Monthly Update – May 2023

Summary: Inflation fighting and liquidity crisis

• Economic indicators are increasingly weakening globally.
• Inflation has passed its peak, but is currently falling only slowly. However, we expect the decline in inflation to accelerate very soon.
• Despite the banking crisis, central banks' monetary policies remain very restrictive globally. Accordingly, money supply and liquidity are falling sharply.
• Money creation and lending in the private banking system are also clearly declining. The high short-term interest rates are leading to shifts from bank deposits to government bonds and thus to an outflow of liquidity.
• Nevertheless, we do not expect any imminent monetary policy easing. Despite the slowdown, the economy, labour markets and inflation are still too strong globally.
• The central banks' room for manoeuvre remains severely limited. Monetary policy continues to walk a difficult tightrope between fighting inflation and, at the same time, stabilising the economy and the banking system.

Significant changes compared to the previous month

• The banking crisis was contained in the short term by virtue of high emergency liquidity from central banks. However, considerable problems remain. Retail banking customers are shifting their deposits into government bonds due to the high short-term interest rates, thus withdrawing liquidity from the banking system. The central banks' excessively restrictive monetary policy, which has been in place for some time, is thus exerting an escalating effect and is now also negatively influencing private money creation and lending.
• Paradoxically, this tightening of liquidity is desired by the central banks in order to dampen the continuing high inflation rates and especially the renewed (slight) rise in inflation expectations, thus reinforcing the credibility of prevailing policy. Therefore, key interest rates continue to be raised. In the US, the Fed's balance sheet reduction continues unchanged and the money supply is accelerating its downward trend, which has been going on for some time. Even the hitherto extremely expansive Japanese central bank (BoJ) is beginning to consider a change of course.
• Thus, the dilemma of the central banks has clearly grown in recent weeks: Should the central banks prove successful in defeating inflation, it would most likely lead to an easing of monetary policy, but also to a recession. However, if the economy and labour markets do not quickly cool down significantly (the purchasing managers' indices in the service sector currently still point to a high level of residual economic energy globally), interest rates will remain high at the long end and inflation could enter a second wave (see "Topics on the radar").
• A marked weakening of the US dollar has also been noticeable in recent weeks. It is a consequence of the Fed's vast emergency liquidity and the expectation of a relatively tighter monetary policy by the ECB (and other central banks) compared to the Fed. The weakness of the dollar further complicates the Fed's balancing act by increasing inflationary pressures in the US.

Current situation and positioning

• The interest rate hikes since March of last year and the restrictive monetary policy are only now, with the usual delay, beginning to have an amplified negative impact on private money creation in the banking system as well as on lending. This means that an important support for economic growth and also for the equity and high-yield markets has disappeared. Many high-yield borrowers in particular are thus facing increasing refinancing problems.
• Bank deposits in the US are declining for the first time since the 1930s. Funds are being shifted into short-term US Treasury bonds, which are currently yielding 5%. On the one hand, this means that the banks, as mentioned, lack the money to lend to companies. On the other hand, the banks achieve significantly lower profit margins in the lending business due to the inverse yield curve structure. These developments considerably boost the braking effect of the restrictive monetary policy.
• The central banks' room for manoeuvre continues to decrease in the current situation. Even small deviations in the form of either too restrictive or excessively loose monetary policy can have disproportionate effects on financial markets, the economy and inflation expectations. Thus, the opportunity/risk ratio remains very asymmetrical, with risk predominating.
• We therefore continue to position ourselves defensively in our strategies with equity and high-yield exposure. Conversely, we see opportunities in investment-grade corporate bonds and in the emerging markets, as here the recession risks are compensated by an increased potential for interest rate cuts.
• Valuations on equity and high-yield markets are currently relatively expensive. A possible recession has not yet been priced in, and the dangers posed by the restrictive monetary policy have been mostly ignored, at least so far. A continuation of the recent interim recovery is possible due to the potential covering of large short positions. However, the current outflow of the emergency liquidity injected as a result of the banking crisis should limit the upside potential.
• We see government bond yields in a narrower range, but with a tendency to be slightly lower. Opposing factors are at work here, which are currently limiting volatility.

Topics on the "radar"

The annual inflation rate in the US is expected to fall significantly soon due to base effects, which add up to around 2% to 2.5% in the next four months. Added to this are increasingly price-dampening influences from the real estate markets and rental prices. Thus, the inflation rate of currently 5% (core rate 5.6%) should approach 3% (core rate 3.5%) in the third quarter.

This would correspond to the course shown in the chart below (red arrow in the first downward wave). The chart shows the course of the US inflation rate from 1966 to 1982 (light green line) as well as the current cycle since 2014 (dark green, overlaid line) and is a sound estimate of the course to be expected in the short term.

However, if this decline in inflation is accompanied by a significant economic slowdown, there could be a premature easing of monetary policy in the US, which would greatly increase the risk of a second wave of inflation. The problematic development in the years 1976 to 1980 could repeat itself, when the Fed prematurely moved away from fighting inflation in order to support the economy.

Chart: US inflation soon lower due to base effects – but second wave possible

Source   BankCreditAnalyst (BCA)