The power of words

Our Counterpoint 2021 mid-year update suggests that volatility could rise from here: there’s less policy ammunition left if things unexpectedly go wrong, such as new virus variants derailing the recovery; alternatively, stimulus withdrawal could prove difficult, potentially raising financial instability. But the main risk, to us, is too much of a good thing: stronger-than-expected growth and perhaps a more protracted period of inflation could lead to a repricing in the bond market, flattening yield curves as investors test central banks’ resolve to refrain from hiking rates in the near term. We’ve already seen some of this playing out following the latest Fed meeting: even moderate changes in policymakers’ forecasts could impact markets when unexpected. With investors hanging on its every word, rather than raising equity market volatility in and by itself, this could increase bond market volatility first and foremost, and affect riskier assets as a consequence, especially at a time when discussions around the tapering of asset purchases will likely intensify. But it’s unlikely to happen in a straight line, with alternating periods of rising bond yields and risk asset outperformance.

The impact of scaling back: Monetary policy normalisation is a difficult process to calibrate. Fed tapering could create extra volatility even if it’s not tightening as such. With inflation running above target for some time and the economy bouncing back strongly, it’s possible that markets will continue to doubt central banks’ commitment to anchor funding costs. These dynamics are key for the US, where the recovery is more advanced, but they apply to most other markets too, from the UK to the euro area, and have global repercussions – emerging markets could be affected as well, as central banks adjust policy in response, as we’ve seen in Russia, Turkey, Brazil and Mexico. These bouts of volatility may impact riskier assets, even though the underlying picture remains quite constructive.

Volatile volatility: Market volatility may well rise from here. Periods of relative calm will probably alternate with periods of market gyrations, making volatility more… volatile. This is because investors now have to second-guess more data-dependent central banks in the context of strong job creation, as shown by last week’s US payroll beat, and – albeit only temporarily, in our view – rising inflation. Plus, the slowdown in the pace of asset purchases by the Fed, European Central Bank and Bank of England may be taken by the markets as signs that rate hikes aren’t that far behind, even though policymakers claim this isn’t their intention. To be clear, we’re not saying that bond yields will never rise. Rather, we do expect a pickup over time, but not that much for the time being.

Here’s why this matters:

Making a move: The epicentre of any increase in volatility is likely to be the rates market, which could affect riskier assets via a higher discount factor. Rather than measures of stock-market volatility, such as the VIX, the key gauge here is the MOVE, a market-based measure of uncertainty about interest rates. It could rise as the Fed normalises its policy. While our base case is more dovish, the market is assigning a good chance to US policy rates rising from late 2022, after the Fed has first announced and then completed a tapering of its bond purchases. How much the MOVE will eventually rise will depend on how transitory inflation looks to bond markets and how in control of the situation the Fed appears. This may mean periods of dollar strength, especially against low-yielding currencies such as the euro, alternating with periods of moderate dollar weakness.

Staying the course: Our framework remains one where expectations of relatively fast monetary tightening will ultimately be disappointed. As long as real rates stay negative (our forecast), this is stimulative. We do see continued inflation in asset prices, but we think consumer price inflation will probably stay close to central bank targets after the current temporary spike. Within a reasonable range, central banks will likely allow long-term bond yields to rise provided that this is because of faster growth, while anchoring short-term yields at low levels. Riskier assets, most importantly equities, remain well supported, given a backdrop of strong economic and earnings growth. Our tactical risk-on positioning has overweights in US equities and UK small-caps over bonds, and is also overweight Asia high yield and emerging market sovereign bonds, offering attractive carry.

Meanwhile, here’s what we’re watching this week…

One minute on the minutes: At the June press conference, Fed Chair Powell indicated that the committee had talked about talking about potentially tapering their asset purchases. However, he did not lay out any specifics on timing. The minutes later this week could help clarify when the policymakers expect that the “substantial further progress” threshold could be reached and whether there’s already been any discussion about the longer-term strategy for the central bank’s balance sheet. Data-wise, the ISM services index is likely to stay close to a record high for the fourth consecutive month, given ongoing reopening. Investors may also focus on whether the current conditions component of the German ZEW survey finally turns positive for the first time since June 2019. In China, producer price inflation is expected to remain elevated. But sequential growth momentum is now easing, partly due to efforts from Beijing to curb the surge in commodity prices.

Daniele Antonucci | Chief Economist & Macro Strategist