The Rate Debate

Ep32: Are central banks at risk of blowing up markets?

• Darren Langer and Chris Rands

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The RBA hiked rates for the sixth consecutive month. With lead indicators showing signs of inflation coming off the boil and European banks starting to see stress, cracks are forming in the credit and equity markets. Have central banks tightened too aggressively risking a recession?

Chris and Darren debate this and more in episode 32 of The Rate Debate.

Speaker 1:

Hello and welcome to the Rate Debate. I'm Darren Langer, co-head of Fixed Income at Yara Capital. And joining me as always is my co-portfolio manager, Chris Rans.

Speaker 2:

Hello everyone. Well,

Speaker 1:

It's the first Tuesday of October and the RBA has just spent and somewhat surprising, the only raised interest rates 25 basis points. I say only cuz uh, I think most people were expecting 50 basis points this month. Although you and I were kind of hoping that the RBA may temper, uh, some of their language a little bit and maybe cut things back a bit. What did you think of the statement? It looked pretty much the same as the previous one to me.<laugh>?

Speaker 2:

Yeah, the, the statement looked remarkably similar to the prior months. I guess the thing that kind of I noticed and pulled out of it was at the very start they say the cash rate has been increased substantially in a short period of time. So because of this, the board decided to only go 25. So the messaging that they've given over the past couple of months, that at some point they will need to slow down seems to be here. It doesn't really kind of explain that reason, but they're saying because we've moved rates so far now time to go 25.

Speaker 1:

Yeah, I think um, it probably means that the previous month's decision might have been a little bit closer than, um, it seemed at the time to them actually going 25 rather than 50. I think two, you know, even though they removed the language about being on a pre, sorry, not on a pre defined path, I think if they had gone 50 again this month, you know, you get five 50 s in a row. That's pretty predefined in my uh, sort of feeling. But I think it's, it's a move in the right direction. I still think they probably could have paused and, and waited to see, but you know, whether they go next month 25 or pause is probably more likely now than, um, you know, going back to 50 I would assume.

Speaker 2:

Yeah, I think there's kind of two things as well that you can pull away from kind of the comments that you made. The, the first is in one of the speeches that LO gave last month, he did say that they were considering 25 or 50 last month. So, you know, clearly they've been thinking about this slowdown for a little while. But the other positive I guess is that, you know, I agreed with you that they, they should be probably pausing and, and looking at what they've done. I think after this the market can kind of start to pull some of their forecasts back a little bit. If you think about everybody forecasting 50 points for this month, they're probably gonna forecast the exact same again next month if they had a done 50 and then they probably would've forecasted it again for the meeting after that. So the fact that they've gone 25 and discussed going 25 last month says, you know, I think the market can start to back away from some of the more extreme

Speaker 1:

Forecasts. Yeah, we certainly saw after the, the announcement, you know, the, the bank bill futures sort of rallied around 75 basis points. The, the three year bonds probably closer to 50, 55 points and the tens probably around that 25 mark obviously, you know, has pulled back a little bit since then to, to probably more reasonable levels where it, it's taken out the 25 extra hike that was probably built in by the market. But I'm guessing given the savage reaction, uh, quite a few people by surprise and given most of the major banks were probably still forecasting 50, uh, other than cba, you know, it probably did catch a few traders I would say, uh, around the wrong way. But I think, you know, from from our perspective this was always gonna happen eventually it was just a matter of when. So given the RBA have pulled back to a 25 point hike, they're obviously starting to see some of the signs that we've been talking about and you know, one of those initial signs we, we did mention at one stage was, you know, the curve starting to invert, but at the time, you know, a lot of people refused to sort of accept that because most other indicators out there weren't showing signs of recession. What are you seeing in the numbers at the moment?

Speaker 2:

Yeah, you certainly I think, see this coming through the RBAs statement. So part of what they said in the statement is that the path they're on is narrow and that it's clouded. So the offshore outlook I think is starting to concern them a bit. They've said for a while that they're pretty comfortable I think with what's going on in Australia, but the language that they're using for offshore I think think's kind of becoming pretty negative. If you think about that curve, Inver at first inverted about three, four months ago and at that point in time, you know, I probably got poo pooed away as not really forecasting too much, but if you look through indicators that forecast a recession now it's really kind of starting to say that something is not quite right. So, you know, if you look at the US economy, I think where most of those indicators sit, housing purchases are slowing, consumer confidence is at 50 year lows, business confidence is at 30 year lows. You're seeing the global PMI drop new orders within those PMI are dropping, you're seeing spreads widening, the NHA B housing index is starting to fall. It doesn't really matter where you look at the moment, you can see an indicator that he's starting to flash recessionary. So I think certainly for the rba, when you're looking at credit spreads widening, when you're looking at lead indicators starting to fall, you're starting to see, you know, banks throughout Europe start to find some stress. You probably do start to become concerned at some point that we're gonna have to slow down and and give a little bit of support to what is going on. So certainly I think the curve was probably the first thing that flashed that warning. They haven't listened to it because they've obviously hiked probably another 150, 200 points since the curve inverted and now you're getting the economic data to confirm that something is not quite right.

Speaker 1:

Two of the more interesting things are, one, the curve is telling you that growth is probably about to slow. We've been talking about that for a long time. The other really interesting one is that bond break evens for inflation link bonds now are moving back towards more around that 2.5 even a little bit lower, probably starting to try and head back down towards 2%. That's certainly not the bond market telling you that inflation is gonna be embedded for a long period of time. The bond market least inflation link bond market seems really relatively san when that um, you know, the central banks will achieve their target, that that may or may not be true bond markets. Not always right, but you know, I kind of have more faith in bond market's ability to predict the future than perhaps the equity market or some of the other more, um, bubbly sort of markets.

Speaker 2:

<laugh>. Yeah, and if you loo if you use the lead indicators as well for inflation, there's also quite a lot of other signs that they're starting to come off. So if you look in the small business optimism survey, there's a prices paid component, it's starting to really drop away. Uh, if you look in the PMI surveys, they have prices paid and it's starting to drop there as well. And as well, commodity prices are are starting to come off. So, you know, you've got a few signs now that inflation probably looks like it has peaked and will start coming off from here, which is probably, you know, the inflation market starting to forecast that as well, that you know, the rates are doing their job and you're starting to tighten things a bit too much.

Speaker 1:

Yeah, I think one of the other things that was also interesting this week is that one of, one of the themes we sort of talked about is that if the Fed and RBA and other central banks kept going at the pace they were going out, the the risk of breaking something was quite, quite high. Our gut feel was that was likely to be something in Europe, we weren't quite expecting it to be the United Kingdom that they were break, but it looks like the UK got itself into a bit of a strife both in terms of, you know, rapid escalation of bond yields and um, and, and also probably a bit of an own goal from their, from their government with fiscal policy. But it is interesting that one of the things we are seeing is that collateral calls are starting to become an issue for the market. And whilst it probably is something that central banks should understand, it certainly hasn't been something they've talked a lot about in in recent month and that, you know, what we saw was that as long bonds and um, you know, long swaps started to lose value, people are forced to put cash up against that collateral. The most easy way to do that is to sell bonds, to raise money, and of course that exacerbated the selloff. So you've got a situation where people are trying to raise cash by selling the assets that they would normally be using to hedge their liabilities. So it, it is quite a interesting situation and you know, the things we keep hearing is that there is kind of a, a shortage of collateral out there at the moment and that's really a function not of the fact that these are bad borrowers or, or bad swap participants, but just the rapid rate of hiking has forced them to post a lot more cash collateral against, you know, a liability side where they, they don't have that luxury to do that on the other, on the other side. It's

Speaker 2:

An interesting situation I think as well because the UK government is obviously doing something to try and, you know, give the economy a bit of kick along as they start to see the same signs that we are talking about that they're probably entering a recession. And so as they're trying to do a bit of, you know, spending essentially to get the economy back to life, they're leaning against what the BOE is doing in hiking rates and trying to slow the economy down. So you're ending up again in this perverse situation where the government is trying to do one thing and the central banks are doing the exact opposite. Now when interest rates are zero, I think you can kind of overlook some of these problems and say it's no, it's no worries, let's forget about it. But as interest rates move to a level where governments and everybody else is gonna struggle to fund themselves, the market just says no. So the interesting thing that I came, kind of took away from this was it took about the BOE about two or two days to back away from the idea that we're not gonna do anything and support the market cuz as you said, somebody's starting to blow up and we need that support.

Speaker 1:

Yeah, we always figured that, uh, quantitative easing would come back in some shape or form in the future. We just didn't expect it to be quite so soon. And almost literally a day after the, uh, Bank of England, uh, had started to talk about quantitative tightening again, yes, it was a limited response, but you wonder that what they've got in their toolkit that they could have used otherwise then that then what they did do. And you know, it was quite a scary run on rates on that particular day and, um, you know, a lot of, a lot of people were suffering. I think, you know, this is, this is one of the conundrums is that central banks eased very aggressively into into the covid period, which created behavior of, you know, various people who would normally have held relatively low risk assets and forced them into higher risk assets. And then they've gone and pulled the rug out from the market rapidly increased rates and haven't really given them a chance to adjust how systemic these problems are still remains to be seen. But we seem to be starting to see some of the same cracks that we saw, maybe not during the gfc, but certainly during the last European crisis in sort of that early 20 10, 20 11 period. And, you know, sovereign governments in in Europe, you know, are, are probably not as strong as, as what they could be and a lot of that debt is also right through their entire banking system. And one of the other things we have seen, um, now is at certain banks, you know, again where they're considered to be a little bit weak or maybe not quite as strong as they could be, you know, we're starting to see some other cracks forming in the, in the credit markets as well. Yeah,

Speaker 2:

If you kind of take that idea and, you know, extend it to what you said just before we, we originally thought that the pain's gonna come somewhere from Europe, but if we had to guess, we probably would've thought that it'd be a country like Italy or something like that. So the idea that it's coming from the UK I don't think is kind of too far away from what we're thinking, but when I look across Europe at the moment, you can still see that pain starting to come. Now when you look at Germany, their economic situation looks pretty dire and they're meant to be the strongest country in Europe holding it all together. So, you know, as the ECB talks about putting rates up to, to slow the economy down when you know, more than likely some of those countries are probably already in recession, you're entering that dangerous territory where credit spreads start to move wider. So I think it was, you know, a little bit of an outcome that we wouldn't have quite expected for to be the, the guilts market to do it. But in the same breath, you know, you're starting to see credit Swiss spread start to widen. You're starting to see UBS bank spread start to widen. So you're getting this kind of link with the sovereigns and the banks again, where it doesn't quite look right. And if you're going to be hiking, you know, a hundred points a meeting for the next few meetings, you might just find out that, that your economies can't handle that.

Speaker 1:

And it's also not just the, the credit spreads, but, but their equity prices for most of these banks have have taken a bit of a tumble over the last couple of months. You know, some of them have probably seen prices drop 20 30%, which obviously impacts their, their capital as well. Again, banks are pretty well capitalized. We we're certainly not trying to say that this is a, a warning sign GFC style, but, but it's certainly something to keep aware of that some of the cracks that we did see during the, the last European financial crisis are still there. And interest rates seemed to be the catalyst. You know, things were looking quite healthy. You know, Italian spreads were 50 over the bones when interest rates were zero. Now even the buns themselves are looking a little shaky and you know, we'd expect to see, you know, the prefer European debt and some of the, um, European banks start to sort of widen in spread terms because of some of these risks that are starting to appear. It's no longer a ni case of, you know, credit risk or default risk. I

Speaker 2:

Guess that as well I think lines up with, you know, the timing of the BOE talking about quantitative tapering and, and this as well, you know, if you look at the ECB again, I, you know, I always seem to end up picking on Italy, but it's the easiest one to make. The example with their, their government debt to GDPs over 150%, they're running a huge deficit. And if they drop into a recession, if the ECBs not buying it, I certainly wouldn't want to be. So you end up in this kind of space with what the BOE has seen, that if it starts moving wider quickly, there's not gonna be really anyone that wants to own it. And so that's kind of, when I pull that back and kind of think about what we are saying is these governments and central banks have been building, you know, a debt position for 10 years. You don't get to just unwind it over three months.

Speaker 1:

So that, that brings us, I guess to the, to the last, uh, sort of, um, corner of the room in terms of, you know, what the Fed are doing. I mean, they, they're really been the, the poster child for rapid tightenings. Um, a lot of what is being, well, a lot of what is happening around the world is being driven by Fed policy. You know, one of the things we've talked about a fair bit over the last few months is that the Fed ultimately becomes central banker to the world, whether it likes it or not. So much of the world is priced in US dollars. Uh, so much of the world revolves around having cheap access to US dollar debt. You know, what are we seeing in the US and do you think, you know, the Fed are still talking tough, but do you think they're about ready to sort of, um, put on the brakes?

Speaker 2:

<laugh>? I kind of think of them as as similar to what the RBA is doing is what they should be doing. They should be getting ready to put on the brakes because as we said before, most of their lead indicators are pointing straight down. So if you're looking at the economy from a lead perspective, you'll be saying, this doesn't look too great. You know, let's think about what we're doing here. It seems though that they're just running the economy off the unemployment rate and inflation, both of which we know are at best coincident indicators, and they're probably actually lagging indicators. So the language that is coming out of the Fed is essentially saying, We're happy to see unemployment rise. You know, we are happy to potentially take a recession if it means that inflation comes down. Now the tough thing with saying that is if you look back through history at unemployment rising, half a percent has always brought with it a recession. So when they say we're happy for unemployment to rise, they're essentially saying, We're happy for this recession to come. Which I think, you know, with what we're seeing starting to see in markets now is a, a pretty dangerous stance to take, but it's the one that they're taking at the moment. Yeah,

Speaker 1:

I think one of the interesting things too is that, um, central banks are, are not voted in to power. They're, they're a function of government to some extent, or at least appointed by government. Central Bank might be quite happy to see, uh, unemployment rise. I'm guessing that the people that lose their job are gonna be less, less happy. And I'm guessing a government up for reelection is going to think twice about, uh, having unemployment rise rapidly, at least. I mean, you can rise slightly, but if you do have a rapid increase in unemployment, I think that would be problematic. I'm not really sure what governments can do about it, but I think, you know, there, there probably comes a time where people start dark up a little bit and we start to have a bit of a social unrest. I still think that's more likely in Europe than in the us but you know, US hasn't exactly been all that, um, stable at various times in recent years either. But it'll be interesting to see how it evolves from a public perception point of view. And you know, we already know consumer confidence is the worst. It's been pretty much ever, it's even worse than what it was in the seventies. So whether, you know, it's people being a little bit, I don't know, I've seen people say the word soft. I think that's, that's a bad way of looking at it, but people are unhappy and you know, whether that's just because, you know, the punch ball's been taken away and things are gonna be a little tougher and that it'll eventually recover. I, I don't know. But I think, you know, it's a worrying sign for, for governments where they've lost the ability to control fiscal policy to some extent because of what's happening with monetary policy.

Speaker 2:

Yeah, and the messaging certainly from the Fed seems to be, it looks like we're gonna have a soft landing to somewhere along that lines coming to. We're fine if it's a recession as well. So, you know, when I kind of think of what you said, the first thing that enters into my head is I certainly didn't vote to put these guys in charge, and I wouldn't vote for someone to have my job lost either. So if, if that's the stance they're gonna take, you can see why governments like the UK start trying to spend to offset it, which is again, where you end up in this situation where things don't line up and perhaps when the government is not gonna be too happy with the policy that they've decided to take.

Speaker 1:

And looking at it just back in our own backyard in Australia, there's been quite a, a lot of people who say, Australia's gonna avoid a recession. Technically it's possible, but from a consumer point of view, they're gonna be in a recession, particularly if house prices keep falling, you know, real wages, uh, are still falling. All those kinds of things that keep people generally a little bit happier. You know, we, we might manage to keep a bit of income from mining and a few things like that, particularly with the Aussie stars to fall, but do you think there's any chance that if the US goes into reception,

Speaker 2:

The argument kind of, I think that most people would use for Australia is that because commodity prices are so high at the moment, we're gonna be able to skate through. The trouble I have with that is if the US or the European Union go into recession, then it's probably pretty likely that commodity prices will drop and we won't have kind of that supporting our economy. If you think back to 2011, interest rates fell quite aggressively. If you think back to 2015, interest rates fell quite aggressively and it was the housing market that supported the Australian economy. So if you look at it from that perspective this time around, housing market's already starting to fall and probably will fall, fall further. And so if the commodity market rolls over, I would very much be thinking that we would probably be entering a recession in that environment too. So, you know, you can look at this and say, it's all good now, but if you're starting to see those clouds form over Europe and the us, which is what the RBA I think is starting to talk about, then it's not that great for our outlook

Speaker 1:

Either. Yeah, I think the, the tricky window now is between sort of November, December, January, you know, over that Christmas period if we keep seeing things worse, and you've gotta assume it's almost impossible for, for 2023 to be terribly positive. But, um, stranger things have happened, but you know, that, that would be my view that if we are starting to see rates bite harder, um, even from previous tightenings, even if we don't go any harder than what we already have, um, you know, it's still gonna be a three or four month before we know for sure, um, where we end up. And I think, again, that's, that's one of the things central banks seem to have forgotten that, you know, monetary policy works with lags, you know, tightening five or six months in a row at unprecedented pace is an experiment that they've never really tried before.

Speaker 2:

Yeah. And when you flow on from that, if the Fed or the RBA or the ECB decided to slow down and take a breather, that would be a very positive sign. But, you know, from what we're hearing from these markets, they're still willing to go and they're still willing to follow through with those fifties and hundreds that, you know, haven't really had the effect from the, the prior five of really flowing through to the economy yet.

Speaker 1:

That's it for this month. If you ever want to suggest topics to Chris or I, um, we can be contacted at the rate debate@yaracm.com. Tune in next month when we deliver our latest thoughts on the RBAs November rate decision and provide an update on what's been happening in markets until next home. Stay safe.

Speaker 3:

The rate debate podcast content may contain general advice. Before acting on anything in this podcast. You should consider your own objectives, financial situation, or needs, and seek the advice of an appropriately qualified financial advisor.