My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

Who do you trust?

This is a pertinent question today when looking at the policies of major central banks, and in some cases, governments (regarding fiscal policy).


We know more or less what the Federal Reserve is doing, and it signals its intentions rather clearly, even regularly between FOMC meetings. It communicates its views and likely policy steps through a regular series of interviews involving various Fed governors and regional Fed presidents with the financial press, as well as comments and presentations by Chairman Powell himself. This creates a level of trust as to the direction of the Fed at least in the short / intermediate term. Some might argue that the Fed has lost credibility because it acted late on inflation. In this respect, it is true that the Fed was wrong, but it is not at all the case that the Fed hid or mis-represented its intentions and associated policy actions. It was just wrong. Bond investors also intervene to forecast the future direction of the US economy and their views regarding the ideal path of increases (or decreases) in the Federal Funds rate. Arguably in fact, bond investors are more nimble – and some would argue are likely to be right – than the Fed is, as far as mapping out the direction of monetary policy.


The Bank of England has even more conviction in its quest to address inflation in the U.K. than the Fed has in the US, providing very clear signals as to its future intentions regarding monetary policy. The history of inflation in the UK is never far from the minds of central bankers, and it ensures that the central bank’s razor-focus is on guiding inflation down following the “pandemic gorge” of (nearly) free money and fiscal stimulus hand-over-fist. There is no mistake about the BoE’s sole priority, which is clearly stated on its website: “Low and stable inflation is good for the UK’s economy and it is our main monetary policy aim.” The BoE also does not hide the economic cost that will likely come along with its near-term policy steps, whereas the Federal Reserve seems increasingly over-optimistic in its forecasts.


Somewhat similar as far as conviction albeit in the other direction, the Bank of Japan states time and time again, in policy meeting after policy meeting, that it will stay dovish. There’s no confusion because the BoJ is an open book – short-term rates will remain anchored at 0%, and yield curve control will ensure that the 10y JGB yields no more than 0.25%. As inflation is increasingly imported via the rapidly-depreciating Yen, the question becomes whether or not the weaker Yen and its inflationary effects will eventually soften the resolve of the BoJ to stay dovish.


Where is there less trust and confidence in the policies of central banks (and governments)? It’s a close call between the European Central Bankand the People's Bank of China, but I would give the edge of least trustworthy to the PBoC. Let me first talk about the ECB though, which is in a real pickle. The issue with the ECB is it is dealing with the three-headed monster of inflation, a disruptive war on its eastern flank, and fragmentation. And of course, there is no ability to provide coordinated fiscal policy in the common currency bloc, since it is only the common currency – not common fiscal policy – that links this disparate group together. I see little reason for investors to take a punt on the Euro or on Eurozone peripheral sovereign bonds, and I am Increasingly bearish (although late) on European stocks, at least the stocks of those companies that depend heavily on sales within the EU. The ECB seems lost and adrift, with a meagre 0.25% increase in the bank borrowing/deposit rate on the table for July whilst the Fed and BoE act much faster and more vigorously in their efforts to tame inflation, which is also raging in the Eurozone. It’s not giving me a warm & fuzzy feeling about the common currency, and it is clear why the Euro is sinking against the US Dollar. Going through parity is almost dead certain once the resistance at 1:1 is wiped out, and I suspect that this is just a matter of time.


China is another matter altogether. I consider the PBoC and the Chinese government in tandem because of a lack of transparency generally, as well as a lack of understanding of the real relationship between the two although the BoC is certainly politicised more than central banks in developed countries. There is an ongoing overhang of “you never know what might be coming next” that always makes me squirm. I like Chinese equities now because I think they have been beaten down so badly and – after all – China is the world’s second largest economy with a large population, a large and willing labour force, and many world-class companies. However, the PBoC also “manages” its currency exchange rate, and the yuan is not fully convertible. China might have a severe property crisis which is being masked, and it is well-known that the government has a knack for vendettas from time to time against certain entrepreneurs, companies or sectors. It’s the uncertainty and lack of predictability that bothers me most and makes investing in China – even at attractive valuations – more risky than investing in most developed market countries. Investors’ perceptions of which central banks to trust the most and the least also has knock on effects into currencies. It’s almost a given that the USD will continue to strengthen against the Yen and Euro, the former for obvious reasons and the latter because the ECB is between the proverbial rock and a hard place. I would be more optimistic about Sterling were it not for the fact that the U.K. economy is in such poor shape with the aftershock of the economically disastrous BREXIT decision starting to really bite as the cover of the pandemic subsides. In markets, it’s always just when you think you have it figured out that the sands shift right under your feet. Maybe this is all too obvious at the moment and we will be in store for a surprise. It’s hard to say, but the “personalities” of each central bank (and in some cases governments) seem crystal clear at the moment, with the ECB facing the biggest challenge and the People's Bank of China (+ Chinese government) being the most unpredictable and most likely to throw an unexpected curve ball. Even so, the road ahead for all of the world’s central banks will be difficult because inflation is raging.

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