The recession integrated by the markets or the showdown with central banks worried about inflation.
The sentiment of market participants is by nature sensitive to marginal changes in leading indicators and activity or price surveys. The perception of risk, even more than the underlying reality, is decisive for the equilibrium of prices of short-term assets. A precarious balance seems to have settled in with an extremely short positioning of risky assets likely to reverse at the slightest sign of monetary easing. Speculative sales of S&P 500 contracts are, for example, at the same level as at the worst of the pandemic in the spring of 2020. Central banks maintain a discourse centered on inflation, justifying rate hikes that are each time greater than anticipated. The latest decisions by the Reserve Bank of Australia, the Fed, the ECB or the People’s Bank of China are consistent with this. Central banks navigate by sight, so their advanced communication appears obsolete. This arm wrestling contributes to the pressure to flatten yield curves, or even to invert them, as on the American 2-10 year spread. The paradox is that the drop in long rates is stabilizing equities, despite the current economic slowdown.
The median increase in wages for individuals who have changed jobs in the past 12 months stands at +7.9% over one year.
The ECB’s first line of defense
The outcome of this showdown will depend on several factors, including the tolerance of central banks for a recession. Christopher Waller’s speech in June implied that the Fed would easily accommodate a rise in unemployment to 4.25%, in order to limit inflation expectations. US inflation is at 9.1%, a far cry from the 5.2% that prevailed when Powell was still defending the idea of transitional inflation in Jackson Hole last year. Although the fall in gasoline prices is already reflected in certain price surveys of businesses and households, wage expectations remain high. The median increase in wages for individuals who have changed jobs in the past 12 months thus stands at +7.9% over one year. The bargaining power of workers risks fueling inflation, despite the recent adjustment in price expectations. Markets react to marginal changes. The neutrality of monetary policy is also elusive. Current interest rates are far from discouraging household demand for credit in the United States. In the euro zone, the 50bp increase in key rates puts an end to the absurdity of negative rates and buys the hawks’ support for the new crisis management instrument. The ECB finally has to react to record inflation. The IPT (transmission protection instrument) is conditional on compliance with budgetary rules and would only be activated after the exhaustion of the resources linked to the reinvestments of the PEPP (Pandemic Emergency Purchase Programme), described as the “first line of defence” by Christine Lagarde. The ECB is thus seeking to dissociate interest rate policy from the management of financial risks. There is no indication that there is a level of spread that would trigger the IPT and in any case, the solvency of a country depends on the level of interest rates, themselves linked to inflation in the euro zone. The articulation of the tools therefore remains nebulous, especially since the ORLTC system (targeted long-term refinancing operation) will have to be extended or amended to avoid a balance sheet contraction of 1,300 billion euros in June 2023.
The Italian risk
Fixed income markets have shown themselves to be sensitive to the price components of the Fed’s regional surveys and more generally to signals of a slowdown. The inversion of the American curve has become more pronounced. The Fed needs to get restrictive, but it won’t stay so forever, depending on the market. Be that as it may, the short-sightedness of market participants seems to prohibit betting on long-term inflation scenarios, especially as the barrel of WTI is beginning to reflect the recovery in American production. Breakeven valuations are nevertheless attractive, at 2.3% at 10 years. In the euro zone, the behavior of the Schatz is erratic. The 50bp rise in rates propelled the 2-year to 0.78%, before a 30bp plunge in two sessions. The market reversal reflected the ECB’s commitment to act “on the data” and then the drop in the French and German purchasing managers’ indices the next day. The Schatz also reflects a certain lack of collateral and the search for security in the face of Italian risk. The IPT is a crisis instrument that will serve more to avoid contagion of Italian political risk to other peripheral debts.
The credit market benefits from redemptions of short positions. Crossover volatility remains high, but the market reacts to the slightest favorable signals, such as the resumption of Russian gas flows. Bad economic news is finally well received, as it reduces the probability of a more restrictive monetary policy and implied volatility. This is a recurrent paradox of current markets, which also tends to favor growth stocks and the “quality” factor.