Priced to Perfection
We're in a bit of a conundrum in markets today, summary of situation below:
- Start of the year, markets expected 2-3 rate cuts in Australia and 5-7 cuts in the US
- This expected fall in rates was founded on inflation falling to the 2-3% bands by the end of the quarter
- An optimistic view of how inflation would pan out?
- This optimism was also conveyed by central banks (rightly so!) who have effectively said no more interest rate rises.
- Equity investors have run with this messaging and money flowed strongly back into markets over the last 6 months and performance numbers have been great
Okay but now what?
- Oil price remains resilient, +17.5% last quarter. Historically the strongest driver of inflation
- There is also absolutely no weakness in employment
- Corporate activity and profitability is pumping
- GDP expectation in the US is getting higher!
- Interest rate markets are now predicting almost no interest rate rises this year. Maybe 1 or maybe none.
We enter an interesting conjuncture where central bankers say no more rate rises and markets say no more rate cuts which leads us to the question, who is right?
Ghosts of Lowe's Past
Central Bankers quite literally have no room for error to make mistakes. They get killed (or worse, fired) if they get it wrong as their words simply affect too many people.
There are 2 ways central bankers do their jobs:
- Change the cash rate - a very finite and absolute method of influencing monetary policy.
- Talk about the cash rate - suggesting potential changes in monetary policy (jawboning!).
The second transmission mechanism is critical to influencing markets, this is what central bankers are really paid for because it is truly an art. This is the true mechanism used to trim around the edges.
And you know what, sometimes bankers say things that at the time can be 100% correct at the time but later on can be 100% wrong. Ahem, Philip Lowe.
I don't think he did or said anything wrong, the facts changed so he needed to change his views. Except for someone in his position, you're not allowed to get it wrong.
Central banks lost control and markets took the driving seat in 2021.
This time around, central bankers in the US and Aus have all said no more rate rises. They're back in the proverbial driver's seat. Yet as inflation rears its head, markets perhaps haven't had their final say yet.
Eek.
Room for error
Really, there is not much left.
Markets suggesting rates aren't going anywhere this year, central bankers suggesting the same thing too. Despite path dependency for both being wildly different.
The new goldilocks scenario is inflation sits at 3% until December, unemployment slowly comes up and central banks decide to do nothing. A blue sky scenario. If either the market or central banks are wrong, something will give. Market gyrations are perhaps suggestive of this "give" but until we receive more data we simply don't know.
(current market movements more likely to just be a healthy correction).
The one thing I will criticise bankers (from my comfy sofa) is that they all communicated interest rates won't rise beyond today's levels despite inflation not falling within the target bands comfortably.
Markets had rallied because central bankers looked to be in control again, but the hints of inflation and market sentiment taking control again is a worry.
If higher rates eventually get priced into cash markets, that is enough to do some severe damage to equity markets. Central bankers won't get a chance to open their mouths and there is a possibility open once again where primary transmission mechanism will be forced to do the job again.
Flight to safety
There is no traditional flight to safety here (sovereign bonds) because of policy boo-boos. Instead, I wonder if we are back to the old school safe-haven asset – Gold. (Also weird to see it and Oil moving higher together for the first time since the 70s.)
In a world where inflation rears its head gold (& bitcoin?), starts working as "alternate" risk free assets.
If we're lucky, we get another opportunity to allocate to 25+ Yr AAA Australian Bonds (GSBE47, GSBK51) at yields greater than 5%. One can hope.