Weekly Market Update: Bonds Fall as Investors Escalate Rate-Hike Expectations

Market Update

Equity markets posted overall gains last week after another volatile session. US stocks rose by 0.5% in GBP terms on rising energy prices, and a generally strong earnings season in which 76% of companies beat expectations. Earnings of mega-cap names had a large impact on the wider US equity market, as a 26.4% decline in Facebook’s share price following a disappointing earnings report led to a decline in major indices, but strong earnings from Amazon helped to fuel a rebound only a day later. European stocks fell by 0.6% in Euro terms after ECB officials made hawkish remarks following higher than expected inflation data. However, owing to a fall in the Pound relative to the Euro after the Bank of England’s interest rate hike, European stocks finished 1.0% higher in GBP terms. Bonds struggled last week due to hawkish central banks and a stronger than expected US jobs report, which caused US and UK 10 year yields to spike and end the week at 1.909% and 1.411% respectively. The German 10 year Bund yield also crossed into positive territory, rising from -0.045% to 0.205%. Emerging market and Japanese stocks rebounded, while oil continued to rise, reaching $92.10 per barrel. Gold remained relatively steady, falling 0.2%.

CIO Analysis

Last week saw the resumption of volatility. American stocks have recovered almost half of their -10% losses, mostly due to soaring energy prices and another good earnings season. More than half of US companies have reported earnings, with a very decent 76% beat of expectations.

But that’s not how all investors experienced it. Facebook, the global social media behemoth and a key holding for many portfolios, found itself losing more than a quarter of a trillion US Dollars in capitalisation during one day, as it reported a plateau in new subscribers. Meanwhile, US 10-year bond yields, the bedrock of global asset management, continue to experience steep price declines, as central banks across the world become more hawkish by the day. Last week, even the dovish ECB, which oversees a more rigid and less prone to wage-inflation market, refused to rule out rate hikes in 2022.

Central bankers have a very difficult task ahead: They need to moderate wage growth enough to curtail inflation expectations but not too much to cause a dampening of demand and swift return to secular stagnation. They have a local bullhorn, but a global problem.

Supply-side inflation will probably eventually sort itself out anywhere between six months and two years from now. It will be done in a bottom-up way, and there’s precious little policymakers can do about. It will all depend on the sum of myriads of inventory and logistics decisions. Until that time, it will be difficult for central banks to do much in the way of curtailing price rises. Messaging and moderate interest rate hikes might be their only tools to try and curtail inflation expectations and stem the wave of demands for higher wages. But, much like they couldn’t control global deflation, it is doubtful they can control global inflation.

And herein lies the risk. Central banks have abandoned market accommodation in favour of trying to moderate inflation expectations. If they are not successful in the latter, then they have stopped performing the function they were good at, absorbing market risk.

The idea that a big problem can’t be managed centrally poses an existential challenge for institutions whose job is exactly to manage big problems. If their core mandates are redundant, for whatever internal or external reason, can their efforts to ‘do their job’, in essence to confirm their usefulness, result in more harm than good?

Business literature is littered with cases of systems and processes that either were not updated in time (if ever), or where changes weren’t done right. Meanwhile, normal operations continued, but ended up causing more costs and less benefits. Central banks have been a key component of the post-GFC recovery. We feel that the time has come where their role and independence will be re-assessed, with implications far and wide for all portfolios, and economies.