Words of the week: what ‘transitory’ and ‘tapering’ mean for investors
We heard a lot of t-words this week — particularly “transitory” and “tapering”. Pendal portfolio manager Tim Hext (pictured) explains what it all means in our weekly Bond, Income and Defensive Strategies wrap.
TWO THEMES dominated bond and equity markets this week.
The first was the Fed’s plan to label the latest inflation surge as “transitory”.
Although US Federal reserve speakers are allowed to speak their views, they generally follow the party line. Right now the party line is that the recent surge in inflation “largely reflects transitory forces”.
The implication is: all will soon be fine if the cycle plays out as usual.
Those Fed speakers were out in force this week — Evans, Barkin, Clarida, Quarles, Daly — and we may see similar sentiments from the RBA next week.
There is some truth to this.
Commodity prices always surge coming out of a recession. Firms generally cut back supply in a recession and are slow to react to stronger demand.
This causes shortages that last about two years before supply catches up with demand. Last week we included a graph that shows this.
However another story coming out of recession is that monetary and fiscal policy are tightening in line with stronger demand.
Equilibrium at lower prices is reached by both expanding supply and contracting demand. This time around governments and central banks globally are very happy to be way behind the curve.
Massive stimulus will stay in place and it is therefore likely commodity and goods prices will be higher for longer.
Transitory perhaps. But when measured in years — not quarters — the risk of embedding inflation in the system is much higher.
The second theme for markets this week was tapering — in particular signs that the idea is slowly entering the minds of central bankers.
At many central banks tapering initially means reducing the size of Quantitative Easing (QE) programs.
US Fed minutes reveal that while there will be no change for now, they will soon be talking about reducing the size of purchases. It’s a similar story with the ECB.
And the Reserve Bank of New Zealand went a step further on tapering, reinstalling its OCR (cash rate) track. This shows potential for rate hikes beginning late next year and into 2023.
RBNZ governor Adrian Orr did provide some fresh honesty for a central banker by reminding everyone this was an educated guess and who really knew the future.
In Australia the RBA has signalled July as a crunch time for tapering, of sorts. They are unlikely to extend their yield curve control beyond the current April 2024 bond, if that can be called tapering.
They are also likely to announce whether QE will be extended beyond September. Here consensus is they will — but perhaps reduced from the $5 billion per week.
The Australian Office of Financial Management recently announced $130 billion of issuance for 2021-22.
The RBA is now buying $4 billion per week (plus $1 billion of state debt). At the current rate this means the RBA will finance the government in seven months.
Of course the RBA is keen to separate its QE (the purpose of which is driving down term rates) from government financing, but by buying the bonds they are financing the government.
We expect a halving of the QE program to $50 billion, reflecting reduced issuance and likely tapering offshore.
So the message from central bankers is clear: “Trust us. Relax on inflation. If it does get too high we’ve got this.”
The market reaction over the past two weeks indicates this is believed. We can see this in the chart below.
The market was gradually pricing in the rising inflation in a steady manner from around October last year.
It got a massive spike upwards in February but since then has consolidated and started trending down.
The question now is which direction will this head.
For now though some of the pain experienced in February is starting to be reversed for bond holders.
Tim Hext is a portfolio manager with Pendal’s Bond, Income and Defensive Strategies (BIDS) team.
Led by Vimal Gor, Pendal’s BIDS boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.
The team oversees $22 billion invested across income, composite, pure alpha, global and Australian government strategies with the goal of building Australia’s most defensive line of funds.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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