As COP 26 gets underway in Glasgow, market attention this week is focused on meetings elsewhere, as central banks in Australia, the UK and US make key decisions on monetary policy against a background of turbulence on short-term interest rates. US employment data on Friday –normally the highlight of the first week of the month, isn’t even in the top 3 of market concerns.
Big bond yield moves
October saw hefty increases in the front-end of yield curves in major markets, with US 2-year yields up 23 basis points (bps). Yet US 30-year yields fell. Long-dated gilts had an extraordinary week with prices rallying by over 10% after Chancellor Rishi Sunak’s Budget cut supply. Moves like that are rarely seen in government bond markets.
The background to all of this is inflation. The Bank of England will probably raise base rates on Thursday; they will certainly stop their quantitative easing (QE) programme. The Australian central bank has abandoned its policy of keeping a lid on short-term bond yields. Rates there jumped from 15 bps to over 75 bps – a massive move. And the US Federal Reserve is set to rein in its QE programme.
Central bank credibility hangs in the balance
All these major central banks face a big credibility problem. Having reassured us that inflation was transitory and that they’d keep policy super loose, they are now facing up to the fact that they’ve got it wrong. The question now is: when to start raising rates and how fast? I reckon that rates will be rising in the spring in the US and that they go up faster than the market thinks. Even with the increases seen recently.
Forward guidance from companies gives grounds for optimism
So where does all this leave equities? Higher interest rates are certainly a headwind. But the earnings season offers grounds for optimism. All the commentary is around whether companies exceed expectations for earnings and revenues. But I’m much more interested in what they are saying about the outlook for earnings going into 2022. Are labour shortages, supply disruptions, and soaring input costs squeezing margins? Or are companies able to push through price rises to keep margins strong? The message so far is that companies have been raising prices. And central banks note that this makes the rise in inflation last longer. So, they have to raise rates. But that need not impact equities.
Higher rates shouldn’t impact equity markets
Indeed, the S&P 500 nearly always performs well in the run up to Fed tightening and for 6 months after. If that pattern is repeated, the bull market has another year to go at least. When will the bull market end? That usually happens when the economy turns down and I don’t see any signs of that.
Sterling weakens on tax and fish, but UK economy set to grow
The UK has been buffeted by all kinds of problems and the escalation of the fishing dispute with France has been another blow. Sterling has weakened as a result. The Chancellor’s Budget also involves a big increase in taxation. But the Bank of England is set to raise rates, the economy will continue to grow, and I reckon sterling will recover once fish moves down the political agenda.
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The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.