The global policy backdrop continues to become more hawkish as Central Banks attempt to grapple with the scale of the global inflation shock. However, their policy toolkit remains similar to that of the lowflation era, creating volatility and risk premium for further policy shifts.
As we wrote last week, "[recent developments have] laid bare the growing crisis now faced by the ECB and the Fed. There is a real risk that the current policy making tool kit and parameters are fundamentally unsuited to the inflation challenges they are now facing”.
The loss of central bank credibility is the true tail risk for global markets, and the increase in this risk was a) priced into markets and b) responded to by key central banks, all within a week. This created extraordinary volatility across key DM rates and FX markets.
What happened?
FOMC: The Fed’s forward guidance of two 50bp hikes was clearly inappropriate, given both the June inflation print and University of Michigan inflation expectation reading showed a “shocking” re-acceleration of CPI.
In response,having previously signaled 50bps right up until the end of the blackout period, the Fed delivered a 75 bps. This was a policy move without recent parallel, the fact that this hike was communicated via an article during the blackout period pre-meeting is a self-admission of the failure of their own policy stance and created significant volatility in US and global rates markets.
Inexplicably, at Wednesday’s FOMC, Chair Powell signaled a 50 or 75 bps hike at the next meeting, again reducing his policy options. It seems highly likely that this attempt at forward guidance will be challenged again if inflation in July remains elevated or accelerates further. We see the distribution of the next hike more likely between a 75 or 100 bps rather than a 50 or 75 bps hike . Indeed forward guidance, of any description in this environment, has consistently failed, resulting in pivots and asymmetric moves in rates markets.
However, policy communication aside, the clear interpretation of the FOMC decision, statement and dot plots was that the Fed are now unreservedly hawkish. They see themselves bringing policy into restrictive territory, and with it generating higher unemployment and lower growth. For equity markets, the Fed put is significantly “out of the money”, and implicitly an earnings recession will come alongside the cooling of growth desired by the Fed.
ECB: Lagarde’s press conference at June’s ECB meeting was a failure in central bank communication. The lack of clear explanation of the monetary policy path and the plan to prevent a widening of peripheral spreads saw a dislocated move in European front end rates and spreads. This resulted in an unscheduled “emergency” ECB meeting on Wednesday, a mere 5 days after their most recent meeting. Here they announced they would apply flexibility in reinvesting redemptions coming due in the Pandemic Emergency Purchase Programme (PEPP) portfolio and mandate the creation of a new anti-fragmentation policy tool. This is likely to be announced at the next meeting, which, based on reporting, will likly include flexibility in purchases between countries with no ex-ante limit on purchases.
If the reallocation of PEPP reinvestments is sufficient, there are near-term implications including, in a relative sense, upward pressure on core yields and downward pressure on peripheral yields. If effective, this will allow for a more aggressive monetary policy path, which will, over time, flatten European yield curves. Outside of the PEPP announcement, this week's moves highlight the unique relative weakness of the ECB to other central banks.
Therefore, there should be a higher level of risk premium in European rates curves and in the EUR, as the main shock absorber should policy risk increase again or the anti-fragmentation tools prove to be insufficient. Once again European financial market integration and the need for a debt/fiscal union has not been implemented adequately to withstand a renewed Eurozone debt crisis. Hence, in this highly inflationary environment where energy inflation has yet to fully feed through into HICP readings, we see a severe test of sovereign spreads and a debt crisis as the path of least resistance.
Switzerland: The SNB shifted hawkish, unexpectedly raising rates 50 bps with hawkish guidance on rates and the currency. Furthermore, they opened the possibility of foreign asset sales. Given the size of the SNB’s holdings of global bonds and equities, SNB quantitative tightening is a meaningful hawkish development for global liquidity conditions.
Japan: The BOJ’s commitment to their yield curve control (YCC) target was tested, with yields implied by futures trading through the target level in the first half of the week. However, the BOJ reaffirmed (and doubled down) its commitment to its extreme dovish policy, and the JPY ended the week back towards the lows. YCC is “unsustainable” only insofar as the Bank of Japan deems the trade offs of maintaining the policy undesirable. For now, weakness in the JPY has not reached that threshold, and furthermore had they changed policy, the volatility created by this shift may have caused a wide vol/var shock given the prevailing market backdrop. While the BOJ stubbornly upholds its overly stimulated YCC levels we see the Yen as a weak link alongside JGBs.
Normally, volatility of the kind we saw last week is indicative of a regime shift or exogenous crisis. This was not the case last week. Rather we saw market participants and central banks recognizing the magnitude of the inflation crisis. The policy outlook continues to be pushed to more and more hawkish footing by the breadth of the inflation crisis, but central banks still remain somewhat adherent to a policy toolkit from a lowflation era.
This policy stance will continue to raise the risk of convex moves in rates markets and increase the size of the ultimate policy adjustment. The outlook for growth is negative and while in more rate sensitive parts of the economy like housing there are clear signs of weakening, on the whole the economy continues to generate excessive demand. Therefore policy needs to deliver more tightening and with that DM interest rate curves are likely to invert and / or flatten further. This is a volatile, risk negative environment and one where rate paths will continue to be priced higher as long as inflation does not ease. We see the combined impact on global equities as a clear negative, notwithstanding the possibility for short lived relief rallies.
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Global Property Markets - At the Epicenter of Policy Shifts
One of the key drivers of sharp post-COVID demand recoveries in the US and several other DMs has been the robust expansion in the housing sector. In the US, this housing sector expansion has been fueled by:
· A structural underbuilding in the US housing market
· Strong nominal household income growth
· Positive demand shock from the rise in remote work
· Historically attractive for-sale mortgage affordability relative to rents
· Expansionary monetary policy.
With the sharp tightening in mortgage rates from 3% to over 6% since the beginning of the year, the last two of these drivers have quickly reversed to headwinds. The combination of the rapid house price increases of the last year and rising rates have pushed mortgage payments for the marginal homebuyer up by a remarkable ~64 YOY, a historic deterioration in affordability that has only been matched in the Volcker shock.
The mortgage rate tightening is not just a headwind for first-time homebuyers – it will also depress refinancing activity and liquidity for existing homeowners.
On the refinance side, mortgage analytics firm Black Knight estimates that the pool of refinance candidates in the US who would benefit from refinancing at lower rates has fallen to just 472,000 households (from ~15 million households last summer).
With the post-GFC regulatory environment constraining HELOC and second lien borrowing options for many homeowners relative to pre-GFC norms, these higher mortgage rates will undermine refinancing activity in the US – effectively trapping much of recent housing market wealth gains in a less accessible form for homeowners.
With most US homeowners holding long-term fixed-rate mortgages, higher mortgage rates will also lock some homeowners into their existing mortgages (and homes) due to an inability to qualify for a new higher-rate mortgage on a second home - this likely will help hasten the decline in housing activity. In the near term, we expect the scale of the affordability shock to sharply dampen housing transaction activity, house price growth, housing market confidence, and refinance activity in the US.
The US’s housing boom, which has been an important reason to be constructive on US growth in recent years, can no longer be counted on to support US growth in the near-term. However, we do not have as a base case a sizable national US housing price reversal in nominal terms or household deleveraging cycle in the US as better underwriting, positive equity positions with fixed-rate long-term debt structures that are affordable relative to rental equivalents (for existing owners), lower household debt ratios, structural US underbuilding since the GFC, and higher inflation should help buffer nominal US house prices.
We see more significant housing-related growth risks in a few DMs facing much more challenging mortgage affordability dynamics than the US – namely Canada, New Zealand, and Australia. As the chart below shows, mortgage affordability pressures are now much more acute in Canada than in the US for marginal homebuyers. In addition to more challenging affordability dynamics, these countries also have higher levels of household leverage, shorter-term and more interest-rate-sensitive mortgage structures, larger household balance sheet exposures to housing wealth, and larger residential investment shares as a percentage of GDP.