Corporate Treasury Weekly: surging commodities, global supply bottlenecks, and enormous fiscal stimulus are all fuelling inflation risks – what’s your hedge?

13 May 2021

Giles GaleHead of European Rates Strategy

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While UK economic growth came in better than expected, a far weaker-than-expected US jobs report has many reading the tea leaves on the state of the recovery there. But elsewhere, surging commodities, global supply chain bottlenecks and substantial fiscal stimulus are catalysing conversations about rising inflation risks – and how to hedge against them.

  • UK economic growth was better than expected: UK gross domestic product (GDP) grew 2.1% in March, better than expected and just 0.1% above our own forecast, and Q1 GDP fell 1.5% – a much less severe hit to economic growth as a result of the lockdown than was feared earlier this year (more on this later).
  • Weaker US jobs could mean several things – and less near-term economic certainty is one of them: the US added 266k (non-farm) jobs in April, a far cry from the expected figure of 1 million, which some believe may challenge the recovery story seen in recent weeks. It’s not yet clear if this is just noise, a warning sign that the data isn’t as strong as we once thought, or whether there is something more fundamental going on – employer caution, skills mismatches, or the simple fact that given still high levels of uncertainty workers just want to stay put. Either way, we see less near-term economic certainty.
  • But more uncertainty means higher borrowing costs are less likely near-term: more economic uncertainty makes higher bond yields less likely because it pushes the prospect of central banks reducing quantitative easing (QE), which has kept downward pressure on rates throughout the pandemic, further off – and in the US, makes it more likely that the next round of fiscal stimulus is larger, comes sooner and with less pressure to be funded by taxes.
  • We still think yields will rise longer term – but with less volatility: all of this reinforces our view that we won’t see a sharp or volatile rise in bond yields, with the discussion over whether to taper QE probably coming in September for the Fed and the European Central Bank. As we noted last week, the Bank of England has already reduced the pace of QE, but left the overall size of its programme unchanged.
  • FX markets are favouring commodity-linked currencies and Sterling – but see a weaker US dollar in the offing: given the strength seen in commodities markets of late – from metals to oil – we expect commodity-linked currencies to perform well (Aussie dollar, Colombian peso, Canadian dollar, and Russian rouble to name a few). With the Scottish elections out of the way and the UK economic recovery performing better than expected, we see scope for Sterling to strengthen. But with questions swirling over the US economic recovery – and the country’s enhanced unemployment strategy – we think the US dollar may weaken.

Rising business confidence drives discussions on liquidity management

Many companies battened down the hatches and bolstered liquidity levels through the pandemic. With greater confidence in the economic recovery, many are starting to consider ways to moderate and normalise their cash balances in various ways: locking up cash for longer to generate additional yield; pay back existing debt through active liability management; or even bolt-on acquisitions. More on how corporates could put cash to work in a low yield environment can be found here.

Surging commodities, global supply bottlenecks, and enormous fiscal stimulus are all fuelling inflation concerns – and the search for hedging solutions

Central banks are happy to keep monetary policy easy until higher inflation feeds into longer-term economic expectations, but this carries potential risks for stocks, credit spreads, and long-term interest rates. But how to respond and hedge against them depends on unique circumstances.

Many companies looking to borrow (particularly in bond markets) are worrying more about higher rates later than they are keen to benefit from lower rates now, nudging them towards solutions like linear swaps. For others, the prospect of higher future rates is also pushing some to consider switching into fixed-rate debt to reduce overall interest costs – or to use tools like swaptions, a kind of derivative that allows company to identify a rate at which they’d be happy to switch to floating rate debt (and get paid to wait until rates rise above that level).

And for others still, particularly in the Euro Area, concerns about thinning margins as a result of rising supply costs and (contractually) fixed customer pricing are rising. This is where macro hedges (against a weaker Euro, for instance) have proven helpful.

Quarterly UK economic growth came in better than expected, and despite the Q1 contraction it is worth noting that the level of GDP in March 2021 was above where it was in December 2020 (as the chart below shows). Impressively, despite the lockdown in much of Q1, the economy managed to recover its early/January 2021 losses by the end of the quarter.

UK GDP Index (January 2020 = 100)

Source: UK Office for National Statistics (ONS)

Digging a bit deeper (see below), we can see that while growth was broadly based across sectors. The services economy continues to lag industry and construction (which edged above pre-pandemic levels in Q1), but the gap is set to close rapidly in the months ahead as the domestic services economy re-opens.

Broad-based growth across sectors despite the Q1 lockdown (January 2020 = 100)

Source: UK Office for National Statistics (ONS)

What does the future of the UK’s service sector look like – and why is it crucial for the UK’s post-Brexit, post-pandemic economic vision? Read Ross Walker’s latest quick-take here.

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