Freedom delayed, momentum stalls, bonds rally and the EU issuance programme kicks off

Blain’s Morning Porridge 15 June 2021 – Freedom delayed, momentum stalls, bonds rally and the EU issuance programme kicks off

“In bond markets there is truth, but often hidden in plain sight…”

This morning: As the US Fed meets to discuss rates and assess the real inflation threat, the UK Covid-freedom delay is likely to stall recovery momentum and add to the economic pain being felt at the micro-level. Markets are pricing for a transitory inflation bloom, but what is the real inflation outlook and what will it mean for bond markets as the European Union launches Europe’s fully mutualised funding programme – don’t anyone tell the Germans its happened!

 What is the Fed going to say about rates and inflation this week…? Analysts think the 10-year Treasury bond’s rally from a yield of 1.63% to 1.43% paints a zero inflation-threat picture… but the reality is the hike in bond prices could hide a multiple of sins. It may be the market anticipates the Fed will have no choice but to hold rates “lower for longer”, or that it collectively believes “yield curve control” means the instrument that best represents the “global risk free rate” (the 10-year bond) is just another manipulated meme stock!

Back in the UK

What will Boris’ decision to stretch the Covid controls for another month mean for the UK economy? Another serious economic misstep? If it achieves one thing, it will be to knock the slowly building recovery momentum out the economy. (It definitely won’t stop Covid!) Anecdotally we are all hearing many small businesses struggling, companies putting staff back on furlough hoping-against-hope they might be able crawl through to full re-opening and a declining hope for commercial normalisation. An extra month could prove just too long for many…

The hospitality industry just lost 25% of their business: they have 2/3 of the summer months – 8 weeks from mid-June to mid-September – to make any kind of meaningful money this year, repay their debts, and rebuild for next year. Forget the agenda-driven stories about wage driven inflation, furlough work dodgers, or how staff shortages pushing up costs and driving businesses into closure are the issues.

It’s simple: govt policy and the imminent cull 20% of the hospitality business makes it a singularly unattractive option for any youngster considering their future options.

The next few months in the UK are going to get messy and nasty. The loan schemes are over, the furloughs are coming to an end, and the Inland Revenue is apparently unwilling to countenance any further tax delays. The pain is going to get very real, and expect to see mass insolvencies….

On that unhappy note….

Inflation and bond markets

The inflation debate rages on… whatever the outcome in coming months: rising inflation + rising rates, rising inflation and flat rates, or even rising inflation and falling rates in a deflating economy – all of which are entirely possible in this crazy financial continuum – the fundamental upside for the bond market looks limited. Notice my choice of fundamental which would infer rates rise to balance inflation – but central banks may decide its worth manipulating interest rates lower, even if we see stagflation in a deflationary economy! Why, You ask….? Because, they may have little choice but to…

The inflation scaring us today is 2-fold.

First there are the resurgent monetarists arguing their voodoo mumbo-jumbo about how monetary mistakes are creating so much money and expanding the money base to such a degree that inflation is inevitable. Economists are split between how the competing definitions of M0 and M3 inter-react, but the reality is probably… not the way they think! The Money we use exists and is created as credit in banks, while the money the government and central banks have created is – by-and-large – trapped in financial assets/markets.

The second is supply chain readjustments. Three stories illustrate the consequences:

The first is post-pandemic over-eagerness – a speculative effect. Lumber prices in the USA are down 40% from their peak, when everyone wanted to rebuild, house prices shot up in anticipation of families spending savings, and now the builders that pushed up lumber prices find themselves over supplied. The same effect can be seen in price of critical materials which, like copper, came off their highs as soon as the market started talking about a new commodities supercycle! Or, how about airline stocks – when we anticipated the reopening of global travel, airline stocks soared.. now they’ve landed again with a hard bump. All around the globle there is the smell of hard-reality around the meme of post-pandemic, repressed spending recovery trades.. Reality bites.

The second is real supply chain issues – like the global dearth of semi-conductors. You can’t open new chip foundries over-night, just like a real trade war, or the end of globalisation will have hard, real effects on global trade and supply chains.

And then you have price inflation – which I read yesterday is happening in the Auto industry. The price of many (not all) cars in the UK have become increasingly “unaffordable” according to the Thunderer of London, rising five times faster than wages! It’s been driven by the cult of increasing the amount of technology in cars, improved comfort and ride, and the switch to hybrid and electric.

A Wrangler Jeep costs double (actually 117%) what it did in 2011 – yet, its still, essentially… just a car. The Nissan Electric Leaf is at the other end of the scale – it cost £26k in 2011 and costs the same today. Since you won’t catch me driving a Leaf – I suspect there is a lesson in that pricing….

There are plenty of financial analysts writing about the unsustainability of continued debt issues, the volume of corporate debt issued by collapsing zombie companies being supported by ultra-low rates, and how the entire financial stability of the west is about to be brought down by sovereign debt crushing currency confidence… etc etc.. Whateva…

Nations have the luxury of owning the keys to their digital money printing presses.. The risk is over-pressing the print money button will compromise confidence in the currency, trigger massive inflation, leading to wheelbarrows full of trillion-dollar notes and all the ills of inflation. The reality is most nations exercise caution, act in their sovereign best interest to balance fiscal spending versus monetary stability and confidence while maintaining the sovereign credit.

Which neatly brings us on to …

The European NGEU bond programme..

In view of the looming inflation threat, the monetary distortions created by ultra-low rates, and the frankly limited upside bond market potential relative to its massive downside risk… it’s an interesting moment for the EU to be launching its new bond programme – The €800 bln Next Generation EU Bond programme. Part of the thinking is for the EU to make itself a global liquid alternative to US Treasuries, perhaps with visions of becoming the global risk-free rate as the pre-eminent sovereign bond issuer?

I think not.

The programme is the beginning of European debt mutualisation. Plain and simple – to anyone except German politicians. The problem is the EU is not a sovereign… it’s at least one step lower on the issuer foodchain – a supranational. There isn’t even a “joint and several” clause in the bond documentation to say all nations are on the hook for the borrowing. It’s assumed they will all meet their obligations under EU membership.

All of which means NGEU bonds are just credit bonds – where you get to weigh up all the pros and cons of just how likely the money to pay interest and principal is going to be. Which, can’t possibly be a risk when the Germans are involved… ahem.. EU Budget Kommissars say: “ The Euro and EU are safe assets, a safe haven” even as they point out the bonds have a beneficial political impact – which is making Euro member states beholden on Brussels for their fiscal financing, and therefore more likely to toe the Brussels line.

The first tranche of €10bln 10-year bonds will price today around 30 bp over Bunds, and will be massively oversubscribed because everyone will want to play and be involved.. but I have my doubts…

Five Things to Read This Morning

WSJ – Pandemic Hangover: $11 trillion in Corporate Debt

Torygraph – Inflation doves are taking a huge risk with the global economy

FT – Wild Popularity of GameStop and AMC leads to ETF distortion

FT – El-Erian: Fed Meeting turns into a test of its inflation narrative

BBerg – Europe’s Debt Avalanche is Just About to Start

Out of time, and back to the day job..

Bill Blain

Shard Capital