First the Fed, now the ECB.
Last Friday, in response to a journalist, Christine Lagarde declared that it is ‘far too early’ to consider tapering ECB asset purchases. Her attempt to dismiss an unwelcome question is reminiscent of the Fed’s efforts to talk down taper. Yet the steadfast refusal of the Fed or the ECB to engage in taper talk is at odds with the approaches taken by the Bank of Canada and the Bank of England, which have already taken steps to slow bond buying.
No matter what central bankers may prefer, taper talk has arrived. And like an annoying houseguest who never leaves the party, this Mr. Taper and his talk won’t go away just because central bankers say so. Moreover, obstinacy could make matters worse.
Global growth is surging past already high expectations. More firms are reporting bottlenecks in procurement, production and distribution. Prices and wages are beginning to climb. It is hardly surprising that journalists and investors should begin to ask central bankers tough questions about easy money policies.
By refusing to engage on the subject, and even more importantly, by asserting confidently that it is not warranted because accelerating inflation will be ‘temporary’, the Fed and the ECB risk spiking the markets’ punchbowls, creating a bigger mess down the road. A bit more uncertainty, on the other hand, could dampen investor exuberance before it becomes irrational.
Talk of tapering is also warranted given a booming world economy. China and the US have led the rebound, thanks to their earlier successes in reducing Covid-19 infection rates, hospitalizations and deaths. In the US, vaccination has been decisive in permitting the resumption of economic activity. Despite a more sluggish vaccination rollout, the EU is now beginning to see improved growth, particularly as export demand lifts goods production. While India and Brazil struggle with the pandemic, other emerging economies are recovering, boosted by soaring commodity demand and prices, alongside accelerating world trade growth. Those trends have been underscored by the latest purchasing manager surveys and a raft of other positive data.
Accordingly, output gaps are closing more rapidly than anticipated. Accelerating economic activity has also outpaced employment growth beyond what is typically seen during recoveries. Labor market rigidities, including lower participation rates among some groups, are impeding re-hiring. Bottlenecks are also becoming more apparent in product markets.
Barring a recurrence of the pandemic, global growth will remain robust over the remainder of 2021. Economic re-opening will occur in successive waves across the world economy, reinforcing activity via trade and production linkages. Although US fiscal support will probably wane by early 2022, it now provides a strong tailwind.
As noted, some central banks have already begun to make adjustments. Also, the latest Federal Reserve Open Market Committee minutes suggests that the Fed will soon debate when to scale back asset purchases. If so, consistency of communication will imply that the Fed will have to change its language, moving away from confident assertions that inflation will be ‘transitory’ and adopting messages that express more balanced views on growth and inflation.
It is clear that taper talk has arrived, and it won’t go away easily. So, what does this mean for the markets?
Bonds are first in line. Over the past nine months, yield curves have steepened, as rising long-term inflation expectations have driven up longer maturity bond yields, while central banks have held short rates down with resolve that policy will not change soon. Accordingly, shorter-dated notes are most vulnerable to taper talk. Long-term yields will also rise, but the most likely outcome is a flatter yield curve.
For equities, much depends on what tapering means for growth and earnings. If tapering is only about tapping the brakes to prevent unwelcome inflation and to promote a long expansion, investors will continue to shift from pricey growth stocks to cheaper cyclical shares. But given that earnings growth is already peaking, and broad market valuations are elevated, talk of taper will coincide with more pedestrian equity returns.
The chief concern remains surging inflation and a jump in long-term inflation expectations. That outcome spells trouble for stocks and bonds, given that central bankers would tighten more quickly and aim to slow growth. Investors would find few places of refuge. Some assets that might perform, such as cryptocurrencies, come with lots of uncertainty. Gold and commodities could do well, but if the US dollar surges history suggests poor performance.
In short, taper talk matters. Neither investors nor central bankers can wish it away.
No one likes an unwelcome guest who won’t leave a party. For central bankers, that guest is the voluble Mr. Taper. And annoying as he may be, Powell and Lagarde must not let him distract them, lest they forget that their primary job is to ensure that the punch bowl is removed before the party, not the guest, becomes the problem.