Merlin Weekly Macro: Central bankers in a bind

Market tensions and nervous energy…..

In these weekly Merlin Macro musings we have often discussed the tensions between markets and central banks about the outlook for interest rates and what type of future monetary policy we might expect. Markets are not a homogenous entity, nor are the central banks: investors have widely differing views on the economic outlook; central banks must deal with their own national idiosyncrasies as well as taking account of global economic factors. The tensions are natural and inevitable: investors are the providers of capital; central banks set the benchmark cost through the official interest rate; investors’ appetite for risk and their varying assessments of that future risk in a dynamic economic environment in which certainty is never assured determines the extent to which the market rate for that cost of capital fluctuates around the benchmark. Liquidity is the market’s oxygen. Data is the empirical measurement of the economy’s health. The barometer of all those tensions is measured in volatility.

Sometimes, as in 2021 when the inflation bubble was rapidly expanding, markets were well ahead of the central banks in recognising the incipient risk. Almost everyone underestimated the order of magnitude of the peak inflation rate. But in a case of shoot first and ask questions later, investors took the view that it was better to assume that inflation would significantly exceed the central banks’ 2% target, possibly for some time, rather than rely on the seemingly coordinated but self-serving narrative from the US Federal Reserve (Fed), the Bank of England (BOE) and the European Central Bank (ECB) that, really, there was nothing to be worried about: ‘People, it’s all under control, it’s a transitory event and we know what we’re doing’. More recently as the pendulum has swung back, central banks have been reasserting their authority, tempering the markets’ determination for interest rate cuts and leaving investors on the back foot.

…. with real consequences

As we have discussed on many occasions, however technical and complex, these factors are neither a nerdy academic exercise nor do they live in a vacuum divorced from reality. Bond holders incurred considerable losses in the period between mid-2021 and late 2023 as bond yields rose sharply (and prices fell equally precipitously) ahead of and during the interest rate hiking phase (remember, in the aftermath of the massive injections of central bank liquidity through quantitative easing when base rates were also slashed to zero to deal with the pandemic, a third of all government bonds in issue globally were on a negative yield where the investor was paying the borrower to take out more and more loans; it has been a long journey). Holders of those bonds need to recover the losses, the only way of achieving that being to drive yields down again with prices going in the opposite direction. Equally, with bond yields now at close to the highest levels they have been since 2007 before the Global Financial Crisis, investors wanting to commit fresh capital in anticipation of “locking in” prospective fixed income returns are keen to ensure that in price terms they are timing their investment astutely and getting in at the bottom.

When the wood is lost for the trees

This week, FT columnist Chris Giles asked whether fixed income investors, especially in government bonds, have become too eyes-down, focused on poring over every shred of economic data as it is published. Growth; headline inflation; wages; employment statistics; purchasing managers’ confidence indices; retail sales and many more: there is a regular tsunami of numbers available to suit all agendas.

Or should they step back and take a more holistic view of the economy? Another way of looking at it is that, rather than being short-termist and giving the impression of clutching at straws, should investors put themselves in the shoes of the central bankers whose policy they are constantly trying to second guess?

In many ways what we have seen this week proves the point. Among the major reserve currency central banks, investor focus is drifting away from the Fed towards the ECB, which seems more likely to break cover first by reducing interest rates. We have been confronted with an apparent sea of confusion and inconsistency. French wages are still growing at 4.7%; wage inflation tends to be a ‘stickier’ component than some others such as commodity prices, which tend to be more cyclical and volatile. The Governor of the Bank of France was dismissive that wages accelerating at more than double the headline inflation target should deflect the ECB from beginning to cut eurozone deposit rates by a quarter point at its policy meeting on June 6ᵗʰ. Even closer to the ECB’s decision making process, in an interview with the FT, the ECB’s own chief economist, Philip Lane, dropped a heavy hint that a June cut is all but a done deal. Since he offered that view, the latest monthly German headline inflation data for May saw a rise in prices from 2.2% to 2.4%; not a disaster, it was largely anticipated, but it remains an unhelpful shift in the wrong direction (not least because it was the first reported rise in the German inflation rate since December and, consistent with the recent UK trend, it is the services sector which is giving cause for concern accelerating from 3.4% to 3.9%). The broader eurozone inflation data has also shown a reversal, rising from 2.4% in April to 2.6% in May, with largely the same characteristics driving that increase.

The answer my friend is blowin’ in the wind

Data pointing one way, kite-flying policymakers pointing another. Now look at the markets: today, according to Bloomberg, it is ‘priced’ as a 97% probability, almost a racing certainty, that the ECB will indeed cut its deposit rate next week by a quarter point. But the reaction in bond yields says something very different: over three trading days, the yield on the benchmark German 10 Year Government Bond (there are no eurozone-issued bonds as such) has risen from 2.53% through 2.7%, its highest level since November last year. The optimist would say markets have all bases covered, whatever transpires they can say “I told you so;” the less generous observer would say they’re scrabbling in the dark, not sure if it’s snowing or Tuesday. As it is, we will know the ECB’s answer soon enough as to whether the deposit rate stays at 4% or is reduced to 3.75%.

Back to the future? Framing future trajectory: real neutral interest rates

As they say, timing is everything. But let us ignore for a moment exactly when the ECB will cut its rate of interest and take a step back and adopt a more strategic view. This applies to all the principal central banks as we approach what is an inflection point in monetary policy. What we have been discussing here is all framed in the language of nominal rates of interest. The true focus is on inflation-adjusted real interest rates. Investors and policymakers make projections about inflation rates to judge the trajectory of future real interest rates and then frame it in the context of the ‘neutral’ rate. That is to say, the inflation-adjusted level which would cause the economy neither to accelerate nor slow down. There is a temptation to think of the neutral rate as a constant, an anchor point; it is not and cannot be because the economy is dynamic. As we know, predicting long-term GDP is little more than an educated guess; an analogy of predicting long-term real neutral rates is like the child’s party game of “pin the tail on the donkey while blindfold”, only in this case, instead of being static, the donkey’s backside is moving up and down. The chance of nailing the tail in the right place is not high.

We have been used to negative real rates for a long time (in fact, in the eurozone there was a period of exactly seven years from July 2015 when nominal deposit rates were negative too). Today in the UK we have a positive real rate of a smidge over 3%, a gap that has just widened by a percentage point with CPI falling to 2.3%. Positive real rates are good for savers, less so for borrowers (it is a double hit for borrowers: not only paying a real positive rate of interest but as the inflation rate falls, they see the benefit of inflation eroding the real value of their borrowings slipping through their fingers). The question in the medium term for the central banks is after the rate cutting cycle begins, whenever for each that might be, how much room there is to keep cutting?

In the UK, BOE Governor Andrew Bailey and the International Monetary Fund have made free use of the term “rock bottom” when it comes to where they see rates going. “Rock bottom” implies zero. However, they are not looking at rock bottom in nominal terms (i.e. where the UK and the Fed both were in the pandemic, and -0.5% in the eurozone); they look at things through the lens of re-crossing the monetary Rubicon back into the territory of negative real rates but based on that neutral level. That of course depends entirely not only on future growth rates but also on what happens to long-term inflation relative to the mandated target of 2%. In this context it is possible that US, UK and eurozone interest rates may halve over next couple of years, all other things being equal. But there is no rationale for them going back to zero.

Reality check: we’re in the risk business!

In any case, lest there be any confusion, lending is a risk business. Lenders should expect a positive rate of interest on the loans they make. Bond holders too, to be compensated for the risk the issuer might default and the bonds are never redeemed. Easy access to cheap or free credit might be superficially seductive for borrowers but it is as irrational for lenders as it is lazy and economically inefficient in the broader financial system. The process of quantitative easing, in which the central banks actively bought bonds from the market and drove yields down, caused all asset classes to correlate positively (i.e. all to go up at the same time) as investors chased income at a reasonable price. However much investors benefited from abnormally high total returns by historic standards in that prolonged period of QE, in reality it was society which paid the price and is still paying it today. It is measured in terms of sky-high debt, lower productivity, the long-term drag on real wages and relative economic decline thanks to the cumulative frictional inefficiencies which the new paradigm fostered. To which add the growing societal divide between the “haves and the have nots” and the polarisation of politics; there are many contributory factors to those divisions, but prolonged ultra-loose policy was certainly one of them.

It was a debilitating experiment the last time, one to which we should not return. Except perhaps in extremis when all other options have exhausted themselves and even then only as a temporary measure.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.