Jupiter: Weaning markets off the liquidity drug

There’s nothing more magnificent than watching a central banker in full retreat from an entrenched position while still fully engaged with the enemy, all the while laying out defensive smokescreens and spitting policy chaff to bluff his own side he’s fully in control. Jay Powell – Chair of the US Federal Reserve (Fed) – is an economic General under pressure.

This week, the Fed set out its stall to deal with inflation. It was a moment Powell had probably wished would never arrive. Remember, he has a target (shared with other major central banks including the Bank of England, the European Central Bank and the Bank of Japan with their own economies) to manage the US economy with an inflation rate of 2%. As Covid roiled around the world and, recognising the potential for future inflation shocks, Powell had unilaterally moved the goalposts for the US at the 2020 Jackson Hole symposium from 2% inflation as a nominal target to 2% as an average (without defining the period over which that average would be measured; how long is a piece of string?).

Thanks to the duration of the pandemic and the significant knock-on effects to both the US and the broader global economy creating simultaneously unusually volatile demand and major economic dislocation, he finds himself confronted with inflation (as measured by CPI) of 7%. Further, with another of his key targets being employment, he sees the labour market has substantially recovered from the 15% unemployment rate recorded in the spring of 2020 to a jobless rate back below 4% (historically, economists have regarded 4% unemployment as being the definition of ‘full’ employment: what remains is either not seeking work, unable to work or unemployable; however, it is all very well being employed, whether one is productively employed is a different matter; it has been an enduring blight across the western world that the effect of more than a decade’s worth of zero interest rates and quantitative easing has propagated an inefficient economic system with surplus labour and surplus capital and a commensurate deterioration in productivity: the ‘zombie’ economy).

And why is he in retreat? Because, in common with his fellow policymakers, even as recently as six months ago the party line on inflation was “nothing to see here! Move on, please. Move on!”. It was his stated aim in his forward guidance that monetary policy would remain loose with effectively zero interest rates persisting at least until the end of 2023 and possibly into 2024. Stability was the name of the game. Markets are perfectly capable of making their own minds up about the inflation risk and, while not panicking about it, they were well ahead of the central banks in preparing for it, pushing bond yields up in anticipation that the Fed and others would be forced to give way to reality and raise interest rates.

So far, the markets have been right, the central banks wrong: the Fed has had to concede that rates may rise as soon as March 2022 and the markets are pricing in a full percentage point’s advance within 12 months. This week, headlines reporting “Markets react to hawkish Fed” are wide of the mark in implying the Fed is in control; however much the Fed likes to present the case for leadership in terms of “aggressive” rate rises, the fact is that it has been asleep at the wheel and, having been jolted awake before the impending car crash, has been forced to execute a screaming U-turn, trying brazenly to pass it off that this was always the intended direction of travel.

A complex backdrop 

The Fed’s position is complicated by several factors potentially pulling in opposite directions. First, thanks to Omicron, short-term US economic activity has taken a sharp dip, as measured by the real-time fast data (e.g. credit card usage, restaurant bookings, retail footfalls etc); second, there is a fast-developing geopolitical crisis in Europe with further ramifications potentially for volatile commodity prices, particularly energy and wheat; and third, however independent the Fed is from government, the hapless Powell is under political pressure from Joe Biden to get a grip on inflation ahead of the mid-term elections in which Biden faces the real possibility of losing what little remains of his political authority for the rest of his presidency. 

Markets concerned with Ukraine… 

As to the markets’ reaction in which equities have retreated year-to-date (particularly highly rated ‘quality growth’ names) and bond prices too (bond prices move inversely to their yield), investors are concerned about the developments in Ukraine. However, it seems increasingly likely that for all the sabre-rattling, NATO will do what needs to be done to shore up its own position against Russia, the usual cocktail of sanctions and dispatching diplomatic missiles, bolstered by sending troops to eastern flank Alliance member states and some weapons to Kiev, but will stop short of direct military intervention in Ukraine itself unless NATO is directly provoked. In the event of invasion, and however much it might become a bloodbath, it is between Russia and Ukraine; unless the prevailing mood changes there is no appetite to put boots directly on the ground to repel boarders. As a non-NATO state Ukraine will be essentially on its own, hung out to dry just like Czechoslovakia in 1938. An analysis of appeasement is not for today’s musing, but make no mistake, appeasement is what it is. 

…but preoccupied with monetary policy 

While Ukraine is a concern, the greater market pre-occupation is central bank policy, and specifically the steps which must be taken before interest rates can rise. As we have described on many occasions, and as is already being practised by the central banks of Canada, New Zealand, Sweden and the UK, who have all already begun their rate-rising cycle, there is a logical, linear progression: 1) taper the bond purchasing programme; 2) stop it entirely; 3) raise interest rates. It is perfectly feasible that 2) and 3) are simultaneous as was the case here in the UK in December, but to have rates rising while still pumping in liquidity is a monetary contradiction. With all due respect to those nations above, they are largely irrelevant; it is the Fed which really counts. 

Weaning markets off the liquidity drug 

Over the decade or more since the Global Financial Crisis (GFC), markets have become hooked on liquidity supplied by central banks. It is the monetary equivalent of methadone after they have been weaned off the hard stuff: the system becomes dependent, extra injections obey the law of diminishing returns but take them away altogether and the risk is relapse and significant cold turkey.

All central banks responded to the pandemic, hosing liquidity into the system through prodigious bond-purchasing programmes; at its peak, the Fed’s own balance sheet had more than doubled from under $4 trillion to $8 trillion in months (governments responded with fiscal measures too, a major difference from the GFC when most were missing in action; however necessary, they added to the inflationary pressure). But the significant and seminal moment was March 23, 2020 when the last part of the Fed’s belated rescue package was put in place as it announced that its bond purchasing programme would not only cover US government treasuries, and investment grade corporate bonds, but would extend into the high yield sector (what used to be known officially as ‘junk bonds’). Essentially, the Fed backstopped all risk markets, thus allowing the dangerous inference that investment was a risk-free exercise.

In heading in the opposite direction, the Fed has to manage a shrinking balance sheet in such a way that markets don’t implode. Further, in its newfound impetus to take robust action to slay the spectre of inflation, it runs the risk of being so aggressive that it kills the economy too. Usually a good indicator of how far rates will shift is provided by the ‘neutral rate’, i.e. the rate of interest at which the effect is zero, neither gunning the engine nor applying the brakes. When the supporting data is leaping about like a demented flea, when confronted with inflation of 7% and an economy which shrank by 3.6% in 2020 and bounced back by possibly as much as 5.7% in 2021, both well outside the normal bounds of GDP travel, and is now disrupted by Omicron, establishing the neutral rate is a significant challenge in its own right. For the Fed, it’s not quite like pinning the tail on the donkey while blindfolded, but it’s not far off.

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.

Postscript: to our political masters and the Establishment, a plague on all your houses 

We referred to Ukraine above. It is serious; even Sleepy Joe Biden rates it the most dangerous threat to world safety since the Second World War. And yet here in the UK the Westminster kindergarten and the BBC (the national broadcaster, let’s not forget) are hard at play obsessing in full flight of moral indignation about birthday cakes, warm wine from plastic cups and retro-vol-au-vents at No 10. Whatever the rights and wrongs of Covid lockdown rules and who broke what when and said what to whom, Putin must rightly be laughing at us in disbelief; Ukrainian squaddies hunkered behind their AK47s in their sodden, freezing cold slit-trenches and facing potential oblivion, despairing of us. We have truly lost the plot.