The unreliable boyfriend

There is a school of thought that says monetary policy has to shock to be effective.

This argument usually harks back to 1979 when Paul Volcker took the reins at the Federal Reserve (Fed) and aggressively raised interest rates against the market’s expectations. Within six months, the US prime lending interest rate had almost doubled to 21.5%. Inflation, running hot at 14% when he took the job, was below 3% three years later. Markets didn’t see it coming and many investors – particularly bondholders – were routed. It was painful, but by getting control of the money supply inflation was tamed.

This is not the perfect strategy! The country suffered two recessions and unemployment ballooned to 10% in the early 1980s. It almost broke the nation. You would rather avoid getting to the point where you have to throw a tenth of your people out of work to restore balance to your money supply.

The lesson from Mr Volcker’s term wasn’t that you have to trip up financiers and speculators to make central banks powerful. The lesson was that central banks have to be credible: markets have to trust them. Throughout the 1970s Fed chairmen talked tough on busting inflation, but when it came to the crunch, they always relented and kept interest rates relatively low. So when Mr Volcker turned up saying he was going to strangle inflation with very high interest rates, markets thought it would be more of the same. People soon realised he was deadly serious; Mr Volcker made the Fed credible again.

Nowadays, central bankers’ interest rate forecasts and market expectations tend to be broadly in synch. This is driven by two things: firstly, central banks are open about their aims for inflation, unemployment and money growth and all sorts of other measures; secondly, the market trusts that the bank will do what it has said it will to get there.

This brings us to Bank of England Governor Mark Carney. Last week, Mr Carney distanced himself from a 25-basis-point increase in UK interest rates in May that he had telegraphed for a few months. Derivative markets had put the probability of this move at 80%, so the gun-shy move sent sterling sharply lower. Mr Carney blamed Brexit talks, weaker economic data and lower-than-expected (but-still-much-higher-than-target) inflation. To be fair, wages and retail sales weren’t the best. And central bankers shouldn’t act just because the market thinks it will. But this is long-running form for Mr Carney.

So when we grumble that he’s back to his “unreliable boyfriend” ways, it’s not because he made an informed decision to change the expected path of interest rates. It’s because the more he backtracks at crunch time, the less credible the BoE becomes. And the more drastic his successor may have to be to win back the market’s respect. 

Source: FE Analytics, data sterling total return to 20 April 

Europe is heating up

French President Emmanuel Macron is entering the third week of a rolling rail strikes that is due to last three months. Almost half of essential rail workers are working three-day weeks to protest Mr Macron’s reform of the cushy sector. State rail network SNCF estimates the disruption costs it €20m for each understaffed day, but the effect on the wider nation will be factors larger. And that’s before you take account of the solidarity strikes recently called by energy workers, Air France, and rubbish collectors.

Both sides feel they are fighting for the soul of France: Mr Macron believes the current employment rules and cosy benefits for those inside the organised labour tent is driving the youth overseas and crippling the country. For their part, the unions are understandably wary of a former investment banker who they believe would love to sell off their nation’s assets. They think this is just the start of a steep slope that ends in an over-liberalised nation that doesn’t look like France anymore.

If Mr Macron is successful, he is widely expected to have a mandate to carry out the rest of his manifesto of moderate reform that brought him to office a year ago. If he is stymied by the unions, he will probably wind up a lame duck. Polls show the population is split right down the middle. This could go on for a long while.

The stiff US sanctions against Russia will also bite France and the rest of Europe. Citing Russia’s military operations in Syria, Ukraine and Crimea, as well as cyberattacks on Western elections, America has applied the harshest punishment to date. A shopping list of prominent Russian oligarchs and strategically important natural resources and financial firms were banned from dealing with the US or its allies. In the past, sanctions on companies meant investors weren’t allowed to buy new debt or equity issuance. Today’s far tougher measures mean investors have to sell their equity and bonds by 7 May. One of the world’s largest aluminium companies, Rusal, was included and overnight the London Metal Exchange banned its customers from fulfilling any futures contract with it. Oil giant Gazprom is also blacklisted. The price of aluminium has already skyrocketed, while the oil price continues to press toward $75.
Usually, the US works extremely closely with the European Union while designing any punitive sanctions on Russia. The energy and materials behemoth can be a geopolitical adversary at times, but it is also a treasured trading partner. Crippling Russia’s basic materials and oil industries would likely raise costs for European households and industry, not exactly what the eurozone wants as it limps out of a decade-long recession.  

Bonds

UK 10-Year yield @ 1.48%
US 10-Year yield @ 2.96%
Germany 10-Year yield @ 0.59%
Italy 10-Year yield @ 1.77%
Spain 10-Year yield @ 1.27%

Economic data and companies reporting for week commencing 23 April

Monday 23 April

EU: PMI Manufacturing, PMI Services, PMI Composite, Eurozone Government Debt to GDP Ratio
US: Chicago Fed National Activity Index, PMI Manufacturing, PMI Services, PMI Composite, Existing Home Sales

Tuesday 24 April

UK: Public Sector Net Cash Requirement, Public Sector Net Borrowing Requirement, CBI Trends and Business Optimism 
US: House Price Index, New Home Sales, Richmond Fed Manufacturing Index, Consumer Confidence Index
EU: IFO Business Climate

Quarterly results: Rio Tinto

Wednesday 25 April

US: MBA Mortgage Applications, Crude Oil Inventories

Quarterly results: Antofagasta, Fenner, GlaxoSmithKline, Whitbread
Interim management statement: Lloyds Banking Group

Thursday 26 April

UK: BBA Loans for House Purchases, CBI Reported Sales, GfK Consumer Confidence
US: Initial Jobless Claims, Continuing Claims, Advance Goods Trade Balance, Retail Inventories, Wholesale Inventories, Durable Goods Orders, Kansas City Fed Manufacturing Activity

Quarterly results: Barclays, Capita, N Brown Group, Royal Dutch Shell, Shire

Friday 27 April

UK: Nationwide House Price Index, Index of Services, GDP, BoE’s Carney speaks in London
US: Employment Cost Index, GDP, Personal Consumption, University of Michigan Sentiment
EU: ECB Survey of Professional Forecasters, Economic Confidence, Business Climate Indicator, Industrial Confidence, Services Confidence, Consumer Confidence; FRA: GDP; GER: Unemployment Rate

Julian Chillingworth
Chief Investment Officer