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Market Update
July 31, 2023

Economic News Domination

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Week Ending 28 July, 2023

Economic news was dominated this week by interest rates from three, key nations/regions and it has not been without its surprises:

US: The Fed raised rates +0.25% (as expected) to take the policy rate range up to 5.25% to 5.50%. What surprised analysts and markets was the lack of forward guidance. Their tune was essentially there may – or there may not – be more to come. It was an almost unchanged press statement from June’s and gave no hints of an early pause. Back in the May statement their statement was clear - there was a likelihood of a pause in tightening in June – which is indeed what followed. Powell stressed any further action will be data dependent and gave no clue about policy action come 20th September. In the statement, the Fed doesn’t sound too concerned by recent declines in bank lending, it no longer expects a recession and he hinted, in future, QT (Quantitative Tightening) could continue while cutting rates. The Fed is in a quandary - inflation keeps edging down (on the back of energy price inflation) but the consumer seems to be holding up despite elevated core inflation. Markets are pricing less than a 50% chance of any further hikes while 18% argue for a September hike. For 2024, they are pricing in total cuts of 1.25% while the Fed itself expects them to drop much more slowly. Policy error is the Fed’s main concern at this juncture – so “data-dependent” it continues to be and we shouldn’t be surprised by it. Bond volatility will remain elevated. An interesting observation is around manufacturing – while this remains weak globally, in the US it picked up +2.7% to 49 which suggests inventory rebuild might be starting again. It could be a one-off but Q2 GDP was better than expected rising +2.4% (expectations: +1.5%). Consumption and corporate spending were the big contributors (consumption grew at 1.6%). Residential construction was still a drag. It could well be we are seeing the first signs of the inventory drag beginning to clear out. Inventory plays a big part in GDP data. Looking at inventory levels vs sales, we are back to pre-pandemic levels.

EU: The ECB raised rates +0.25% to 3.75% (Deposit Facility) and 4.25% (main Refinancing Rate) for a ninth, consecutive meeting. This was expected. The door for more tightening has not been shut if officials judge more action is necessary to return inflation to the stated 2.0% target (code for “data-dependent”). Inflation has been coming down (currently 5.5%) and further declines are expected. Europe looks weaker than the US. The € has had a strong run this year and is up +3.55 vs the US$ and investors are strongly positioned for the € - but investors are questioning the will of the ECB in its fight against inflation – which to my mind is harsh. They are rightly distinguishing between the controllable elements of price rises which can be influenced by rate hikes vs those beyond their control. Unlike the Fed, they don’t seem to be in the same hurry and wish to avoid being where the Fed is now (lots of hikes but limited impact). The ECB can afford to lag the Fed. If nothing else, it slows down the advance of the €, something that is welcomed for EU exports. At a time when Germany is trying to diversify itself from China and embark into alternative markets, it can’t afford to price itself out of the market via expensive, FX-driven goods.

Japan: The BoJ shocked markets with a policy tweak to its YCC (Yield Curve Control) by allowing “greater flexibility” to its monetary policy. It sent the Yen whipsawing vs the US$ and equities and bonds took a dive. The issue here is that this tweak was not expected so soon. YCC is a long-term policy that targets an interest rate and then buys and sells bonds to achieve that target rate. Currently, it targets 0% on 10y JGBs. It’s policy statement yesterday said it will allow these same bonds to fluctuate +/- 0.50% either side of its 0% target but then went on to say the BoJ will offer to buy 10y JGBs at 1% yields through fixed-rate operations. In effect, they expanded the tolerance band by a further 0.50% to 1.00%. Contrast this with what Japan has been used to for all these years/decades (remember, it has been 0%), that’s huge! It immediately begs the question whether rate hikes will follow. The BoJ expects core inflation to reach 3.0% in FY to March 2024 (up from 1.8%) and added it sees upside risks to this forecast. Governor Ueda’s press conference was vague. When asked if this was a shift from dovish to neutral, he said “That’s not the case. By making YCC more flexible, we enhanced the sustainability of our policy. So, this was a step to heighten the chance of sustainably achieving our price target”. Overall, this benefits the Yen (becomes stronger with time) and does look like the end of YCC. It also means by allowing bond yields to rise, rate hikes can follow later purely as a form of catch up. Market operations remains the main tool for rate control. In its monetary policy statement, the BoJ will purchase ETFs and J-REITS as required with an upper limit of Y12tn. It will buy corporate bonds at the same pace as pre-Covid allowing it to return to Y3tn pre-covid. 2% remains its overall price stability target. In summary, it’s the suddenness of this announcement that’s surprising – not the mechanism! Japan’s bond market is huge – multi-trillions, albeit largely domestic-owned. The foreign-owned portion is negligible. This is a first step in gravitating away from YCC. In so doing, it has – I believe – already identified what it can stomach when it comes to bond price moves and resulting losses. Being the principal owner of them, it can absorb the losses. If it had hiked rates instead, the Yen would have gone AWOL and domestic bond markets would have been in disarray. This is the best it could hope for in terms of volatility. The surprise was the lack of guidance around this – some form of communication would have been helpful. Instead, it conveys the impression their fight against inflation is not going to plan!

Two other points worth noting:

  1. US Regulators have proposed sweeping changes to capital rules for large banks (assets over $100bn). These proposals are estimated to result in an aggregate 16% increase in CET1 (Common Equity Tier 1) capital requirements. CET1 measures an institution’s presumed financial strength and its buffer against recessions or trading blowups. The proposals will be primarily aimed at the biggest banks with more complex structures. They will have until July 2028 to fully comply. The proposals would also force more banks to include unrealised losses and gains from certain securities in their capital ratios – thus eliminating a loophole enjoyed by regional banks. Entities have until 30Th November to put forward their comments – pushback is expected. Overall, it’s one more step to diluting the role of banks even further. Increasingly, they will focus on lending activity skewed to larger organisations while SMEs will struggle even more for funding. This opens up the door even more, in my view, to shadow banks (Private lending) – after all, where else can they turn?
  2. We often speak about different generations i.e. WWII (1922-1927), Post-War (1928-1945), Boomers I (1946-1954), Boomers II (1955-1964), Gen X (1965-1980), Millenials (1981-1996) and Gen Z (1997-2012) but something that doesn’t get analysed is the wealth effect. In the US alone, Baby Boomers (BBs) hold half of the nation’s wealth (an estimated $140TN). Boomers I hold the most ($78.3TN). In terms of what they will actually pass on (after adjusting for their own spending), Fortune estimated the figure could be some $53TN. That’s huge! I have often wondered whether analysts take this into account in their forecasting and impact on economies and, if so, to what extent. It just shows how complex a society we have become and the extent of “cross-subsidisation” that takes place. These transfers are wealth-enhancing on a massive scale. For example, a Gen Z’s median net worth is around $13,900. By contrast, a BB’s sits at $260,000. The average figures are $76,300 and $1mn respectively! BBs are living longer, there are lots of them (hence the vast sums running into trillions) and were able to benefit from affordable housing back in their day.

Something else that caught the eye is the wealth transference taking place in the UK. The BoE found deposits put down by today’s generations for a property are 2.5X larger, loans are some 30% smaller and properties are costing some £15,000 more – thanks (not entirely but significantly) to receiving help from the bank of “Mum and Dad”. Those without support take 10 years longer to buy a property for the same sum vs a 26y old with parental help. The average 26y old, with parental help, paid some £254,000 for their first home. Those with no support, had to wait till 37y to pay the same, equivalent sum. Those receiving hep from the bank of Mum and Dad are typically less leveraged and have lower mortgage payments. The wealth effect is yet another risk mitigant / hedge in today’s economic survival game. Think of the lessons that can be gained from having government policy aimed at promoting housing affordability!


Source: Refinitiv Datastream/Fathom Consulting
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