To begin with, what do we know?
We know that vaccines prevent the variants that have evolved. We also know that the pace of global vaccine distribution is uneven, and mostly weighted towards the Developed World. However, the pace of vaccine distribution is accelerating and the pandemic seems to be peaking in the virus hotspots (Brazil and India).
We also know that the huge amount of liquidity in the financial system has created a number of imbalances and valuation issues that may or may not be a problem in the future. As we move through the crisis, the economic effect of lockdown is becoming less pronounced economic recovery is now in place. At some point we will see tapering and perhaps one day, we’ll see interest rates increasing in some countries – The US the most likely given what we know today.
What do we not know?
We do not know if new covid-variants will evolve and therefore how effective current vaccines will be and will inflation be transitory.
Looking at the unknown unknowns, there will always be something that emerges, and I fully expect some additional bouts of volatility/risk off as we move through the second half of the year. I am still relatively optimistic given what we do know and continued positive earnings expectations, combined with no bond market taper tantrum are both key to the ongoing market stability. If economic growth begins to slow and/or the US Federal Reserve (Fed) withdraws stimulus too quickly, then we could see some retrenchment in markets to less lofty levels. Offsetting these unknowns is the abundant liquidity in the financial system that will support any sell-off, although it might feel painful in the very short term.
The Fed is certainly sounding more hawkish now, with Chairman Powell sounding upbeat on the economy in the US and employment. The market has taken this to mean more focus on interest rates, thereby reducing inflation risk, leading to a flattening of the yield curve. The dot plot now shows that seven Fed members see a rate hike next year, with consensus for two hikes in 2023. It would seem a little pre-emptive to expect both tapering and rate hikes in such a short space of time, especially if some of the current economic strength begins to dissipate as we move into 2022.
Transitory inflation
Inflation will continue to drive the rates narrative for now. According to Bloomberg, supply chain blockages are still causing problems. The composite rate of container freights at $6,500 per 40ft box[1] is the highest in data stretching back a decade. The recent drop off in lumber and other commodities has somewhat supported the idea that inflation may be transitory, but it is just too early to tell. In addition, we don’t know how long transitory inflation will last. The employment situation will be key to this. The skills gap means that businesses are struggling to find workers, jobs are increasing and furlough schemes are somewhat skewing the data given that employees are still happy to stay at home.
Why we retain our shorter duration bias
With US treasuries rallying in the face of stronger economic data, for now the market is buying into the transitory inflation argument. If Treasury yields continue to trade in a narrow range, that will be generally good for risk assets. Low volatility is one’s friend at this point. We have seen this somewhat reflected in lower commodity prices and a stronger US dollar.
Furthermore, the Fed has hung its hat on employment. The latest Non-Farm Payroll data was strong but not strong enough. The unemployment rate actually went up slightly – a good sign as it means more job openings. However, the skills gap remains large and if we see more robust jobs numbers coming through, the narrative may change again.
I feel at this point we should continue to see a solid support to markets in the very short term, but there is the risk of yields beginning to move up again as we get closer to the Fed’s yearly retreat at Jackson Hole in August and increased market speculation on tapering. As a result, we retain our shorter duration bias and focus on higher coupon bonds with more insulation to rates volatility.
[1] Bloomberg, 27 May 2021, Shipping Container Rates
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