Your weekly economic update from the team at FXD Capital
On Thursday, the Bank of England called everyone’s bluff and kept interest rates unchanged at 0.1%. The decision was a strange mixture of surprise and inevitability; while the market had been pricing in a rise to counter recent inflation danger, there was also the sneaky feeling that Threadneedle Street was always going to try and keep the lid closed a little bit longer.
Since the decision, GBP lost ~1.5% against USD to 1.34 as carry trades unwound following the flattening of short-term yield curves. Stocks rallied as their prospects granted a stay of execution (for the time being), with the opportunity cost of switching to higher-yielding bonds declining. UK government debt rallied, with ten-year yields sinking 0.14% to 0.93% and the curve steeping, with two-year marks dropped 0.21%. The ripple effects brought similar effects in German and US bond markets too.
So what does the decision mean for investors and the economy? The main takeaway is the danger of the BoE losing credibility as its goal of keeping inflation unchecked seems incongruous with prevailing conditions. The pessimist in me expected an unchanged rate decision, as the desire to maintain the status quo is substantial, based on the naive view that inflation is transitory. However, a rate rise would bring about a maelstrom of conditions that could put the economy into a tailspin: pressure in the housing market, stock market falls and, let’s not forget, higher government borrowing costs.
In contrast, on Wednesday, the Federal Reserve announced the curtain call for its $120bn monthly bond-buying programme. It will now start to taper its support, which will release the valve on demand for bonds and, according to theory, place upward pressure on yields. The decision looked to be priced in, as markets rose off the back of the call.
Elsewhere, the Reserve Bank of Australia also curtailed its yield curve control initiative, beating the Fed by one day. The result of the decision is that the RBA will no longer look to maintain a peg of 0.1% on three-year bond yields while persisting with its target of keeping inflation in the 2-3% range. Instead, Bond-buying will continue at a pace of AUD 4bn until at least February 2022.
One of the more intriguing barometers of global sentiment is CNN’s “Fear & Greed Index”, which tracks various indicators to view overall holistic feeling: are investors scared or displaying irrational exuberance. At the moment, it sits at 82 out of 100, with the top mark signalling “Extreme Greed”. The main conditions resulting in current conditions are stock market performance (7.01% above 125-day moving average), junk bond yields (at a low of 1.83% over investment-grade debt), and stock put/call option ratios (put option volume lagging calls by 64%). The index level of 82 sits at levels similar to pre-Covid (March 2020) and pre-2021’s mini spring crash. While the markets will never conform to such simple signals, the indicators now do point to some form of future turbulence, as investors are displaying excitable optimism in the face of irrational conditions.
In banking news, Metro Bank is in the crosshairs of a takeover by US private equity firm The Carlyle Group. Over its 11 years, Metro Bank (at the time, the first new UK high street bank for 100 years) has seen a spectacular rise and fall. Its inability to make a profit and compete with established players sees its shares trade at a 98% loss to its highs from 2018, with the collapse driven by non-performing loans, governance issues and opaque plans for sustainable profits. The fall of Metro Bank shows how optimism about a new form of banking has evaporated over the past couple of years, with even neobank Fintechs like Monzo losing their sheen. While high street incumbents are not perfect, they have prevailed over upstarts due to their sheer staying power and entrenched relationships, which are barriers to entry for new firms. As a result, Metro Bank has to operate at the periphery, moving into alternative forms of lending (e.g. Peer-to-peer lending) in an attempt to find margin. With its book value of assets trading at a steep discount, a move out of the firing line of public markets into private control may represent an opportunity to convalesce under a less scrutable manner of governance.
All the best for the week ahead
Our weekly column is written by Alex Graham, Economic Advisor to FXD Capital. Originally a bank treasurer, Alex’s weekly roundup intends to provide a conversational, top-down view of what is going on in world macroeconomics and how it impacts business on the ground level.
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