Jonathan Gregory

Noise canceling: Tuning into interest rate signals

One of the challenges of work in a busy office is simply to focus on the task at hand. The holy-grail for many is to tap into the so called alpha-waves of brain activity that can enhance calm, concentration and creativity. 

My preferred approach is to turn to the music of composer and pianist Philip Glass. His minimalist, multi-layered, and repetitive style is instantly recognizable, being a soundtrack staple of films and television across several decades. But it is his Piano Études that work for me. There is just something about the lucid, free flowing, repetitive but harmonic progression (some might say obsession) of the Études that gets me to a flow-state like nothing else. Almost all of Bond Bites is written to this background music; the strange and haunting No.5, the hyper-energized No.6, the almost lullaby of No.14, the richly symphonic No.17 and the pure romanticism of No.20.1 But as alpha-waves are also associated with drowsiness and some sleep-states, as much as creativity, you may wonder about my productivity in such moments. Well, hopefully my boss will not read this month’s edition.

In fact I am probably not alone in the world when the biggest challenge to achieving the flow-state is now the post-pandemic office environment itself; where ‘more people, less space’ is the order of the day. So, as I glance around me, I see the essential work-wear for the post-COVID office is now pervasive – noise cancelling headphones.

Our own recent office reorganization leaves me in close proximity to my smart colleagues in our Risk function. You might imagine that recent weeks packed with the odd bank-failure or near-death experience, a 30% fall in front-end US yields, a slump in global equities and yet higher central bank policy rates has made them, justifiably, more vocal than usual. And you would be right.

But as I toggle-up the noise cancellation on this triumph of 21st Century tech, I can’t help dreaming of an even more profound scientific breakthrough – noise cancelling glasses. It is one of the great dilemmas for the investor; screening the signal from the noise. In the mayhem of the last few weeks choosing between meaningful events worthy of action, and the merely messy price action, will have serious consequences for value creation. Imagine sitting at your desk, slipping on some designer Silicon Valley eyewear and the right trades come popping out of your screen while the rest fades to black.

Signal or noise?

It is a nice dream. But the discordant urgency of Études No.13 brings me back to focus; what in all of this is signal and what noise?

Both the European Central Bank (ECB) and the Federal Reserve (Fed) met in March against a backdrop of turmoil in the banking sector. This posed quite a challenge. Setting the policy rate to address inflation and managing financial stability are closely entangled issues, however much policy makers might try to persuade us that they can address them separately.

The challenge was most stark in the US where recent employment and inflation data probably exceeded the Fed’s comfort level. Indeed, on 7th March Fed Chairman Jay Powell suggested a 50 basis point (bp) rate hike was possible for March and the ultimate level was “likely to be higher than previously anticipated”.2 Come the meeting itself though on 21st and the tone had completely changed. The Fed signalled rates, in fact, might be close to the peak and removed wording from the statement that “ongoing increases” would be needed to bring inflation back under control.3

A few days earlier the ECB had walked its own monetary tightrope; pressing ahead with the well flagged 50bp hike but dropping a previous statement to “keep raising rates significantly at a steady pace” and refrained from providing any guidance on future moves at all.4

So central banks are getting edgy about the collateral damage to the broader economy from the higher policy rates already needed to tame inflation. Inflation targeting is an inexact science anyway – especially the “long and variable lags” of rate hikes to use central bank parlance.

Recent events suggest some of the cracks are starting to show. Silicon Valley Bank was upended by mark-to-market losses on its holdings of long-dated bonds which it had to sell in order to meet deposit outflows. Somehow none of the right stakeholders had the imagination to ask what would happen as yields rose. To be fair, perhaps it was just experience that was lacking, the last double-digit losses in US Treasuries being, well, never.

Up until now similar sized banks had escaped full regulatory scrutiny, despite these regional banks being critical to the smooth functioning of the US economy; according to TheEconomist they account for 50% of all commercial lending and 80% of commercial mortgages.5 As the sector now comes under more official enquiry, one that will have to confront its systemically important nature, there will be an inevitable tightening of business and lending standards that has the potential to hurt the economy.

Be careful what you listen to

In other words, we might just have heard the early cracking of a broader credit crunch. While undoubtedly painful for some sectors, this in itself could rein in growth and bring down inflation faster than anticipated – a point the Fed also made.

The Fed has already upped rates by nearly 5% in a year; the ECB by 3.5%. It takes time for the full impact of these moves to work their way into all the cracks in the financial system. Policy makers will need to take these growing stresses and strains into more account, even if inflation stays stubbornly above target. And that is precisely what we have just been told in the March meetings. We should expect a more cautious approach from here.

Recall, also, that globally there have already been problems in this cycle. In September last year the UK pensions industry was nearly felled by an unexpected spike in bond yields and volatility. Now the US regional banking sector posed systemic risks with the same root cause. Near-catastrophes predicted by almost no one. The onset of these financial stresses follows on directly from higher rates. While the systemic problems are unlikely to be as serious as the Great Financial Crisis, the signal from the March central bank meetings is simply that we are at, or very close to, peak policy rates.

What about the noise? It is hard to say for sure but, despite recent instability in financial markets, rate cuts are probably not on the cards this year, unless things get materially worse very quickly. At the time of writing bond markets had priced an expectation that the Fed would cut rates by about 50bp before the year is out. This seems the wrong conclusion to draw. Even while the Fed was highlighting the risks in the financial sector last month it stuck with its 5.1% median rate projection for the year (incidentally about where the rate is today, so again signaling we might be close to the peak).6

Expecting rate cuts this year therefore seems like too much of a stretch based on what we know now. The situation in the UK highlights the dilemma well. Both headline and core inflation rose unexpectedly in February (Chart 2), even after nearly 4.25% of rate hikes in a little over a year (headline even went back into double digits). Meanwhile, UK growth remains stubbornly weak and the financial sector was hit by the same shockwaves in March as everyone else, and with some previously hidden vulnerabilities that were brutally exposed last September. What is the Bank of England to do? Tread carefully, one hopes.

Chart 1: UK YoY CPI: Contribution by sector

UK QoQ Real GDP Index: Line chart compares the UK’s real GDP index against the 2010-2019 trend and extrapolation through 2022

UK YoY CPI: Contribution by sector. A chart that tracks inflation by individual consumer sector over the last three years. Food and housing have been the biggest contributors to the rising Consumer Price Index since 2022.

Chart 2: UK QoQ Real GDP Index

UK YoY CPI: Contribution by sector. A chart that tracks inflation by individual consumer sector over the last three years.

UK QoQ Real GDP Index. Line chart compares the UK’s real GDP index against the 2010-2019 trend and extrapolation through 2022 to demonstrate that actual GDP in 2020-2022 was far off trend.

All these events took place during our recent quarterly Fixed Income Investment Forum. The conclusion for our global strategy was to reduce our bond exposure (i.e., cut duration) as bond yields fell (prices rose), and markets priced rate cuts this year that we thought unlikely. However, the apparent increasing frequency of shocks to the financial system appear to be a signal we are close to peak policy rates in the Eurozone and the US. Much further tightening beyond this point risks a much harder landing than most policy makers could live with. That in itself should limit further downside for bonds.

Admittedly, the range of possible outcomes now seems wider than even a few weeks ago, so we will stay alert and flexible in the face a very complicated (and noisy) world. And the current situation increases the risks I highlighted last month – that the rate hikes needed to bring inflation back to target trigger an unacceptable round of collateral damage. In which case the debate might move from “how to get inflation back to target” to “how to get the target up to inflation”, an altogether more hazardous environment for bond holders.

In Piano Étude No.20 the silences are as integral to the beauty of the music as the melody. For central banks, from here on in, the things they can’t see (unimagined weakness in the financial system) will be as important to policy setting as what they can see (the latest inflation print). Rate hikes will be ill-advised unless they can be sure financial markets have stabilised.

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