Central banks and the reverse rotation trade

What happened? At its June 15-16 meeting the US Federal Reserve Open Market Committee (FOMC) left its target range for the federal funds rate unchanged at 0-0.25 per cent. But in its ‘dot plot’ forecasts, 11 of 18 policymakers signalled two rate increases in 2023. And several officials expect to increase the federal funds rate in 2022, including St. Louis Federal Reserve President James Bullard, who said on Friday that the FOMC has started discussing scaling-back the FOMC’s US$120 billion per month bond buying program.

Financial markets: On Friday, the Dow Jones index shed 533 points or 1.6 per cent. The S&P 500 index fell 1.3 per cent and the Nasdaq index lost 131 points or 0.9 per cent. For the week, the Dow slid 3.5 per cent – its worst weekly loss since October 2020. The S&P 500 fell by 1.9 per cent and the Nasdaq lost 0.3 per cent. Elsewhere, European shares fell the most in a month, the greenback gained for a sixth straight day, commodity prices tumbled, short-term US Treasury yields rose and the price of crude oil lifted.

Implications: Some investors are concerned that central banks could begin scaling-back their massive pandemic emergency stimulus in response to building inflationary pressures and a strengthening in economic activity as Covid-19 vaccination rates lift. With the ‘taper’ debate now under way in both the US and Australia, investors should expect market volatility to increase. Already Wall Street’s ‘fear gauge’ – the US CBOE volatility index (‘VIX’) – hit 4-week highs on Friday.

What happened?

• Investors have been busily repositioning their portfolios in the aftermath of the US central bank’s June 15-16 meeting. The most powerful central banker in the world, US Federal Reserve (‘the Fed’) Chair Jerome Powell, on Wednesday said that the FOMC had begun discussing about when to discuss a slowing or ‘tapering’ of the bank’s US$120 billion per month bond buying program. Also known as ‘Quantitative Easing’ (‘QE’), the program is considered a monetary policy tool used by central banks to increase the money supply, while reducing market interest rates (or government bond yields), making it cheaper for households, businesses and governments to borrow.

• With inflationary pressures building, and the US economic expansion quickening on the back of the Biden Administration’s US$5 trillion fiscal stimulus, investors and economists had expected US policymakers to begin discussing the timing of a ‘tapering’ of bond purchases at some point this year. Already the Bank of England and Bank of Canada have slowed their bond buying programs in recent weeks. Of course, the Reserve Bank of Australia’s $100 billion QE program ends in September and it will consider whether to extend it on July 6.

• Last week US Federal Reserve Chairman Jerome Powell was quick to stress that it was still way too premature to talk of a ‘lift-off’ phase for official interest rates. But what ‘set the cat amongst the pigeons’ was the FOMC’s fabled ‘dot plot’ interest rate forecasts – the quarterly display of the median FOMC officials’ federal funds rate projections. Previously the ‘dot plot’ suggested that interest rates wouldn’t be hiked until after 2023. But those squinting at the dots in the chart noted that 11 of 18 policymakers signalled two rate increases in 2023. Even more alarming perhaps was that seven Fed officials saw the first rate hike in 2022, including St. Louis Federal Reserve President James Bullard, who on Friday said, “I think it’s natural that we’ve tilted a little bit more hawkish here to contain inflationary pressures.”

So why are global central banks considering paring back stimulus?

• Global central bankers are contemplating removing pandemic emergency policy settings as Covid-19 vaccine rollouts and immunisations increase and global GDP growth pivots from recovery to expansion. With 44.2 per cent of the US population now fully vaccinated (source: ourworldindata.org) and the Biden administration unleashing massive fiscal stimulus on top of the Fed’s ultra-accommodative monetary policy, US economic growth is expected to strengthen in the back end of 2021. The US central bank now expects real US GDP growth to surge 7 per cent in 2021, compared with the 6.5 per cent forecast at its March meeting. And it now sees inflation running at a 3.4 per cent annual rate this year, above its previous estimate of 2.4 per cent, with the jobless rate easing to 4.5 per cent by year-end.

• Commonwealth Bank (CBA) Group economists forecast US GDP growth of 6 per cent in 2021, the FOMC to start tapering its asset purchases in October 2021 and the Fed to start increasing the federal funds rate in March 2023.

• While the ‘big three’ central banks – the US Federal Reserve, European Central Bank and Bank of Japan – are unlikely to pare back stimulus in the near-term, the Bank of Canada cut its weekly C$1 billion bond-buying program last month and signalled that its benchmark policy rate could lift in 2022. The Bank of England has already slowed its QE program to £3.4 billion a week, from a £4.4 billion weekly pace. Elsewhere, Sweden’s Riksbank SEK700 billion bond buying program is scheduled to wind down this year; Norway’s Norges Bank has signalled that it could lift interest rates in the second half of 2021; and Reserve Bank of New Zealand Governor Adrian Orr recently said, “We are talking about the second half of next year” for a potential rate hike.

So what about the Reserve Bank of Australia (RBA)?

• RBA Governor Philip Lowe delivered a speech on Thursday entitled “From Recovery to Expansion.” Dr. Lowe fronted the lectern before the release of Australia’s bumper labour force survey – where a surprise 115,200 jobs were added in May. The Governor provided an upbeat assessment of the economic and labour market recoveries, but remained cautious about inflation and wages growth. The RBA Board continues to stress that it would like to see the unemployment rate down from current levels of 5.1 per cent to near 4 per cent, which could stoke annual wages growth of around 3 per cent, pushing its annual underlying or ‘core’ measure of inflation into its 2-3 per cent target range. These pre-conditions aren’t expected to be met “until 2024 at the earliest”, which is considered a ‘dovish’ policy stance when compared to some other central banks.

• At the July 6 RBA meeting, CBA Group economists expect the Board to keep the 0.1 per cent yield curve target pegged to the April 2024 bond. And we favour the RBA announcing a package of $A50 billion of bond buying over a six-month period, which constitutes a ‘tapering’ of its QE program. The official cash rate is likely to remain at 0.1 per cent.

How have financial markets reacted?

• Sharemarkets: US sharemarkets have retreated on worries that the US Federal Reserve could start raising interest rates sooner-than-expected. US shares began last week at record closing highs, but the Dow Jones index – a proxy for value shares – shed 1,009.3 points or 2.2 per cent since Wednesday to be down 3.5 per cent over the week – its worst weekly loss since October 2020. The benchmark S&P 500 index fell by 1.9 per cent – the most since late February. And the tech-heavy Nasdaq index lost 0.3 per cent, despite posting its two highest ever finishes in the past five trading sessions.

• In Europe, the pan-European STOXX 600 index snapped a nine-day winning streak on Thursday – the longest since 1999 – to be down 0.1 per cent. On Friday, the index fell further, down by 1.6 per cent to be 1.2 per cent lower over the week. The German Dax and the UK FTSE 100 index shed 1.8-1.9 per cent on Friday after more muted responses on Thursday to the Fed’s ‘hawkish’ tilt.

• But the Aussie benchmark S&P/ASX200 index rose 0.1 per cent on Friday, closing up 0.8 per cent over the week – powering to its fifth straight weekly gain – the best run since December 2020. That said, according to the latest share price index (SPI) futures, the S&P/ASX 200 index is expected to open the day 111 points or 1.5 per cent lower this morning.

• US bond markets: Short-dated US Treasury yields lifted on Thursday and Friday with the US 2-year yield climbing 8 points to end the week at 0.2521 per cent, after touching 0.284 per cent, the highest level since April 2020. But US 10-year yields fell by 7 points to 1.4431 per cent on Friday, unwinding the 8 point lift on Thursday. The flattening of the yield curve is often considered a “go-to” trade. When policy interest rates lift, traders expect longer yields to fall since the US economy may not do as well in the future. Higher policy interest rates and short-end yields both reflect expectations of the Fed hiking rates.

• Currencies: The Bloomberg US Dollar Spot Index rose for a sixth trading session on Friday to finish the week 2 per cent higher, its biggest weekly jump in about 14 months. On Friday, the Aussie dollar (AUD) fell from highs near US75.49 cents to 6-month lows near US74.75 cents at the US close.

• Commodities: Commodity prices have eased sharply off elevated levels. The stronger US dollar (USD) weighed on industrial metals making metals more expensive for buyers with other currencies. Copper fell 8.6 per cent last week, its worst since March 2020 after the US Federal Reserve signalled it could begin tightening monetary policy and China said it would sell state reserves to cap prices. The gold futures price lost US$110.60 an ounce or 5.9 per cent last week – the most since March 2020. But global oil prices posted a fourth straight weekly gain after OPEC sources said the producer group expected limited US oil output growth this year. Brent crude rose by 1.1 per cent to US$73.51 a barrel and the US Nymex added 1 per cent to US$71.64 a barrel. And iron ore fell by US$2.65 a tonne or 1.2 per cent over the week.

Implications for sharemarket investors

• It’s been a remarkable run for Aussie sharemarket investors. Last week Aussie shares hit all-time highs experiencing its best sequence – five successive weeks – of gains in six months. The lift coincides with the Aussie dollar hitting 6-month lows. At the time of writing, the S&P/ASX 200 index is up 11.9 per cent year-to-date and 2.9 per cent higher so far in June. Aussie shares could extend a monthly run of gains to nine months, the longest stretch in at least 14 years, continuing to outperform US shares in 2021.

• Economically-sensitive financial sector shares have led gains so far in 2021, up 22.7 per cent year-to-date with consumer discretionary sector shares 18.5 per cent higher. But the utilities sector is lagging, down 2.2 per cent with the information technology shares 0.9 per cent lower. That said, tech shares surged 6.1 per cent last week.

• Of course, similar dynamics are at play in the US sharemarket. At the beginning of 2021, investor fears over rising inflation and higher bond yields weighed on ‘mega cap’ tech stocks, while energy and financials sectors surged as investors bet that stronger economic growth would boost cyclical and value-focused sectors.

• But the Fed’s pivot last week saw bond traders unwind their reflationary and bond yield curve-steepening portfolio positions. And long-term inflation expectations – as represented by breakeven inflation rates – eased further. In fact the ‘transitory’ inflation narrative has seen US 10-year Treasury yields fall about 30 points since March to 1.44 per cent, but the 5-year and 30-year US Treasury yield curve flattened by the most since 2011 last week.

• For now, it appears that the US Federal Reserve policy pivot has put the value stock rotation revival in doubt. US cyclical companies tied to reopening and reflation trades, such as financials and energy, fell the most last week, while growth-orientated Nasdaq 100 index shares outperformed, up by 0.4 per cent – its longest weekly winning streak since August 2020.

Outlook

• Investors are questioning the outlook for inflation and growth, central banks are pivoting towards reducing highly accommodative monetary policy and the corporate calendar is thinning ahead of the next corporate reporting seasons. So investors should expect heightened volatility in the near-term. In fact, the CBOE volatility index (‘VIX’) – Wall Street’s fear gauge – is at the highest levels in four weeks. And this week various Fed governors give speeches, with some more ‘hawkish’ and some more ‘dovish’ on policy with mixed messages having the potential to sway markets. Also, the Fed’s preferred inflation measure – the Personal Consumption Expenditure (PCE) deflator is due late in the week – and is expected to surge over the year to May, owing to pandemic base effects.

• But it’s not all ‘bad news’. Investors should be comforted that monetary policy is likely to remain highly accommodative for the foreseeable future. And government spending is showing no signs of abating. Policy stimulus is focused mainly on achieving “maximum or full” employment. Outside of Australia and New Zealand, employment remains largely below pre-pandemic levels in most countries. And wage inflation is still contained for now due to spare capacity in labour markets. In this environment, central banks are likely to slow bond purchases, rather than increase interest rates, over the remainder of 2021. And investors should be reassured that policy shifts reflect an easing from pandemic emergency settings, driven by a strengthening global economy, which bodes well for a sustained recovery in corporate earnings.

• While market liquidity could become an impediment for shares as central banks step back from asset purchases, amid lifting bond issuance to fund government spending. But upgrades in company earnings and income associated with dividend payouts could offset valuation and Fed ‘taper’ headwinds.

• Also, the last time the US central bank announced a tightening of policy (in 2013), US 10-year Treasury yields surged, sparking a ‘taper tantrum.’ And while the US S&P 500 index dropped almost 6 per cent from its May peak that year, it rallied 30 per cent over the full calendar year.

• Last week Bloomberg data showed that retail investors poured around US$28 billion into equity exchange traded funds (ETFs) – three times the 2021 average – in a ‘vote of confidence’ in the sharemarket. In our view, it still makes sense to remain overweight shares relative to bonds over the investment horizon with equity returns and dividend yields more attractive than the zero-to-modestly negative returns of bonds and cash.

• CommSec expects Aussie shares to outperform over a 12-month horizon as economic growth rotates from the US to the rest of the world. And don’t forget dividends, with the two biggest dividend paying sectors – banks and miners – on track to pay-out around $50 billion each to investors in financial year 2021/22.

• We acknowledge that our ASX200 index year-end forecast of 7,400 is conservative, but ongoing political tensions with China, rising Taiwanese geo-political risks, increasing US tax rates, lifting inflation (impacting price/ earnings multiples) and a reduction in stimulus present downside risks to the sharemarket.

• In this environment, we expect healthcare, consumer discretionary and materials companies to outperform, but the ‘tug-of-war’ between financials and information technology shares is the main game for investors in the short-term.

Published by Ryan Felsman, Senior Economist, CommSec