To the great surprise of many doomsters, particularly in the media, January has turned out to be one of the best first months for financial markets in several years. Both share and bond prices rose strongly, potentially signalling that the turning points in inflation and its future expectations have been reached and passed. Indeed, all significant recent statistics have confirmed that the trend is now pointing towards gradually lower inflation numbers as the year progresses.
This said, it is noteworthy how core inflation remains persistently too high in light of still-tight labour markets across western economies. Much has been written about this topic and the origins of the apparent change in potential employees’ attitudes towards work. Only time will tell but an increase in US jobless claims in the months to come would, astonishingly, be seen as a positive by financial markets, reducing the risk of a wage-price spiral.
What has also helped markets is the improved liquidity picture that began when the external value of the US dollar began to drop during the fourth quarter of 2022. This was broadly accompanied by falling bond yields across the world, thereby improving the previously tight liquidity position that had served to spook markets throughout last year. That world stock markets bottomed out at the same time is no coincidence as bond market activity resumed in all parts of the markets, especially those for corporate bonds, including high-risk issuers.
Chinese and Indian markets also rose strongly in anticipation of the re-opening effect resulting from the abandonment of Covid-related lockdowns in China.
One important caveat exists in the shape of growing discussions around the fate of the US debt ceiling, also known as the debt limit. In order for this debt ceiling to be extended later this year, it requires the approval of Congress which is admittedly controlled by Republicans but threatened by a hard core that could fail to extend the debt ceiling. This would have the potential of losing the US its prized triple-A sovereign bond rating, which has happened in the past.
This situation has triggered the use of the so-called Treasury General Account (TGA), a form of liquidity reserves used to finance the day-to-day business of government via the banking system. For some observers, the improved liquidity position and falling bond yields mentioned above are the artificial result of the TGA being put to use. Once this ceases, as some observers would claim, the previous liquidity squeeze would once again kick in. However, it is not clear what portion of the TGA ends up in financial markets rather than in the broader economy. What is clear according to Bloomberg, however, is that US corporate pension funds are now sitting on a surplus of $1 trillion, and much of this is likely to find its way into the bond market in the coming months.
Meanwhile, commodity prices have returned to pre-Ukraine war levels. This would also argue in favour of lowering both inflation and its expectations.
Nonetheless, most central bankers remain hawkish even if their rhetoric has subtly changed. For them, labour market tightness must recede and inflation in the service-related parts of the economy must abate. For bond markets in the US, on the other hand, wage growth is already pointing downwards. For central bankers, one risk lies in the possibility that rising asset prices would spur the feel-good effect and generate a positive feedback loop that would slow down falling inflation and inflation expectations through increased consumer spending.
This background has produced a clash of the titans, with bond markets signalling an improved inflation picture whilst central banks warn of rising interest rates to come. The question thus arises of who is in charge of the price of money: bond markets or central banks?
In a noteworthy recent interview with the FT, Philip Lane, a prominent member of the European Central Bank’s Executive Committee, described the role of bond markets as “anticipating” moves from their central banks. This expression is vague, either intentionally or not. Yet it is established that in the midst of historically very hawkish rhetoric emanating from world central banks, bond yields have dropped significantly during the year under review, dragging share prices higher in their wake. As the perennial search for yields continues now that their levels are more attractive, certain observers would claim that it is bond markets who are in charge, not central banks. These markets are not anticipating monetary policy by central banks, they are setting the tone and sending the signals for the central banks to follow. For some this seems academic whilst for others it will pave the way for an upward trend in stock markets, not to mention the share price performance of profitable and established long-duration businesses that fall into the asset class of quality growth. It will also spur debate around the question of whether the Big Long is waiting to return.
If the world economic growth picture is turning out to be more robust than feared as inflation dampens; if liquidity in financial markets is sustained as the year progresses; and if share price valuations are supported by more-moderate-than-expected fixed income yields, the three pillars that support financial markets could be back on an even keel.
January 31st, 2023
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