A soft landing is becoming a distant dream
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Major moments in markets tend to come with some sort of gimmick to explain them. In 2020, it was letters of the alphabet. After the initial Covid crash in markets and in the economy, investors focused on what shape the recovery would take. Would it be V-shaped, with a rapid pick-up from the depths? Or W-shaped, with a succession of setbacks? Or would it take an L-shape, with us all getting knocked down, unable to get up again?
Economists and central bankers spent considerable time using letters to help the public understand what might lie ahead. In the end, the V prevailed. Now, a historic overshoot in inflation is causing concern — the invisible hand drawing the upward flick in the winning letter just won’t put the pen down.
Central bankers are fighting back but the letters have been discarded. Instead, the framework to help us all understand the task for Fed chair Jay Powell and fellow policymakers, has been focused on landings: hard landings, soft landings, and bumpy landings in between.
Cue reams of analysis over how much space pilot Powell has to work with. “The soft landing is still our base case but the runway is getting shorter and narrower,” as Nuveen’s chief investment officer Anders Persson put it last month.
However investors’ confidence in that glide path is now evaporating. At this rate, that short, narrow runway will be surrounded by shark-infested waters and beset by hurricanes. “Policymakers have lost control of the narrative so they have to act, but they would be geniuses if they can soft land this thing,” says Kit Juckes, macro strategist at Société Générale. Juckes recalls that on a recent trip to see investor clients around Europe “every single one thinks there’s going to be a hard landing”.
Personally, I think this theme could be made even more engaging if Powell donned a uniform and aviator sunglasses for his press conferences — but so far, no joy.
In his latest pronouncements on the matter this week, the Fed chair effectively told passengers to brace for a rough ride. Tackling inflation “is highly likely to involve some pain”, he said at a central banker get-together in Portugal.
A close focus on the Fed is appropriate of course. For all the talk of a multipolar financial system, US markets clearly dominate the global investment landscape. When investors sense that US inflation is running far beyond the Fed’s control and it will bump up interest rates even more aggressively than the market already fears, US government bonds fall hard, pulling down stocks in their wake and usually boosting the dollar too.
And the ripple effect spreads widely — witness the latest scare in eurozone government bonds that particularly punished Italy. To Juckes’ mind at least, that was in good part attributable to the gravitational pull of US bond yields, not to news specific to the eurozone or to Italy itself.
But it is not only Powell who is attempting a tricky unscheduled landing that could tip markets over the edge. Europe’s debt markets still have the capacity to rupture if funds decide to take on the European Central Bank’s commitment to stop the eurozone bond market from fragmenting. Confidence in its ability to find a way to stop Italian yields spiralling higher is not universal.
And do not forget the Bank of Japan, which is bucking the trend for higher rates and still working hard to keep Japanese government bond yields close to zero. Some investors and hedge funds spot an opportunity to raise a challenge, and are betting that yields are poised to break higher.
Mansoor Mohi-uddin, chief economist at Bank of Singapore, warns that if they are right, this would be a destabilising moment for global markets, drawing a parallel with the Swiss National Bank’s shocking removal of the upper limit on its currency in January 2015 — a step that sent the franc rocketing, wiped out traders from hedge fund managers to have-a-go retail punters, and shook every major currency.
“JGB yields would go through the roof,” he says. That would, in turn, likely fire up other bond yields too. He believes that on balance, it just won’t happen. “[BoJ governor Haruhiko] Kuroda will not relent,” he says. “This is a once-in-a-generation chance to get inflation up to 2 per cent.”
Schroders notes that to this end, the BoJ has had to “swim hard” to hold yields down, snapping up north of Y10tn of government bonds a week lately, from an average well under Y2tn. It now holds nearly half of all the outstanding JGBs.
So, the BoJ is flying in the opposite direction to most of its peers, but it faces a difficult landing of its own. For most, the issue is trying not to avoid undue pain in economies and, by extension, in portfolios.
The Bank for International Settlements — the central bank for central banks — is clear that policymakers must be resolute. “Transitioning back from a high-inflation regime can be very costly once it becomes entrenched. All this puts a premium on a timely and firm response,” the BIS said in an examination of inflation pressures released as part of its annual report.
“Central banks fully understand that the long-term benefits far outweigh any short-term costs,” it added. “And that credibility is too precious an asset to be put at risk.”
If you are still hoping that central bankers will rescue your portfolio after a dreadful first half of the year for most investors, that statement should tell you that now is the time to check for your nearest exit from the aircraft. Please remember it could be behind you.