BondWorld : Inflation and turtles. Conditions still favourable, but leverage and central bank confusion suggest caution.
Andrea De Gaetano – Independent Analyst
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Soaring inflation and economic recovery create confusion within central banks. There is no longer a unanimous consensus on interest rates.
Bundsbank President Jens Weidman compared inflation to the giant tortoises in the Galapagos Islands, wrongly classified as „extinct“ for 100 years. „Inflation is not dead,“ Weidmann noted, urging the ECB to reduce bond purchases „step by step“. „Inflation could touch 4 percent in Germany during 2021.“
European inflation stood at 2% in May and is estimated at 1.9% in June, Eurostat reports. Levels close to the ECB’s 2% target.
Weidman’s view contrasts with that of Fabio Panetta, executive member of the ECB: „even taking into account the planned fiscal stimulus, economic stagnation will remain broad-based for some time. Employment will not return to pre-pandemic levels before 2023. Even if it does, there was no wage pressure even before the pandemic. Our core inflation forecast is just 1.4% in 2023.“
On the other side of the Atlantic, US employment data offer a fresh assist to the Fed to remain accommodative. Excellent new employment figures of 850,000 in June, higher than expected, were offset by unemployment at 5.9%, up from 5.6% in the previous month and higher than expected (5.8%).
Since April 2020, employment has risen by 15.6 million jobs in the non-farm sector, but is still 6.8 million, or 4.4%, below pre-pandemic levels in February 2020.
Confidence in central banks, rebounding economic data and bond yields that do not protect against inflation have given equities wings, with the S&P500 closing one of the best half-years since 1998.
Bank of America strategists estimate that if equity fund buying flows continue at the current pace, they will raise more money in 2021 than in the previous 20 years combined.
US government bonds seem to be ignoring the 5% inflation data in May. The 30-year T-bond has a yield to maturity of 2.04%. The 10-year 1.42%, the 5-year 0.85%, the 2-year 0.23%.
Manufacturing PMI data confirms the economic expansion phase in the US and Europe.
While the new Covid outbreak in Southern China weighed on services, with the CAIXIN PMI index at 50.3, the worst decline in 14 months.
The recovery in transport and the difficulty within OPEC in agreeing on an increase in oil production inflamed oil prices, over $75/barrel for WTI.
Besides employment not yet back to pre-pandemic levels, the risk of new COVID variants is one of the main reasons for caution in reducing stimulus plans. Even in Israel and the UK, where the vaccination campaign is far more advanced than in the rest of the world, the Delta variant is raising safety measures.
On the other hand, unconventional policies protracted for too long increase the risks of financial instability, as Loretta Mester of the Cleveland Fed and, in the past few hours, Andrea Enria, president of the ECB’s Supervisory Board, have pointed out: „strong market leverage threatens to leave banks exposed to corrections“.
Ample liquidity and a recovering economy play into the hands of the markets. However, divergences within the central banks make the pillar on which the rally of the last few years has been based – zero interest rates – less stable.
Quarterly reports and pandemic developments will dictate the timing of the coming weeks. New clues on monetary policy will arrive between Wednesday and Thursday with the FED and ECB minutes.
The market’s bias in favour of equities means that when a correction does come, it will be swift and incisive, with everyone running for the exits.
The protection lies in increasing the liquidity in the portfolio while staying on trend.