September quarter market commentary

The persistence, magnitude and momentum in inflation remained a key focus for markets in the third quarter.

As inflation continued to surprise on the upside almost everywhere in the developed market complex, central banks, led by the US Federal Reserve, adopted an increasingly aggressive tack. After initially appearing to downplay that message, market expectations of required central bank policy rate increases, along with bond yields adjusted sharply upward.

At the same time markets assessed that the engineering of a “first-best” solution has got beyond developed country central banks. Having let inflationary expectations escape the realm of being within their ability to comfortably manage without a serious risk of a substantial growth dislocation, central banks find themselves in the realm of “least bad” approaches.

Some have a shot at “second best” outcomes. Others, such as the European Central Bank and Bank of England, having got a long way behind the inflation curve, face potentially bigger challenges.

Consequently, central banks are engaged in the most delicate of monetary policy high wire acts: charting a path between getting inflation back toward target without tipping the economy into recession.

The result was higher bond yields dominated by a flattening of the yield curve together with struggling equity markets. The USD was stronger as the Fed charts a more aggressive course than its major developed country peers in Europe, the UK and Japan.

A major disruption in the UK Gilt market added to market volatility as policy missteps by both the Bank of England (on inflation) and the incoming UK Truss Government (a debt financed fiscal package) placed UK bond yields under intense pressure, igniting financial stability concerns as UK liability-driven-investment (LDI) pension schemes were forced into a “fire sale” of Gilt holdings. The crisis seemed to be averted by a Bank of England back-stop measure, although concerns remain.

Indications are that financial markets may well remain in a volatile phase as they take time to assess the success or otherwise of central banks in reining in inflation without risking a substantial economic dislocation or recession.

20 October 2022