Your weekly economic update from the team at FXD Capital
Markets saw a skittish week stimulated by the relentless rise of energy prices, which naturally resulted in bond yields following in step. The US 10-year yield is at 1.53%, a three month high and consequently, long-duration stocks (tech et al.) have seen a retreat this week. The technology sector, in particular, was further hit by an outage at Facebook, which brought its communication apps down for a significant period. While the effect of this may appear like an inconvenience for influencers and family chat groups, the impact is far more powerful – raising discussion about how reliant the world can be on one company for managing communication infrastructure.
With oil prices reaching new heights – Brent (three-year high) and WTI (seven-year high) – energy producers (i.e. OPEC) are turning the screw by showing reluctance to open spigots and increase production. With energy prices fuelling inflation, especially with the northern hemisphere entering winter, it portends a period where price pressures will inevitably keep escalating. The situation is particularly worrying in the UK, where price caps on suppliers reach a point of forcing private suppliers to supply energy at a negative gross margin.
The pressure on western central banks to raise interest rates is continually ratcheting up. The situation is particularly delicate due to the seemingly aligned interests between all parties to maintain low rates, despite the external conditions providing contradictory sentiment. Governments are happy with low rates, keeping borrowing costs down, and the corresponding QE programmes prop up stock markets. After years of low interest rates, consumers are also accustomed to cheap mortgage costs and enamoured with the returns seen in equity investment accounts.
The US treasury market remains a great unknown in terms of the aftermath of QE. It’s a $22 trillion market, which has had willing and infinite liquidity provided by its issuer for over a decade. If QE tapers and buying support contracts, it’s unclear whether market makers will offer a seamless transition back to free-market dynamics. While banks and asset manager primary dealers will always provide support, their participation rests on the economic rationale, a different ball game to the house playing the table. Primary dealer positions in Treasuries have been on a continuous fall for the past eight years and now sit at half the level they were eight years ago. With consensus all around that yields will rise to a new precedent, it’s only natural that liquidity is constrained – as no rational actor wants to be holding the proverbial hot potato.
Here in the UK, the situation is perhaps more delicate than in the US and EU. While all economies are readjusting to the post-COVID standard and managing packets of inflation, the UK’s complexity muddles further by Brexit-related labour and supply chain constraints. Concerning the former, all sectors see an apex predator mentality from more prominent and appealing employers poaching staff and job vacancies in some sectors seemingly sitting there perpetually.
Yet the pincer movement of tax increases (already happening in the UK) and interest rate rises are approaching, and the effect on the economy and consumers could be profound. Stagflation seems like an easy phrase to throw around, but government rhetoric about solving labour problems with local sources supports observations that the country is indeed about to enter a period that many believed was an anachronism from the 1970s.
This week saw New Zealand increase its base rate for the first time in seven years, from 0.25% to 0.5%. Perhaps a pyrrhic victory in the camp that sees the Pacific nation as a cauldron of overheating sentiment needing containment, especially in its housing market, where supply is anaemic.
Emerging Markets
Poland raised rates for the first time since 2012 to 0.5% this week. The move follows similar decisions in Eastern Europe, with Romania, Czech Republic, and Hungary marking up their respective benchmarks in 2021. With Poland being the most advanced economy in the region, it signifies that the eurozone’s moment of reckoning is soon approaching.
For the traditional emerging market stereotypes of Brazil, South Africa, et al., the year has seen erratic sentiment swings. Back at the start of 2021 there was optimism about recovery, with everything ranging from energy price rebounds to tourism restarting; this quickly disappeared as US yields increased and borrowing costs spiralled. The year has seen central banks aim to parry inflation and support their currencies with rate increases; Russia, Brazil and Mexico base rates now sit at a heady 6.75%, 6.25% and 4.75%, respectively, yet the effect has been short lived, with USD appreciation eroding any of those currency gains. EM countries’ bond yields and equities are now moving with painful negative correlation, away from the traditional divergence.
All the best for the week ahead
Alex
Our weekly column is written by Alex Graham, Economic Advisor to FXD Capital. Originally a bank treasurer, Alex’s weekly roundup intends to provide a conversational, top-down view of what is going on in world macroeconomics and how it impacts business on the ground level.
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