely what happened with the oil price shocks of the ‘70s when policy generally “accommodated” the increase in oil prices. If supply shocks manifest themselves in higher inflation expectations then that can have an impact on purchasing behaviour, putting increased pressure on limited supply.

A taper tantrum may have been avoided for a time but inflation frustration may still yet emerge.

By Steve Miller, investment strategist

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Steve Miller

There were no real surprises in RBA Governor Lowe’s Statement issued following the latest RBA Board meeting.

While continuing to acknowledge a more positive outlook insofar as growth and employment are concerned, the absence of any evidence of significant price or wage inflation saw the Governor again stress that the  RBA will  continue with the  application of historically high levels of monetary accommodation: the ‘pedal to the metal’.

The RBA strongly reaffirmed the commitments made in February, including:

• the 3 year bond target of 0.1%
• a commitment to ongoing QE and
• reiterating the RBA Board’s expectation of no increase in the cash rate before 2024.

(A decision  on when or if the 3 year bond target will roll to the November 2024 bond will be made later in the year.)

In so doing the RBA, like most of the global central banking fraternity, is unconcerned by market expectations of inflation rebounding. While markets are anticipating a rebound in inflation, it is from an extraordinarily low base and to a level that central banks would likely welcome. In that context the current market-based measures of inflation expectations and what the world’s central banks, including the RBA, are seeking to achieve on inflation are entirely reconcilable. In that context too, central banks are not yet overly concerned by the recent rise in global government bond yields.

Of course, the dynamics would change if some of the prognostications of ‘too much’ stimulus – promulgated by the likes of Obama era Treasury Secretary Larry Summers – come to pass.

In reaffirming the maintenance of historically accommodating monetary policy settings,  the RBA was motivated to avoid an unwelcome movement in the AUD, even if it comes as some relief to the RBA that the AUD is closer to 0.75USD than the 0.80USD of late February. Any move up in the AUD could well frustrate the task of getting unemployment down and wage growth and inflation up. To this end the Governor reaffirmed the message from previous meetings that the RBA Board: “will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.”

While the economy’s performance has certainly exceeded expectations, and recent wage growth surprised modestly on the upside, it still remains at levels that are uncomfortably low for the RBA and its inflation objective.

The unemployment rate, again while having bettered expectations, is still some way north of the “4 point something” cited by the Governor as getting close to capacity.

On that basis, and with an eye firmly on the AUD, the RBA has decided that erring on the side of ‘too much’ rather than ‘too little’ is at this stage remains the least risky pathway for monetary policy.

By Steve Miller, GSFM investment strategist

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Steve Miller

Various key Fed spokespeople, including Chair Powell, Vice Chair Clarida and FOMC member Brainard, have all appeared to downplay nascent concerns that current Fed policy, combined with fiscal stimulus, may lead to the economy overheating and inflation.

In so doing Fed speakers appeared keen to emphasise that any talk of withdrawing stimulus is a long way off.

Inflation concerns/tapering

Any signs that the Fed is concerned about the potential re-emergence of inflation? Will that lead to tapering talk?

In testimony before the House Financial Services Committee, Federal Reserve Chair Jerome Powell emphasized his view that the economy has a long way to go in the recovery and signs of prices rising won’t necessarily lead to persistently high inflation. He emphasised that Fed policy “is accommodative because unemployment is high and the labour market is far from maximum employment”. In that testimony he seemed to insist that recent signs of inflation were temporary or down to base effects and were indicative of ongoing price rises. Those sorts of influences don’t “necessarily lead to inflation because inflation is a process that repeats itself year over year over year,” he said, rather than a one-time surge.

Earlier in the week Powell said that for some of the sectors that have been most adversely affected by the pandemic, prices remain particularly soft.

During his testimony, Powell voiced confidence that the Fed would ultimately succeed in lifting inflation and getting it to average 2% over time, but added that the task is potentially a long and drawn out one saying that “[w]e live in a time where there is significant disinflationary pressures around the world and where essentially all major advanced economy’s central banks have struggled to get to 2%.” Powell added that “it may take more than three years” to reach that goal.

His comments were reiterated elsewhere by Fed Vice Chair Clarida who expressed “cautious optimism” on the outlook but said it would “take some time” to restore the economy to pre-pandemic levels.

Fed Governor Lael Brainard warned that inflation remained “very low” and the economy was still far from the Fed’s goals.

Rising bond yields

Is the Fed concerned that there may be some sort of message in rising bond yields? Will rising bond yields potentially frustrate the Fed’s objectives in terms of employment and inflation?

At this point, the Fed seems to be charting a fine line of portraying the move up in yields as a natural consequence of an improving growth outlook and a statement on confidence of a robust and ultimately complete recovery in the offing on the one hand, while at the same time maintaining a dovish tilt emphasising that the economy is a long way from the Fed’s employment and inflation goals, and that it is likely to take some time for substantial further progress to be achieved. The Fed continues to suggest that QE will continue at its current pace until substantial further progress has been made toward their goals.

RBA and the rise in bond yields. Wage cost index data

In a slight difference of approach from the Fed, who doesn’t seem to be overly perturbed by the rise in bond yields, some press reports suggest that the RBA might seek to more aggressively defend its 3 year bond target currently at 0.10%. That might prove easier said than done if yields elsewhere keep rising unless the RBA wants to own the entirety of bonds on issue at that part of the curve. Arguably the RBA doesn’t need to be that aggressive. If yields are on the rise elsewhere then that will take pressure off the $A to appreciate and allow the RBA some ‘slippage’ in its target objective. The problem is that the magnitude of the move upwards in Australian bond yields is greater than that elsewhere.

Further tolerance of ‘slippage’ would be occasioned by upside surprises in wage data, as with yesterday’s release of wage cost index data for December. It is true that wage growth remains some way away from where the RBA would like to see it, and there were some compositional ‘quirks’ in yesterday’s numbers, but the data is another ‘straw in the wind’ that the economy has weathered the storm much better than had previously been thought and that, accordingly, previous (“best guess” rather than “pledge”) guidance from Governor Lowe may be revisited at some stage in the future. It is too early for that yet, despite yesterday’s upside surprise, wage growth remains moribund and the unemployment rate, again while having bettered expectations, is still some way north of the “4 point something” cited by the Governor as getting close to capacity. Indeed, the Governor explicitly cited wage growth in articulating his and the Board’s expectation of no increase in the cash rate before 2024, noting that “wages growth will have to be materially higher than it is currently” – still true after yesterday’s numbers. And “[t]his will require significant gains in employment and a return to a tight labour market”.

All said and done, I don’t think, therefore, that there is much doubt that there is a fair bit of anxiety up at Martin Place at the moment about the magnitude of the move in Australian bond yields over the last week or two compared to that which has taken place elsewhere.

As for next week’s RBA Board meeting, I don’t expect any new policy measures or changes to existing ones. I expect, however, that the tone of the Governor’s Statement will be very similar to February: an upbeat assessment of economic conditions but an aggressive statement that the RBA intends to maintain historically high levels of monetary accommodation. Despite slightly better than expected wage growth data, wage growth is still well short of where the RBA might wish it to be and the unemployment rate, again while having bettered expectations, is still some way north of the “4 point something” cited by the Governor as getting close to capacity. I expect the Governor to reiterate his and the Board’s expectation of no increase in the cash rate before 2024, and assert a strong desire for wages growth to be materially higher than it is currently and that this will require significant gains in employment and a return to a tight labour market.

For the RBA, with an eye firmly on the AUD, erring on the side of ‘too much’ rather than ‘too little’ is at this stage the least risky path.

RBNZ

The RBNZ, while welcoming the reasons behind rising bond yields, such as higher growth and inflation expectations, sought to remind the markets that if pricing went “too far” it might take action to push back on those developments and ease financial conditions further. In so doing Governor Orr sought to remind the market that it could still reduce the OCR further and sought further to underline that preparations for a negative cash rate are complete. The latter is a step of dubious utility, and implies another twist in RBNZ thinking on the efficacy of negative rates, but nevertheless Governor Orr presumably thought it a point worth making. Perhaps the bigger message the RBNZ sought to impart was that, despite some nascent market commentary to the contrary, it wasn’t even close to thinking about any tweaking of financial conditions firmer (some commentators had expected the RBNZ to start lifting rates from August 2022).

By Steve Miller, Adviser

The post Will current Fed policy lead to inflation? appeared first on AdviserVoice.

Steve Miller

The following are some comments from Steve Miller, an adviser at GSFM, on inflation and bond yields. He also looks at the minutes from the Federal Open Market Committee (FOMC) on inflation, and upcoming data on unemployment.

1. Inflation and bond yields

The sharp rise in bond yields and attendant yield curve steepening appear to reflect rising concerns about the potential emergence of inflation down the track. There are both structural and more “cyclical” influences at work that might explain the current focus on rising inflation.

Structural: arising from the reversal of the two great structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (as well as that for goods and services) and baby boomer workforce participation, are on the cusp of reversing. The fall of the Berlin Wall in 1989, combined with the dramatic increase in prominence of key emerging markets, particularly China, at a time when baby boomer participation in the workforce was at its highest, and female participation was secularly increasing, constituted a massive global labour supply shock. The result was a decline in wage growth and a structural deflationary trend on a global scale. That is now coming to an end. Add to that a backlash against globalisation of markets, re-regulation and supply chain constraints it may well be that structural forces are no longer as powerful in keeping inflation dormant. Of course, there are still structural inflation suppressors such as technology and demographics but certainly the structural risks now begin to look a little more two-way.

“Cyclical”: arising from concerns in some quarters that with a US budget deficit already at a peacetime record of around 15-16% of GDP, the $1.9tr Biden stimulus is “too much” and will lead to an economy that is “on fire”, according to Obama Treasury Secretary and sometime chief apostle of fiscal stimulus Larry Summers. With the economic fallout not as great as might previously have been feared and given the impressive progress on the vaccine front the shortfall in GDP as a consequence of the pandemic may be much less than previously thought. The Biden package may rapidly use up available slack in the economy and have inflationary consequences, particularly given the historically extreme levels of monetary accommodation and increased central bank tolerance of inflation. Rising commodity prices (including oil) and some upside surprise in recent inflation prints in Europe and the US (albeit of modest dimensions) underscore those concerns.

Last night’s January PPI release continued the run of upside surprises with core PPI coming in at 2.0% yoy versus 1.1% expected and 1.2% in December. Strong January retail sales at 5.3% versus 1.1% expected and -1.0% in December also potentially add fuel to Larry Summer’s warnings of an economy “on fire”! 

Quiescent inflation is pivotal to the ‘cheery narrative’ that has driven equity markets to historic highs. While ever inflation is quiescent, the more anchored are bond yields to their current levels and equity valuations remain within the realm of plausibility; if not then that cheery narrative is called into question.

Bond supply: the other issue that might be driving bond yields higher is to do with the likely issuance needed to fund those deficits, or ‘bond supply’. At 15-16% of GDP the US budget deficit is about $3tr. The Fed at the moment is buying around $1tr annually as part of its QE program which leaves a further $2tr to be financed at least in part by bond sales to the public. Given the immensity of that task it may be that higher bond yields are needed to entice the requisite number of buyers into the market. Were a Powell led Fed disposed to increase its purchases, that would limit the rise in bond yields and therefore any appreciation in the $US, but it has a lot of bonds to buy to achieve that outcome.

The latest FOMC minutes seem to downplay inflation concerns… 

2. FOMC minutes

The FOMC minutes indicate that the Fed believes that any acceleration in inflation is likely temporary noting that one-time moves in relative prices and / or base effects “could temporarily raise measured inflation but would be unlikely to have a lasting effect.”

The FOMC also  did not see the conditions for reducing their massive asset-purchase program being met for “some time”. Noting that employment and inflation goals were a long way from where the Fed would like and “[w]ith the economy still far from those goals, participants judged that it was likely to take some time for substantial further progress to be achieved.”  Such language is consistent with previous statements from FOMC members, including Chair Jerome Powell, that sought to dismiss any notion that tapering is on the Fed’s policy radar.

There have been reports that Fed Officials are looking to refine their newly adopted average of ‘flexible’ inflation target, by looking at including a suitable ‘averaging’ period and whether there is a ceiling, in order to help clarify uncertainty around the inflation outlook.

3. Coming up

Australian labour force figures are released today with the Bloomberg consensus looking at the addition of 40k jobs in January and for the unemployment rate to tick down one-tenth to 6.5% from 6.6%. Maybe a bit of upside risk in those numbers for employment and downside for the unemployment rate.

Such an outcome should be viewed positively by the market particularly given forecasts from March last year were looking at 10% unemployment rate at the end of 2020.

That said, such numbers are unlikely to move the dial for the RBA given wage growth remains moribund and the unemployment rate, even while having bettered expectations, is still some way north of the “4 point something” cited by the RBA Governor as getting close to capacity. Indeed, the Governor explicitly cited wage growth in articulating his and the Board’s expectation of no increase in the cash rate before 2024, noting that “wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market.”

The post Structural and cyclical influences driving focus on rising inflation appeared first on AdviserVoice.

Steve Miller

Climate change is gaining traction as a global policy initiative, a key risk factor and an emerging investment theme, according to the BlackRock Investment Institute (BII) Australian strategist, Steve Miller.

In the lead up to next month’s UN Conference on Climate Change in Paris, the BII looks at the likely impact of climate change on investors and investment outcomes, and the winners and losers in the race to reduce carbon footprint.

“Even if you are skeptical of global warming and its causes, no one should ignore that significant regulatory, economic and technological factors make this a major investment issue,” Mr Miller said.

“Investors, corporations and governments are focusing on the risks and opportunities, as well as how best to tackle the challenges that are arising. These profound changes have the potential to affect asset prices in all areas for a long time to come.”

Dr Joanna Nash, research analyst in BlackRock’s global Scientific Active Equity team said: “Our research has shown a link between reducing carbon intensity (as measured by carbon emissions divided by sales) and improved firm productivity.

“We believe that if firms take a holistic view of the way they operate their businesses, it is a mark of operational and management quality. We are now looking to extend this same line of research to firms that are improving their water usage.”

Highlights

Climate change risk has arrived as an investment issue. Governments are setting targets to curb greenhouse gas emissions. This may pave the way for policy shifts that we could see ripple across industries. The resulting regulatory risks are becoming key drivers of investment returns.

The momentum behind mitigating climate risk in portfolios appears to be building. Long-term asset owners worry about extreme loss of capital and/or ‘stranded’ assets (write-downs before end of their expected life span). Do securities of companies most susceptible to physical and regulatory climate risks already trade at a discount to the market? BlackRock has not observed such a discount in the past – but could see one in the future.

Global insurers have led the way in pricing natural disaster risks. A huge US storm in 1992 (Hurricane Andrew) almost wiped out the industry, leading to a revolution in how it underwrites risks through an influx of capital, use of big data and increased capital requirements. Other industries may need to catch up.

BlackRock views environmental, social and governance (ESG) excellence of asset owners as a mark of operational and management quality. It means responsiveness to evolving market trends, resilience to regulatory risk, and more engaged and productive employees.

Divesting from climate-unfriendly businesses is one option. The biggest polluting companies, however, have the greatest capacity for improvement. Engagement with corporate management teams can help effect positive change, especially for big institutional investors with long holding periods.

Climate change related data can be used to measure physical and regulatory environmental risks, to mine for alpha opportunities or to reflect social values in portfolios. As examples, the report analyses the carbon intensity of an insurer’s corporate debt portfolio and points to research that ties improving carbon efficiency to equity outperformance.

Securities markets are evolving to include emissions trading and green bonds, enabling investors to limit carbon exposures in portfolios and direct capital to projects that reduce emissions. Putting a price on carbon emissions is key for determining the value of energy-intensive industries. Carbon prices are mostly driven by policy and currently offer little incentive to force emitters into palliative action and consumers to switch to non-fossil fuels.

Efforts to mitigate climate change will produce winners (potentially China and India as fossil fuel importers) and losers – but maybe not always the obvious ones. The oil industry and energy-exporting countries may look like losers, yet low-cost operators should do fine as de-carbonisation will likely be gradual. Assets that may benefit from a transition to a low-carbon economy include renewable infrastructure debt and equity. BlackRock also likes selected companies specialising in energy efficiency and clean technologies.

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