Hendry: Markets are pricing in hawkish rate hikes

Hugh Hendry, manager of the Eclectica fund, explains why central banks' inaction on interest rates has led markets to take matters into their own hands.

The market has become emphatic. We are in the midst of an orthodox, read strong, economic recovery and monetary policy is deemed too loose.

Not willing to wait for official rate hikes, the money markets have taken matters into their own hands: a hawkish series of rate increases has been priced into forward curves.

We are now very close to the rate pricing environment of 2004/07 when the global economy enjoyed almost unprecedented strong synchronized growth. The message from the fixed income desk is clear: we are preparing for a global boom.

We, of course, dissent. I will reiterate our objections in a moment. But for January our rate book lost a further 134bp. At this rate of hawkishness we will have no rate risk by March. This loss was mitigated by a 95bp gain from Japanese CDS protection and a 38bp gain from our modest and agricultural facing equity book.

Gold option premium cost 8bp and a rally in the euro cost a further 48bp. Net, the fund lost 1% for the month. We are bearish and the market is bullish. Our risk book is correspondingly small. But have no doubt that we have a strategy for making money this year.

The stampede to protect against the certainty of rising rates is creating a very attractive background for us to re-engage with the market place. We suspect we need another month of strong economic data. A big non-farm payroll number would be perfect.

Perhaps I am being greedy (or masochistic) but another 50 bp of rate rises priced into forward money markets and an actual rate hike from, say, the Bank of England would create a safer pricing environment to re-enter receiver swaption packages as we discussed last month. It would be the equivalent of the stock market rally on 20 March 2003 when the US finally announced its assault on Iraq.

Good news, bad news, it doesn’t matter; markets just love certainty. Let us not forget how unprecedented events were back at the start of 2009. Official central bank policy rates in Europe and the US had never been as low. These were justifiably deemed emergency and temporary levels. And as risk markets recovered it was rationally assumed that such crisis levels would be removed quickly.

The forward expectation for euribor had 250bp of rate hikes, returning the ECB’s policy rates to 3.5% by the end of next year. For as long as we have had the euro we had never seen such an outsized expectation of forward rate increases. But it made sense, the financial crisis had abated and rates could now revert to some semblance of normality.

Of course today, almost two years later, we understand that 1% ECB policy rates are less transitory. 2008’s solvency crisis in the banking sector has ensnared several European sovereigns and the money markets were forced to spend most of last year reappraising their hawkish expectations. That was, of course, before the advent of the Fed’s QE2 stimulus that has had the deleterious effect of encouraging investors to hoard equities and commodities.

The resulting sharp price rally has made speculators more confident in global economic growth and has pushed European inflation rates beyond central bank targets.

The upshot of all this is that we have almost round tripped back to the pricing environment of 2009 with investors again expecting very steep rate increases over the next three years. How steep? This time around the three-year forward has the ECB raising rates by almost 200bp. I am not quite ready to take this on but to understand why a further 25 – 50 bp move higher would see us step up our risk positions you need to reflect on the nature of the ECB: it is cautious, ponderous and less volatile than the Fed. Recall their last cycle of rate increases. They never cut as far and never raised rates as aggressively as their American counterparts.

Second, despite the leveraged banking growth of 2004/7, and its attendant property bubbles, record LBOs, the rampant price increases in the commodity complex and the surge in equity prices back to the previous record TMT bubble highs, neither the ECB nor those that anticipate future rate movements in the forward markets were inclined to believe that 4% rates were too low.

While even I have to contend the global economy is growing robustly once more, I struggle to believe it is possible to recreate the intensity of the boom experienced three to five years ago.

For one thing, a property bubble in Dublin or Madrid can be dismissed as can the manic lending of the Icelandic banking system. Today banks continue to deleverage, there is no loan growth and Europe’s debtor nations are being forced to address their uncompetitiveness via severe austerity measures.

It is against this background, therefore, that we continue to believe forward rates are either correct, should we witness another global boom (unlikely in our opinion), or are rapidly approaching very profitable trading levels should any subsequent rate tightening cycle be moderated by a recovery that fails to scale the dizzy heights of its predecessor.