Reminiscent of what we saw from late June through mid-August, over much of October markets had another healthy dose of PIVOT!™ (in honour of our friend Ben Hunt, we borrow his “trademark” indicator of something that has entered the common narrative). PIVOT!™ is the phrase that encapsulates the strongly held market sentiment that central bank interest rate hikes are nearing their end, presumably aligned with inflation measures topping out and commencing their precipitous declines back to target, and that the much hoped for recession is just around the corner. This, of course, will lead to the inevitable PIVOT!™ by the central banks as they leap back to what they do best, supporting asset prices, and put an end to this anomalous period of worrying about their price stability mandates.
Approximately around the conclusion of the annual IMF/World Bank meetings in Washington DC in mid-October (probably just a coincidence), when all the who’s who of the respective Sharpe World practitioners from the worlds of economics and finance were gathered, the narrative around PIVOT!™ leapt to the front of all market commentary. Markets responded with great joy and enthusiasm. Of particular note, the Dow Jones Industrial Average had its best monthly return since 1976! Who saw that one coming?
Figure 1: DJIA Index (white). SPX Index (blue). NDX Index (orange). YTD normalized
Source: Bloomberg
Figure 2: Dow Jones Industrial Average (log scale) Monthly 1976-2022
Source: Bloomberg
It wasn’t just the US equity markets that felt the love. European markets also surged back from their September lows. The SX5E European Index was up 9% on the month.
Figure 3: SX5E Index (white). DAX Index (purple). CAC Index (orange). YTD normalized
Source: Bloomberg
For any readers that are unfamiliar with our thoughts on the efficacy of forecasting, we suggest reviewing our July 2022 Update, “The Pointlessness of Forecasting”, https://convex-strategies.com/2022/08/16/risk-update-july-2022/….although, the title kind of says it all.
As we query the efficacy of the predictions leading to PIVOT!™, we can start, yet again, with the visionaries at the ECB. Figure 4 is now updated through the ECB’s September 2022 projections, as well as for the actual realized HICP numbers for October 2022. One thing we can credit ECB Chief Economist Philip Lane with is consistency.
Figure 4: Eurozone HICP yoy% (blue) vs ECB quarterly forecasts through September 2022
Source: Convex Strategies
We first noted our doubts about the “accuracy” of the ECB’s forecasts after their September 2021 projections. We were not alone in querying the data at that time, prompting ECB President Lagarde to come to the defence of her economic forecasting corps with this oft quoted statement:
“We really looked and very deeply tested our analysis of the drivers of inflation, and we are confident that our anticipation and our analysis is actually correct.”
Going back to that auspicious September 2021 projection, we can roughly recreate the ECB’s view as per Figure 5. We are fairly confident that Ms. Lagarde and Mr. Lane employ troops of PhDs with access to all manner of computing power, implementing highly sophisticated multi-variate Dynamic Stochastic General Equilibrium (DSGE) econometric models. There is no way for us to know the full range of variables, nor to even guess at the complexity of the mathematical calculations (Sharpe World based, no doubt), so for simplification purposes we will dub their model the “Draw a Straight-line Down Model” (DSDM).
Figure 5: Eurozone HICP yoy% (white). ECB Deposit Rate (blue). ECB Sept 2021 DSDM Inflation Projection (red)
Source: Bloomberg, Convex Strategies
As we don’t much believe in forecasting, and certainly don’t have our own DSGE supercomputer handy, we are going to simply propose an alternative model, that without any of the underlying complexity to generate it, we will simply dub the “Draw a Straight-line Up Model” (DSUM). As we played with the DSUM over various short forecasting periods subsequent to September 2021, it has proved to be broadly accurate. If we matched the forecast period of the above official ECB forecast, the DSUM model would have projected something like Figure 6 through Q3 2022.
Figure 6: Eurozone HICP yoy% (white) ECB Deposit Rate (blue) Hypothetical DSUM Sept 2021 Inflation Projection (red)
Source: Bloomberg, Convex Strategies
Jumping forward to today, noting how much more accurate one model was than the other, we can implement the current version of the two models, courtesy of the ECB’s September 2022 projections. Again, we have no idea on the vast assumptions and computations that go into generating the ECB’s forecasts but, conveniently, the results once again replicate the output of a simplistic DSDM, making it quite easy to show them in Figure 7, and no doubt very deeply tested at ECB HQ.
Figure 7: Eurozone HICP yoy% (white). ECB Deposit Rate (blue). ECB Sept 2022 DSDM Inflation Projection (red)
Source: Bloomberg, Convex Strategies
Running our own hypothetical DSUM, we generate the results in Figure 8 that look equally nonsensical as the ones that were generated a year previous, but which turned out to be spot on accurate.
Figure 8: Eurozone HICP yoy% (white) ECB Deposit Rate (blue) Hypothetical DSUM Sept 2022 Inflation Projection (red)
Source: Bloomberg, Convex Strategies
We would never claim that the DSUM forecast has any relevant predictive power. Nobody could realistically imagine measures of consumer price inflation, in developed Eurozone countries, guided by the ever-prudent ECB, rising exponentially to nosebleed levels near 25%, as implied by our silly model. Unless, of course, they were talking about PPI measures.
Figure 9: PPI yoy% Eurozone (white), Germany (orange), Italy (blue)
Source: Bloomberg
We note from the ECB’s website – “The primary objective of the ECB’s monetary policy is to maintain price stability. This means making sure that inflation – the rate at which the prices for goods and services change over time – remains low, stable, and predictable….. The Governing Council considers that price stability is best maintained by aiming for 2% inflation over the medium term.”
Despite their efforts to date, the leadership at the ECB, that has overseen the failure to meet their stated “primary objective”, is all still firmly in place. Who does the ECB Governing Council answer to? Is there any sense of accountability? Is there some sort of annual performance review? The same folks that have guided us to this point, announced another 75bp hike to their various policy rates at their meeting the last week of October.
ECB 27 October 2022 Monetary Policy Announcement.
https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp221027~df1d778b84.en.html
“The Governing Council today decided to raise the three key ECB interest rates by 75 basis points. With this third major policy rate increase in a row, the Governing Council has made substantial progress in withdrawing monetary policy accommodation. The Governing Council took today’s decision, and expects to raise interest rates further, to ensure the timely return of inflation to its 2% medium-term inflation target.”
ECB 27 October 2022 Press Conference.
https://www.ecb.europa.eu/press/pressconf/2022/html/ecb.is221027~358a06a35f.en.html
To her credit, Ms Lagarde, at the press conference, when asked about further rate hikes said: “We are not even, in October, at a meeting when we have a set of data that helps us have projections: outlook for growth, outlook for inflation. We will have that in December and we will take all these elements into account to determine what rate, by how much the rate will be increased.”
Unlike last October, when she dug her heals in to defend the ECB’s September 2021 projections, this time around she is happy to totally discard the concept of any reliance on the ECB’s September 2022 projections from just six weeks previous. She may be coming around.
Will the ECB’s actions “ensure the timely return of inflation to its 2% medium-term inflation target”? Recall, just a year ago they assured us that inflation, already rising well above their target, would return to target, not just without them engaging in any tightening of policy but, literally, with them continuing to pursue the most aggressively stimulative policy in their history. That was obviously wrong. Are they correct now?
Figure 10: Eurozone Real Policy Rate. ECB Deposit Rate – HICP yoy%. White Vertical Line Oct 2021
Source: Bloomberg
Just as a simple proxy of policy tightness, figure 10 above is the ECB’s Deposit Rate minus the yoy% change of their HICP price measure. A year ago, when they were certain there would be no inflation issues looking forward, the “real rate” by this measure was -4.6%. Today it is -9.2%. Is this the “substantial progress” they refer to? Or are they continuing to fall further behind? Will their moves to date be sufficient to get us to the much hoped for PIVOT!™?
Another view of it, below in Figure 11, adds in the Eurozone Unemployment Rate (inverted), along with inflation, the size of the EBC’s balance sheet (inverted) and the Deposit Rate. To summarize, HICP and Unemployment indicate all-time hot in economic conditions, while the Deposit Rate (slightly off the lows) and the balance sheet (all-time large) would, by our general estimate, register as still pretty loose as a policy setting.
Figure 11: ECB Deposit Policy Rate (white). ECB Assets (purple-LHS inverted). Eurozone HICP yoy% (orange). Eurozone Unemployment Rate (yellow-inverted)
Source: Bloomberg
PIVOT!™? Really?
We’ve asked this before, have they considered if maybe their overly loose policy setting, over roughly the last 18 months, might have something to do with their price stability measure’s continued tracking of the DSUM forecasts?
Of course, the same can be aimed at pretty much any of the esteemed central bankers. Possibly the largest champion of PIVOT!™ in that world is BOE Governor Andrew Bailey. After hiking 75bps in their recent meeting, Governor Bailey came out with strongly targeted PIVOT!™ language. These opening remarks are a must read but should really come with a Sharpe World trigger warning.
“We can make no promises about future interest rates. But based on where we stand today, we think Bank Rate will have to go up less than currently priced into financial markets.”
“Regardless of the path for Bank Rate, the MPC judges that the risk to its inflation projections are skewed to the upside. In part, the skew reflects the possibility of more persistence in wage and price-setting.”
“This upside skew has important implications for monetary policy. If I can put this simply, yes we project a steep fall in inflation, but there are substantial upside risks to that path.”
“But the central projections, conditional on the market-implied path for Bank Rate, serve as a reminder that we should not increase Bank Rate too far. The MPC judges that the path for Bank Rate required to return inflation sustainably to target is shallower than that priced into financial markets.”
PIVOT!™
Clearly, the BOE know better. So, with a, shall we say, poor recent accuracy rate in their forecasting, the BOE is going to set policy based on their interpretation of the absolute doom and gloom they project should their policy rate track to current market pricing. Sharpe World indeed!
We might suggest the MPC check in with Mr. Goodhart on his namesake law. It also all but forces us to go back to our oft used Nassim Taleb quote: “Anyone who causes harm by forecasting should be treated as either a fool or a liar.”
Taking a quick look at the equivalent visuals for the UK, we see that a year ago, just before they shocked that market by not hiking rates in the November 2021 Policy Meeting, they were forecasting a quick return to their inflation target with the real policy rate at -4.10% (Bank Rate at 0.10% and CPI at 4.2%) and their intention to do, give or take, nothing. Now a year later, they have watched as CPI has followed, not what could have been likened to a DSDM forecast, but rather some sort of DSUM projection to 10.1%. This has been met with moderate tightening of their nominal Policy Rate to 3.0%, for a now real Policy Rate of -7.10%. We are meant to believe that their efforts will reset their inflation measure back along the DSDM path.
Figure 12: UK Real Policy Rate. BOE Bank Rate – UK CPI yoy%. Vertical line Oct 2021
Source: Bloomberg
We also include the view adding in the inverted versions of Unemployment and BOE’s balance sheet, along with CPI and the Policy Rate.
Figure 13: BOE Bank Rate (white). BOE Assets/GDP (purple-LHS inverted). UK CPI yoy% (orange). UK Unemployment Rate (yellow-inverted)
Source: Bloomberg
Somewhat hard to see the imminent and catastrophic recession they have been forecasting for the last year. Not so hard to see why their CPI numbers rather dramatically overshot their forecasts. PIVOT!™ Really?
Leaving the United Kingdom, we can at least find in the US their Fed Chair Jerome Powell, who seems to have become a disciple of risk management. In the most recent post Policy Meeting press conference, the Fed Chair put it like this:
“Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.”
And maybe even more directly:
“And trying to make good decisions from a risk management standpoint, remembering of course that if we were to over-tighten, we could then use our tools strongly to support the economy, whereas if we don’t get inflation under control because we don’t tighten enough, now we’re in a situation where inflation will become entrenched and the costs, the employment costs in particular, will be much higher potentially. So, from a risk management standpoint, we want to be sure that we don’t make the mistake of either failing to tighten enough, or loosening policy too soon.”
We concur! The politest way we can query what is happening here is that given how central banks marched in lock step for so long, how is it now that, with such broadly similar issues to face, only the Federal Reserve appear to be doing anything meaningful to fix the problem?
Chair Powell sounds a bit like our own often used quote on the importance of price stability. We put it this way at a recent conference here in Singapore:
“Without price stability, there can be no stability. Without price stability, there can be no job stability. Without price stability, there can be no growth stability. Without price stability, there can be no financial stability. Without price stability, eventually, there will be no socio-political stability. They must restore price stability.”
Figure 14: US Real Policy Rate. Fed Funds – US CPI yoy%. Vertical line Oct 2021
Source: Bloomberg
The Fed deserves some credit. Their aggressive series of hikes, four 75bp hikes in a row, has at least returned their real Policy Rate back to roughly where it was a year ago, circa -4.95%, when they admitted they should have started hiking in the first place. Is it enough? Team PIVOT!™ enthusiastically wants to think so, and sentiment has firmly shifted to the Fed starting to slow down the pace of their rate hikes.
Figure 15: US Fed Funds Rate (white). Fed Assets (purple-LHS inverted). US CPI yoy% (orange). US Unemployment Rate (yellow-inverted)
Source: Bloomberg
The Reserve Bank of Australia, while having thrown in some aggressive 50bp hikes over the summer, decided to get ahead of the PIVOT!™ bandwagon and has dialled back to 25bp hikes in each of their last two Policy Meetings. In their recent statement, RBA Governor Philip Lowe noted that they were raising the forecast for full-year 2022 CPI inflation to 8% and projecting it to decline to 4.75% in 2023 and further to 3% in 2024. They updated also for growth forecasts of 3% and 1.5% for 2023 and 2024 respectively and an unemployment rate that stays around 3.5% and gradually rises to 4% in 2024, in line with the slowing growth. The soft-landing unicorn is real!
Figure 16: RBA Real Policy Rate. RBA Policy Rate – Australia CPI yoy%. Vertical line Oct 2021
Source: Bloomberg
If you have been paying attention, you will remember that just one year ago Governor Lowe was still claiming that his 0.10% Policy Rate was unlikely to need adjusting until 2024. This even after his brave attempt at YCC (Yield Curve Control) had been unceremoniously taken to the woodshed. Back in Oct 2021, by our simple measure of Policy Rate minus CPI, real Policy Rate was circa -2.90%. Today that stands at -4.95%. His model says multi-decade high inflation is going to return to 3%, with nary any impact to growth and employment, while he runs a negative real policy rate. Look out Down Under for hens laying soft boiled eggs!
Figure 17: RBA Policy Rate (white). RBA Assets (purple-LHS inverted). Australia CPI yoy% (orange). Australia Unemployment Rate (yellow-inverted)
Source: Bloomberg
Of course, we don’t know what central banks are going to do. They all seem very much primed for a PIVOT!™. We don’t forecast, other than constructing silly DSUMs to poke fun at the professionals. We merely observe. Much of what we observe at the moment takes us back to our December 2021 Update – “Arthur Burns mea culpa” https://convex-strategies.com/2022/01/17/risk-update-december-2021/.
“In principle, no matter how high the nominal interest rate may be, as long as it stays below or only slightly above the inflation rate, it very likely will have perverse effects on the economy; that is, it will run up costs of doing business but do little or nothing to restrain over-all spending……In many countries, however, these rates have at times in recent years been so clearly below the ongoing inflation rate that one can hardly escape the impression that, however high or outrageous the nominal rates may appear to observers accustomed to judging them by a historical yardstick, they have utterly failed to accomplish the restraint that central bankers sought to achieve.” Arthur Burns 1979
In many ways, despite having originated way back in June 2021, our Quote of the Year for 2021, from the Poet Laureate of Economics, Bill White, still rings true for many global central banks today.
“The Fed says it will no longer react to anticipated higher inflation but only to actual higher inflation. Yet they are failing to react to actual higher inflation because they anticipate it will decline. Perhaps the real framework is anything that justifies not tightening?” Bill White; Financial Times, June 28, 2021.
Nowhere is that more true than with the BOJ. In Japan policy easing is still full throttle. NIRP, QQE, and a YCC that we define as “unlimited, every day, forever”.
Figure 18: BOJ Real 10yr Policy Rate. 10yr JGB Yield – Tokyo CPI yoy%. Vertical line Oct 2021
Source: Bloomberg
Relative to their global peers, we can’t really fault the BOJ for holding onto their maximally loose policy stance one year ago. At that time, their inflation measure was benign, they were still on a pandemic lockdown, at our measure above of their real policy rate was just -0.10%. Fast forward to today, however, and it is time to snap to it! Today, that measure of real policy rate is -3.25%. Their measure of inflation (we used the Tokyo number because it is already out for October and tracks the nationwide number very closely) has rocketed to multi-decade highs. The currency, aided in no small measure by the relentless money printing for bond market interventions, has weakened at a pace not seen in decades. And yet, they persist. As we have said to all of the central banks as they pursued their extreme measures, none more so that the BOJ, “what if it works?”
Figure 19: JGB 10yr Yield (white). BOJ Assets (purple-LHS inverted). Tokyo CPI yoy% (orange). Japan Unemployment Rate (yellow-inverted)
Source: Bloomberg
The BOJ would have us believe that Japan is immune to the shifting inflation regime plaguing the rest of the world. We aren’t so sure. Lagged? Maybe. Immune? Doubtful.
Figure 20: Japan (blue) and Tokyo (white) CPI yoy%. Australia CPI yoy % (orange). Singapore CPI yoy% (purple). Korea CPI yoy% (yellow). Eurozone HICP yoy % (light blue). US CPI yoy% (papaya). UK CPI yoy% (fuchsia)
Source: Bloomberg
So far, the aggressive BOJ interventions have prevented Japanese yields from tracking higher with the rest of the world.
Figure 21: JGB 10yr Yield (white). 10yr Swap Rate JPY (blue), AUD (orange), SGD (fuchsia), KRW (red), EUR (papaya), USD (blue), GBP (grey)
Source: Bloomberg
This looks arguably even more extreme using 2yr yields, like a coiled spring. Something that we can’t help but ponder, but gets not even a whisper in the market, is the consideration that should the BOJ decide they do need to respond to the shift in inflation, simply releasing the JGB peg is likely not enough. They, like all those that went before, would most certainly have to entertain an adjustment to their long-ignored policy rate that currently sits ignored at -0.10%.
Figure 22: JGB 2yr Yield (yellow) and JPY 2yr Swap Rate (papaya). Bund 2yr Yield (purple) and EUR 2yr Swap Rate (orange). US Tsy 2yr Yield (white) and USD 2yr Swap Rate (blue)
Source: Bloomberg
Are leaders in Japan sufficiently certain that they are utterly different to the entirety of the world, utterly immune to global trends, that they can continue with the most aggressive money printing exercise in their history and still not see their price numbers continue to track the rest of the world? If so, based on what? ECB thought that too. Fed thought that too. BOE thought that too. RBA thought that too. It is possible to rephrase that not as they “thought” but rather that they “hoped”. As somebody wise once observed, hope is not a strategy.
Will the central banks fight the hard fight, come what may, until price stability is restored? Or, in Burns-esque fashion will they buckle to a PIVOT!™ at every frightening tremble of a slowdown? We have our guesses and inevitable biases, but if we are being honest, we do not know!
What we do know, is that positively convex portfolios outperformed Sharpe World portfolios during the long steady crawl of one of the greatest low volatility, pleasing correlation, bull markets in known history. As we near what may be the end of that bull cycle, convexity has starred yet further. Participate and protect serves the goal of compounding.
Just another example of the simplicity of it. Our ever-popular Barbell Racer, the Always Good Weather Portfolio (AGW) versus the Endowment Index, this month’s sample of a Balanced Racer (ie. driving slowly). We’ve de-risked the Endowment Index down to an 80% allocation to equalize the risk a little bit, though it still has a much higher downside deviation.
Figure 23: AGW 40/40/40 (blue) vs Endowment Index (red). Mar’09-Oct’22. Scattergram and Return Distribution
Source: Convex Strategies
The Scattergram view above doesn’t really show a huge amount of difference. But, as is always the case, its those few dots out in the wings, the big numbers (especially the big down number) that make all the difference in the compounding path.
Figure 24: AGW 40/40/40 (blue) vs Endowment Index (red). Mar’09-Oct’22. Compounding line
Source: Convex Strategies
Truly, all that is needed is a decision to embrace compounding.
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