Markets Weekly podcast - 24 May 2021

Julien Lafargue (JL): Welcome to this edition of Barclays Private Bank’s Markets weekly podcast.

My name is Julien Lafargue and I am the chief Market Strategist here at Barclays Private Bank.

In a few minutes, I will be joined by my colleague Michel Vernier, Head of Fixed Income Strategy, to discuss inflation and its impact of the bond markets.

But before that, as usual, let’s look at what moved markets recently. For this week, we wanted to focus on three main topics: peaking macroeconomic data, the Fed minutes and cryptocurrencies.

Starting with macroeconomic data, our readers will be familiar with this notion of peak growth that we discussed in the May edition of our monthly publication Market Perspectives. There, we argued that, going forward, the macroeconomic momentum will slow and that positive surprises will become harder to achieve.

In the US it started with a poor job number in April, followed by underwhelming - albeit still elevated - retails figures. Last week, we saw one of the hottest parts of the economy, the US housing market, showing signs that it is cooling down.

Indeed, April housing starts slipped 9.5% month on month when the consensus was looking for a much more modest 2% decline. At the same time, the NAHB homebuilder index was unchanged in April, seven point below its recent peak. While this reading remains very elevated by historical standards, like many other macroeconomic indicators, it is not getting any better any more.

The silver lining last week came in the form of better-than-expected purchasing manager index, or PMI, figures. The preliminary readings, in both the US and the Eurozone, came in well ahead of expectations. The service component was particularly strong, at 70 in the US and 55 in the Euro area. In the UK, it’s the manufacturing component that surprised positively, jumping more than five points to 66.1.

Not everything in these releases was perfect though, as manufacturers expressed concerns about raw material shortages and unsustainable demand conditions. And, this was echoed in May’s Philly Fed Index which saw the prices paid sub-component hit its highest level in 41 years.

While the data will remain strong in the coming months, we continue to expect a gradual deceleration and continued price pressures, which will likely translate into additional volatility for risk assets.

Now, as we talked about increasing inflationary pressure, the second key topic of last week was tapering and whether two lines in the Fed FOMC minutes were the first sign of what’s to come. Indeed, and I quote, “a number of participants suggested that if the economy continued to make rapid progress towards the Committee's goal, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases”.

It would be hard for the Fed to be more non-committal that this. With these comments, the central bank has set the stage for a busy summer for Fed watchers. We’ll hear more from Michel in a minute about our views with regards to the Fed’s path going forward.

But, from a market perspective, these comments did not really move the needle. And, the consensus is already factoring in some form of action, or at least an indication that some Fed action is coming, by the end of the year.

The last major development to impact markets last week was the rollercoaster ride in the cryptocurrency world. From a peak above $60,000 less than a month ago, Bitcoin, is now trading at around $35,000 and most other major coins have experienced similar pullbacks.

Last week’s weakness was driven by a combination of factors, including China and the US ramping up the rhetoric around regulation of cryptoassets and a complete U-turn from Tesla’s self-proclaimed “techno-King”, Elon Musk, as environmental concern forced him to stop accepting bitcoin as a way to pay for his electric cars.

As investors and portfolio manager, our views on cryptocurrency remain unchanged. While, digitalisation is the natural step in the evolution of money from precious metal to paper banknotes and now to electronic coins, this technology is still in its infancy.

The resulting volatility makes cryptocurrencies an asset class that is impossible to integrate into a portfolio framework, leaving these as purely speculative instruments for the time being.

Encouragingly, though, the rout in the crypto universe did not percolate through to the broader equity market, this seems to indicate that investors are able to differentiate between the two asset classes and that speculative behaviours are much more present in cryptos than they are in equities.

Now let’s welcome our guest speaker Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank, to discuss inflation and its possible impact on bond markets.

Michel, thank you for joining us. Let me start by asking you a very straight forward question: are we at the start of an era of structurally higher inflation?

Michel Vernier (MV): So US inflation in April jumped the most since 1981 on a monthly comparison, up to 0.92%, and the most since 2008 on annual basis at 4.2%. This was also the biggest overshoot compared to what economists would have predicted since 1996.

So what a high number does not tell us, whether the surge in inflation is temporary or transitory, as the Fed calls it, or if the surge is part of a secular trend change. So it's well worth to look at what has driven the latest search.

So the April inflation surge was largely driven by a rise in household energy prices, airline fares and lodging from home and a very large increase in prices for used cars. So the first place base effects when looking at energy and pent-up demand and bottlenecks when looking at cars, for example, impacted the numbers. Now likely to persist in the next coming months.

Also, the Fed would very much want to see a bit of overshoot in inflation. So we believe that a very large part of the inflation surge will be temporary and what we will see is a moderation over the next two years again, with inflation only just over 2% going into 2022-2023 for the US.

We think the risk for 1970s style inflation is there but it's relatively low as the circumstances that a closer look have been quite different back then.

JL: Now Michel, can you please tell us how the bond market has reacted to those strong numbers and are we about to see higher rates finally?

MV: Yes. The US 10-year yield jumped to 1.69% after the print, but have consolidated since then. So interestingly, breakeven yields, does the market for implied expectations for inflation has moderated since the print. So at 2.6% for the 10-year breakeven, for example, a lot has been priced in.

Consolidation of rates with higher inflation numbers may not be an obvious observation for many market participants. But we think it very much makes sense.

Why? So first rates have already come a long way from the August lows, for example. So 110 basis points increase. That’s quite a big move for yields, even in such a recovery.

Secondly, longer term rates rarely move along with high inflation prints. We have looked at this in our April Market Perspective and the correlation was extremely low. So while inflation is important, especially the longer end is influenced by a lot of other factors.

So the usual perception of higher inflation, therefore higher yields, is not always correct at all. So, for example, the rate market is also very much focused on the Fed strategy going forward.

JL: So Michel, you just mentioned that inflation is transitory and it isn’t likely to be quick to react. Yet, as we touched on earlier, the recent FOMC minutes revealed that the Fed could actually end the bond-buying programme at some point. What can we expect from the Fed going forward?

MV: Yes, you are right. But the question is why would the Fed be tempted to reduce accommodation if it believes that inflation will moderate again and want to avoid potentially dangerously low levels of inflation, as seen in the last decade.

Now the last FOMC minutes mentioned that a number of Fed voting members were discussing tapering, so the powering down of bond purchases as you mentioned earlier.

But at the time of the meeting, the FOMC members looked at a rapid improvement in labour markets. But since then, payroll numbers, for example, have been dramatically revised downwards, so pointing to a somewhat more volatile path to recovery. And the Fed wants to see improvement, particularly on the labour front and likely will remain patient.

The Fed could potentially become more vocal about tapering in August, September with first actions as early as March, April 2022 potentially. But by the latest, when the Fed has evidence of the substantial progress which we are looking for in the labour market. So when it comes to rate hikes, we think it's not going to happen before Q1 2023.

JL: So one final question for you Michel. We've heard a lot about breakevens, inflation-linked bonds. Are these good ways to hedge against inflation?

MV: Yes. As mentioned before, the inflation-linked bond market prices in short of 2.5% average 10-year inflation. This is possible, but already at the higher end of what we've seen in the last decades.

So for investors who want to hedge the risk of inflation going far beyond 2.5% persistently, linkers appear to be an effective hedge. And beside, inflation-linked bonds even in a period of lower trending inflation have outperformed the nominal counterpart over the last 25 years.

So inflation linked-bonds are worth considering. But pricing, as ways, is important. So for investors who more think of making quick gains, we would argue that the short tactical trade on inflation seems a crowded one.

JL: Thank you very much Michel. That’s it for this week. Thank you very much for listening in, we wish you all the best for the trading week ahead and will talk next week.