As always very insightful thank you. Businesses confidence and PMIs putting the recession play to the front. What's the significance of the ECBs focus on yield spreads? Why are they trying to control it? I would have thought investors can price and manage sovereign risk, these mechanisms are sacred.
The ECB is mandated to deliver price stability through monetary policy across the whole eurozone. Currently as rates increase to fight inflation, the yield differential between European countries is growing. The ECB is aiming to control yields in some of the more heavily indebted European nations to ensure those countries can still access the intl debt markets cheaply. This is effectively QE for some countries while pushing through higher rates which is somewhat controversial.
These articles give more colour to the ECB’s TPI initiative.
Thank you for replying and the additional reading, that was very interesting.
Is it just me or does the ECB actually not have a plan to manage inflation? Do they realistically think a terminal rate of 2% (which comes of with the caveats) will quell inflation? Coming into winter when at present gas will run out in January and all the other input cost pressures? Not to mention encouraging government borrowing and money market speculation buy propping up the secondary bond markets. Call me chicken little but I have some concerns. I bought this bond fund recently
BetaShares Global Government Bd 20+Y - Just a few weeks ago they announced they were clearing out of European bonds and solely focusing on US Treasuries. Possibly feel the same as me about the ECBs plan to manage inflation.
All central banks have no real plan to manage inflation. The old means to deal with the inflation beast by raising interest rates are fairly ineffectual in the current environment with the unique set of circumstances that we currently have.
As we know QE was introduced in the face of the financial crisis and then revived again over the Covid pandemic years. The markets have in effect been artificially inflated and that provides another conundrum for the central banks.
If we look at the 3 major central banks and their attempts to fight inflation.
The Fed has made it clear since March they want to raise rates to such a degree that they cause pain ie they want to try to raise rates to cause stocks to sell off for the purposes of wealth destruction so people have less money in their pockets to spend and hope that that will drive prices down. Equally with stocks lower they are of the opinion that companies will either reduce margins or lay off staff again causing people to have less money in their pocket to buy stuff with. So the Fed is using a higher and aggressive rate path coupled with the hope that lower stocks will do some of their heavy lifting. The problem is they need to hold their nerve and they have little control on how the market reacts as can be seen by the market’s “perceived pivot” from the Fed after last week’s FOMC. This has seen stocks rally and rates falling to such an extent that mortgage rates fell to their lowest level since April this week.
The BoE was the first to hike but in effect they have no weapons to fight inflation because in the main it is driven by an external supply side shock ie. oil and energy costs. They tried to up the ante yesterday but also on the same day ratcheted up their inflation forecasts when they predict 50y high levels in the coming months. Peashooter in the face of an elephant. Again a touch of the hit and hope and their hope is that the 5 quarter recession they are predicting will kill off inflation as the stark choice for a lot of people will be heat their home or feed their family.
The ECB similarly is a basket case until last month they had negative rates and were still in the throws of QE with inflation rampant. Hardly text book central banking. They are looking to ramp up rates next month again but the bottom line is they are well behind the curve especially versus the Fed and BoE in addition their countries’ economies are falling off a cliff and they have the market stresses we have seen with spreads widening between the haves and have nots. The bottom line is the Euro was fabricated and built on a sand foundation with countries allowed to fudge their entrance requirements to appease the politicians. The cracks have been there for years and until they stop bailing out the southern countries the stresses shall remain. Politically for peace the Euro has been a good thing but from a monetary and fiscal standpoint one big fudge. Inflation wise again raising rates is a token gesture and again a bit like the BoE they will hope a recession kills off inflation. However once again they have no control over the main driver of inflation; energy costs so it is a hit and hope.
The answer to your question is none of the major central banks have a full proof plan but if the Fed holds their nerve they may just about get away with it. The other two are long lost I would say.
Again the time for action was late 2020 not mid 2022.
Well, can I just say that is a brilliant synopsis and thank you for your candour. I won't add to your points as I'm often wary of those that share the same opinions as me.
I was trying to find a historic comparison to the current inflationary environment. Of course there is none exact, most periods of sustained inflation have several years of strong GDP growth preceding them. But what we do have is a vast expansion in the money supply. Doubling in the past 10 years in Australia while GDP has grown by <6% so you could possibly say that one emulates the other.
The closest comparison I could find was the 1973-74 Oil crisis. CPI was running between 5% and 5.3% in 1972 which we would consider punitive now but more to do with the limitations (all though ending that year) central banks had on increasing the money supply. The cash rate set at approximately 5% on average through the year. December 1973 inflation hits March 1975 inflation peaks at 17.7%, from my glancing I can't see the official rate getting over 11% through that period. Similarly during that period we had a spendthrift government which was most controversially ousted in 1975.
The point is, it took 3 years for inflation to peak. Okay 50 years ago technology and supply chains aren't what they are now. Except if your importing coal to India for example. This flash-in-the pan concept people have about inflation is not supported by history. Inflation is a slow moving sticky variable few really understand.
Also of note from that period, the official cash rate lagged behind inflation. Likely this was proportionate to the demand-pull effects they would target and not attempting to target the cost push side of things. Inflation remained high in Australia effectively until 1990 which for those who experienced it, not me I was too young, a time of incomparable hardship. Between 1975 and 1990 peaks in inflation lead swiftly to recession in 1980, 1982 and 1987.
It's highly possible inflation won't peak for another 12 months and it could take years to return to a moderate borrowing rate again. The risk of ruin is too great to gamble with and CBs will take collateral damage without hesitation along the way. The US jobs report just hit an hour before NY open, I watched price waterfall off the chart. The exuberance following June 2016 still amongst investors is concerning. They've became to accustomed to bailouts, handouts and special conditions and all other vein attempts to prop up what survived of capitalism after 2008. Money markets were forecasting inflation to fall off a cliff between now and December. Anything is possible but it would be a first as far as I'm aware.
I don't think history will play out exactly as it had and exactly how it plays out I've no idea. One thing I'm relatively sure of is the present collective consciousness of investors is about to experience an economic phenomenon not felt in a generation.
Appreciate these articles!
You're welcome David, thanks for reading!
As always very insightful thank you. Businesses confidence and PMIs putting the recession play to the front. What's the significance of the ECBs focus on yield spreads? Why are they trying to control it? I would have thought investors can price and manage sovereign risk, these mechanisms are sacred.
Thanks for your question, Maximilien.
The ECB is mandated to deliver price stability through monetary policy across the whole eurozone. Currently as rates increase to fight inflation, the yield differential between European countries is growing. The ECB is aiming to control yields in some of the more heavily indebted European nations to ensure those countries can still access the intl debt markets cheaply. This is effectively QE for some countries while pushing through higher rates which is somewhat controversial.
These articles give more colour to the ECB’s TPI initiative.
https://www.abnamro.com/research/en/our-research/ecbs-new-tool-gives-it-green-light-for-faster-normalisation
https://www.nytimes.com/2022/06/15/business/ecb-bond-market.html
https://www.reuters.com/markets/europe/ecb-finally-join-rate-hike-club-with-big-move-agenda-2022-07-20/
https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp220721~53e5bdd317.en.html
https://www.zerohedge.com/markets/euro-tumbles-spreads-blow-out-market-realizes-ecbs-tpi-just-another-useless-word-salad
Thank you for replying and the additional reading, that was very interesting.
Is it just me or does the ECB actually not have a plan to manage inflation? Do they realistically think a terminal rate of 2% (which comes of with the caveats) will quell inflation? Coming into winter when at present gas will run out in January and all the other input cost pressures? Not to mention encouraging government borrowing and money market speculation buy propping up the secondary bond markets. Call me chicken little but I have some concerns. I bought this bond fund recently
BetaShares Global Government Bd 20+Y - Just a few weeks ago they announced they were clearing out of European bonds and solely focusing on US Treasuries. Possibly feel the same as me about the ECBs plan to manage inflation.
All central banks have no real plan to manage inflation. The old means to deal with the inflation beast by raising interest rates are fairly ineffectual in the current environment with the unique set of circumstances that we currently have.
As we know QE was introduced in the face of the financial crisis and then revived again over the Covid pandemic years. The markets have in effect been artificially inflated and that provides another conundrum for the central banks.
If we look at the 3 major central banks and their attempts to fight inflation.
The Fed has made it clear since March they want to raise rates to such a degree that they cause pain ie they want to try to raise rates to cause stocks to sell off for the purposes of wealth destruction so people have less money in their pockets to spend and hope that that will drive prices down. Equally with stocks lower they are of the opinion that companies will either reduce margins or lay off staff again causing people to have less money in their pocket to buy stuff with. So the Fed is using a higher and aggressive rate path coupled with the hope that lower stocks will do some of their heavy lifting. The problem is they need to hold their nerve and they have little control on how the market reacts as can be seen by the market’s “perceived pivot” from the Fed after last week’s FOMC. This has seen stocks rally and rates falling to such an extent that mortgage rates fell to their lowest level since April this week.
The BoE was the first to hike but in effect they have no weapons to fight inflation because in the main it is driven by an external supply side shock ie. oil and energy costs. They tried to up the ante yesterday but also on the same day ratcheted up their inflation forecasts when they predict 50y high levels in the coming months. Peashooter in the face of an elephant. Again a touch of the hit and hope and their hope is that the 5 quarter recession they are predicting will kill off inflation as the stark choice for a lot of people will be heat their home or feed their family.
The ECB similarly is a basket case until last month they had negative rates and were still in the throws of QE with inflation rampant. Hardly text book central banking. They are looking to ramp up rates next month again but the bottom line is they are well behind the curve especially versus the Fed and BoE in addition their countries’ economies are falling off a cliff and they have the market stresses we have seen with spreads widening between the haves and have nots. The bottom line is the Euro was fabricated and built on a sand foundation with countries allowed to fudge their entrance requirements to appease the politicians. The cracks have been there for years and until they stop bailing out the southern countries the stresses shall remain. Politically for peace the Euro has been a good thing but from a monetary and fiscal standpoint one big fudge. Inflation wise again raising rates is a token gesture and again a bit like the BoE they will hope a recession kills off inflation. However once again they have no control over the main driver of inflation; energy costs so it is a hit and hope.
The answer to your question is none of the major central banks have a full proof plan but if the Fed holds their nerve they may just about get away with it. The other two are long lost I would say.
Again the time for action was late 2020 not mid 2022.
Well, can I just say that is a brilliant synopsis and thank you for your candour. I won't add to your points as I'm often wary of those that share the same opinions as me.
I was trying to find a historic comparison to the current inflationary environment. Of course there is none exact, most periods of sustained inflation have several years of strong GDP growth preceding them. But what we do have is a vast expansion in the money supply. Doubling in the past 10 years in Australia while GDP has grown by <6% so you could possibly say that one emulates the other.
The closest comparison I could find was the 1973-74 Oil crisis. CPI was running between 5% and 5.3% in 1972 which we would consider punitive now but more to do with the limitations (all though ending that year) central banks had on increasing the money supply. The cash rate set at approximately 5% on average through the year. December 1973 inflation hits March 1975 inflation peaks at 17.7%, from my glancing I can't see the official rate getting over 11% through that period. Similarly during that period we had a spendthrift government which was most controversially ousted in 1975.
The point is, it took 3 years for inflation to peak. Okay 50 years ago technology and supply chains aren't what they are now. Except if your importing coal to India for example. This flash-in-the pan concept people have about inflation is not supported by history. Inflation is a slow moving sticky variable few really understand.
Also of note from that period, the official cash rate lagged behind inflation. Likely this was proportionate to the demand-pull effects they would target and not attempting to target the cost push side of things. Inflation remained high in Australia effectively until 1990 which for those who experienced it, not me I was too young, a time of incomparable hardship. Between 1975 and 1990 peaks in inflation lead swiftly to recession in 1980, 1982 and 1987.
It's highly possible inflation won't peak for another 12 months and it could take years to return to a moderate borrowing rate again. The risk of ruin is too great to gamble with and CBs will take collateral damage without hesitation along the way. The US jobs report just hit an hour before NY open, I watched price waterfall off the chart. The exuberance following June 2016 still amongst investors is concerning. They've became to accustomed to bailouts, handouts and special conditions and all other vein attempts to prop up what survived of capitalism after 2008. Money markets were forecasting inflation to fall off a cliff between now and December. Anything is possible but it would be a first as far as I'm aware.
I don't think history will play out exactly as it had and exactly how it plays out I've no idea. One thing I'm relatively sure of is the present collective consciousness of investors is about to experience an economic phenomenon not felt in a generation.
This is a great morning read and is the first one out each morning so it's the first one I read. Thanks for a great service!
No problem Paul, appreciate the comment - thanks for subscribing!