It just got messy
Just when it seemed that the Central Banks could focus just on inflation, along comes a “potential” banking crisis that may yet derail their well-laid plans for a smooth landing and lower inflation. On the surface the policymakers look calm and collected (just like an elegant swan floating across the lake) but one suspects that behind the scenes there is a frenzied atmosphere and a massive amount of work being done on understanding the potential risks.
The post-pandemic world seemingly has one more sting in the tail!
Unsurprisingly, the topic that we look at in this quarterly economic update is monetary policy which is the key issue that is consuming financial markets and is also uppermost in our discussions on portfolio risk and asset allocation with clients.
Where now for Central Banks?
The bond market is forward looking as it factors in risks and starts discounting changes in policy well ahead of other markets and policymakers. Despite the further tightening by the US Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of England (BoE) (admittedly at a shallower pace than previously) the forward implied rates have begun to factor in a loosening in policy later this year. We must remember that the Fed fought against the bond market last year when it sold off as it saw an underlying inflation problem only for Central Banks to follow their lead. The bond markets are now predicting that the Central Banks will yet again be behind the curve and over tighten.
At this stage, we reiterate our narrative from earlier this year namely that the major Central Banks are well advanced on the path of moving to a tight monetary regime through interest rates and QT (Quantitative Tightening[1]). We also indicated at the start of the year, that financial stability remains integral to the monetary regime but was not high up the agenda at that time. This is no longer true, and it must be that the probability of a shift to a pause in monetary policy is now closer even if looser conditions may take longer. The Bank of Canada has already done so, and the Fed has also hinted that it will be guided more by underlying economic data. We will therefore pour over incoming data in coming weeks to challenge our base case of a soft landing and a gradual reduction in inflation.
We had already reduced risk at the start of the year through asset allocation changes adding more high-grade bonds and lowering beta[2] across all portfolios. This shift was factoring in medium-term risks and underlying valuations across bond and equity markets and remains, as applicable now.
Laid out below are the three main areas we are looking at, and almost certainly replicates what Central Bankers have in front of them, in attempting to work out whether this period of monetary tightening is over and done or whether it will continue or indeed will it reverse.
