Please see the below article received by Legal & General late yesterday afternoon:
Quid Game
The Bank of England has signalled it’s getting ready to move, although battle lines were drawn last week as Silvana Tenreyro and Catherine Mann, both members of the MPC, voiced opinions against a rate hike. Nonetheless, there is an overall hawkish tone coming from Threadneedle Street. That has clearly been reflected in rates, with gilt yields moving higher even more aggressively than their international counterparts – both at the short end and further out.
The same cannot be said for the pound. Although interest-rate differentials are low today, such changes in expectations usually drive some currency movement, too. But the energy crisis, rising inflation and a lower growth outlook have kept sterling at bay; across the pond, rising yields and a risk-off environment have helped the US dollar dominate virtually all other currencies. The enthusiasm for dollars is also reflected in various measures of investor sentiment and positioning.
With supportive valuations, we think the combination of market dynamics and valuation warrants a trade, so we are moving to a more preferential view on the pound against the dollar. To diversify the idiosyncratic risks from picking one currency, we also have positive views on the Australian dollar and euro against the US dollar. Even though the fundamentals for each currency look a little different, they share the common factor of light positioning versus the greenback.
The Fed’s Gambit
Last week’s US CPI print of 0.2% confirms our view that we’re reaching the middle-game for the current inflationary spike. With the initial spike from the reopening of the economy potentially winding down, the Federal Reserve (Fed) is much more focused on the breadth of the current shock. In that regard, the 0.5% jump in median CPI is concerning. Some broader measures are already elevated and, if the others follow suit, that could bring forward Fed action. Our economists and the markets expect the first rate hike in late 2022, though there’s a strong consensus that the risks are skewed heavily towards an earlier lift-off, rather than a delay.
The Fed is gambling that labour market participation will pick up, providing a release valve for wage pressure and limiting the risk that consumers’ rising inflation expectations lead to higher pay and ultimately into an ugly endgame where rate hikes are needed to stop price rises from spiralling out of control. The growing risk is that there has been a negative structural shock to labour supply through a combination of retirements and people re-evaluating their work/life balance. With unemployment down to 4.8%, despite disappointing payroll data, we would need to see a rapid return of workers to alleviate this concern.
Considering the above, we are moving back to a negative view on US rates after a few weeks on the sidelines. A challenge to this position is that investor sentiment indicators point to a widespread consensus short view on rates, though not an extreme one.
As regular readers know, we don’t like to join the herd too often. We lean against another widely held position by taking a short US inflation view against the market’s overall long predisposition; if necessary, then we’d expect the Fed to act, reducing the risk of a prolonged spike in inflation pricing 5-10 years in the future. Higher today, lower tomorrow.
Peso Blinders
There are several currencies known as the peso in the Americas, and we are revisiting our stance on Chile’s versus its Colombian counterpart. We are bullish on the Chilean peso and, where possible in portfolios, short the Colombian peso.
The recent performance of the Chilean peso has been poor, but with reason in our view; the Chilean economy is overheating. Loose fiscal and monetary policy has caused the current account to deteriorate, inflation to rise, and the peso to underperform. Chile’s recent central-bank action to hike the policy rate by 1.25% is an important signal that it is keen not to see further currency weakness. Politics in Chile is messy, but it’s the same in Colombia and the whole continent has been leaning left in recent years.
Finally, while not a driver of the trade, Chile is massive exporter of copper, which could see a tailwind in case the metal’s price rises on the back of the global decarbonisation drive.
Combining these factors gives us confidence to take a position. The Chilean peso adds risk to our portfolios but, combined with a trade against Colombia, we believe it becomes more of a diversifier.
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Andrew Lloyd DipPFS
19/10/2021