After unleashing the strongest combined emergency package we have ever seen in 2020, central banks are now entering perhaps the most challenging phase of their COVID-19 response, trying to balance the economic recovery while at the same time having to reassure the markets they can control the threat of runaway inflation.
Faced with this task, it is perhaps no surprise that while most emergency measures remain in place, we are starting to see a shift toward a more hawkish tone as the world’s policymakers look to manage expectations and prepare investors for an inevitable weaning off stimulus.
It should be said that a ‘hawkish’ central bank is very much a relative term at the moment. In developed markets a hawkish central bank could currently be defined as one that is talking about the possibility of tapering its quantitative easing (QE) programme, whereas in emerging markets it generally relates to hiking rates by a level greater than market expectations. What is most important though is the signal, as market participants are trying to ascertain when the monetary policy tightening cycles will begin.
Emerging markets central banks are typically the first to become more hawkish. EM economies are generally more susceptible to inflationary shocks and steeper currency depreciations. In a scenario of rising commodity prices that brings about both stronger economic growth in a number of EM countries and more price pressures in consumer price index (CPI) baskets, it makes sense that these central banks move first. So far this year Brazil, Russia, Ukraine and Turkey (which was already in hiking mode) have moved monetary policy rates higher, while a number of others including China, Hungary and South Africa have shifted to a clear hawkish tone.
There has been very limited policy change in developed markets as of yet, but there are a growing number of central banks delivering more hawkish rhetoric. The Bank of Canada was the first to move in late April when it cut the pace of its bond buying programme and brought forward its guidance for rate hikes. More recently the Reserve Bank of New Zealand published its updated forecasts projecting monetary policy rates to rise in the second half of 2022, though RBNZ governor Adrian Orr did downplay the move by saying “you’re talking about the second half of the year, who knows where we’ll be by then” (the New Zealand dollar rallied 1% nevertheless). In addition, we’ve had similar comments this week from the Bank of England’s Gertjan Vlieghe, who said that it would probably take until Q1 2022 for the BoE to have a clear view of post-furlough scheme unemployment and wage dynamics, so “a rise in the Bank Rate could be appropriate soon after, along a slightly steeper path than in my central case”.
Which brings us neatly to the Fed and the minutes of its April FOMC meeting, which included the first subtle hint of future monetary policy tightening: “A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases”. IMF projections suggest the US is likely to have the strongest GDP growth of any major developed economy in 2021 at 6.4%, and the US also scored the smallest economic contraction in developed markets last year at -3.5%. Unless something unforeseen happens, it does seem likely that the Fed will increase its hawkish rhetoric in the coming months as it starts to gradually manage market expectations of an inevitable tapering.
The long gradual journey towards higher monetary policy rates has begun, which in our view should be welcomed; it is a control of inflationary pressure, the nemesis of the fixed income investor. Central banks in developed markets have only just started managing market expectations, and they will want this to be orderly so as to avoid any surprises that can result in the kind of ‘taper tantrum’ we experienced in 2013. It is a fine balance policymakers need to strike between supporting the recovery and keeping inflation expectations in check, and over the next few months we will get a better idea of whether the inflation building up is merely transitory or more fundamentally entrenched.
Again, until we get more clarity we think running a little more cash to give flexibility over the leaner summer months is a sensible strategy, while maintaining an overall bias to credit.
