Markets Weekly podcast

Julien Lafargue (JL): Welcome to a new edition of Barclays’ Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist here at Barclays Private Bank, and I will be your host today.

Today, I will be joined by Michel Vernier, Head of Fixed Income Strategy here at Barclays Private Bank, to discuss the rather volatile fixed income market. But, before that, let’s focus on the week that was. And quite a poor performance from US equities. They ended the week lower as good economic news was, in fact, bad news for markets. And we will get to that in a minute.

I wanted to start with Europe, where equity markets were actually higher on the week, and there was no particularly good news from the region. But, as we have mentioned repeatedly in recent weeks, sentiment about the region has been so poor that sometimes no news is, in fact, good news.

Well, in fact, we did get developments, in the UK in particular. Indeed, UK assets came under pressure with gilts, sterling and the domestic-leaning FTSE 250 selling off sharply. Again, there was no one catalyst for the move. Instead, the UK seems to be a victim of the global rise in bond yields. Gilts have, in fact, moved in lockstep with Treasuries since September, but poor demand last week at a gilt auction may have exacerbated the move, and increased the scrutiny of the sustainability of the UK government’s economic policies.

Treasury officials were forced to defend their fiscal plans, and sources said that Chancellor Rachel Reeves could look at spending cuts as early as in the spring if markets do not stabilise.

Now, back to the US. A lot of news coming from there last week. There were two pieces in particular, from an economic standpoint, that stood out and led to this poor performance of equity markets and to the further increase in yields. First, we got the ISM services survey. So, in December it came in at 54.1. The consensus was looking at 53.0, so an improvement, and an improvement that was even stronger than expected.

Within that survey, new orders rose to 54.2, up from 53.7. The employment index fell to 51.4 but remained in expansion territory. Very interestingly, the price index rose to a 22-month high of 64.4. It was at 58.2 in November. And this is really what may have spooked the market, ie higher prices, potentially higher inflation down the line. 

So, we got the first sign of stronger, and not great from a yield perspective, economic data with these ISM services numbers, but the real big deal came on Friday with the US nonfarm payrolls. And the headline payroll came in at 256,000, which was well ahead of consensus. The consensus was looking for about 160,000.

We also got a very strong household survey, which means that the unemployment rate ticked down a tenth of 1% to 4.1%. The only good news was maybe on the wage side, where average hourly earnings were in line, at 0.3% month on month and the annualised figure, at 3.9%, was a touch lighter than what was expected.

So, the result of all that is, well, the first and now possibly only Fed rate cut this year is not expected to take place before December, which is quite a staggering number, ie the Fed futures haven’t priced fully a rate cut before December.

We also saw the three-year government bond yield breaking 5% to the upside. We saw some buyers coming in at that level, but there was clearly a significant move higher across the curve. Now, these upside surprises on the economic front mean, of course, a more hawkish backdrop for Fed policy, but we’re maybe here at a stage where there isn’t much room left for those easing expectations to move further on the hawkish side, given how far they’ve already moved. If you think about it, we’re just now pricing one cut this year and this cut is to happen at the very back-end of this year, which is really, really hawkish.

At the same time, FOMC officials have sounded a lot more comfortable on inflation than what the present narrative would suggest. This was visible in the FOMC minutes last week, and, as I pointed out, while the December jobs report was very strong, this wasn’t accompanied by inflationary pressures coming from wages. 

So, we may be at a point where yields could come down, but let’s see what our expert says, and let’s hear it from Michel.

So, Michel, great to have you on the podcast once again. Happy new year to you too. Maybe we can start by taking a step back and think a bit about what’s been happening since the end of last year in terms of fixed income markets.

So, maybe looking at the US and the UK, where we’ve seen some of the bigger moves, what do you see happening in terms of rates, in terms of the shape of the curve? A lot has been happening, so maybe give us a bit of background here.

Michel Vernier (MV): Yeah, of course. Happy new year, Julien. This has not been so happy a start for bond market investors, because, as you said, we have seen quite a big rise in bond yields. Now, over the last month, long-end yields, in particular, have led this trend of rising rates. The 30-year gilts and 30-year Treasuries as well, they have risen by about 65 basis points over the last month.

Now, in the US, yields are close to the highs seen in 2023, when we had the so-called debt-ceiling uncertainties, and if they surpass these levels, that would mark the highest yield since 2007 now. 

Now, in the UK, 30-year gilts are yielding as high as was seen in 1998. So, these are, indeed, some significant moves what we have seen. Now, at the same time, short-end yields have moved up but to a much lesser extent, and this has led to a continuation of the so-called bearish curve-steepening, where yields trend higher, but more emphasised on the longer-end of the curve. So, investors are clearly demanding more premium, the so-called term premium, to hold longer-dated bonds.

JL: And is that something that you would have expected?

MV: Well, we have expected rates to trend higher and expected volatility going into 2025. Now, we wrote about this in November 2024, in our ‘Outlook’ for this year. We have adjusted our view from a preference for slightly longer duration to a more shorter, neutral duration, given that we had seen two main reasons for volatility potential back in November.

Now first, inflation uncertainty. The market, in our view, up until September was too optimistic about imminent and significant rate cuts. Inflation has not accelerated. That’s good news. But it also hasn’t moderated further over the past month, and we learned from the Fed, as you said, that it has little time to be patient when it comes to cuts.

And then, secondly, we had the fiscal uncertainty. We have already been given a taste of what this can mean, in 2022 in the UK and 2023 in the US, how fiscal uncertainty can derail the bond market, and this chapter does not seem entirely closed.

Now, the US is far from in fiscal consolidation mode, with the new Trump administration. The fiscal deficit is likely to stay north of 6% over the coming years, pushing the debt from one record level to another, and potentially reaching over 140% debt to GDP over the next 10 years.

In the UK, October’s Budget surprised, in the form of the plan to take on more debt in coming years. Remember, Reeves surprised the market with a £70 billion-a-year spending commitment, which is only half covered by tax rises. So, high inflation and fiscal uncertainty does not bode well for fixed income markets, hence, we took a more defensive positioning back then.

JL: Great. So, let’s look forward a bit, and maybe let’s start with the UK. Long-end gilts, in particular, do you think we’ve seen the worst in terms of the move higher in yields? Do you expect yields to move higher still? And, are we basically going through another “mini” Budget/Liz Truss moment like the one seen in 2022?

MV: Yeah, the current move may well feel like a mini Budget moment, but I think there are some differences. Now the recent move in high-end yields, they’re definitely maybe painful for many bond investors who positioned themselves at the long end. Now, the move was not entirely disorderly, as opposed to what happened in 2022 when, in a matter of two months, 10-year yields doubled from 2.5% to 5%, the true sell-off, which was magnified by ‘fire sales’ within the LDI market for pension funds, which basically stopped functioning.

Now, the BoE had to jump in to rescue it back then. Also, Liz Truss wanted to spur growth by injecting more debt, so highly inflationary measures at a time when inflation was already high. Today, the Budget has consolidation in mind, but it’s about the execution risk this time. But, still, the market is rightly worried. Remember, Chancellor Reeves has given herself only around a £10 billion cushion against the government’s primary fiscal rule, and the latest market moves could have wiped that out, given interest costs have substantially risen and are eating up that cushion.

Now, the Chancellor’s left with very limited options, as you just mentioned, given tax rises seem to have been ruled out, and a change in the fiscal rules may have severe consequences, so let’s see what Reeves comes up with.

Coming back to the growth and inflation aspect. So, growth will be likely be even more compromised. For a second consecutive month the UK economy contracted in October, by 0.1%, and if we’re seeing something like 1.5%, we’re probably lucky this year. And let’s not forget that inflation may have found its bottom, we are at 2.6% when it comes to the headline inflation. So, the inflation risk has clearly abated and we need to put things now a bit into perspective.

This makes us more confident that over nine to 12 months, or let’s say medium-to-longer period, we see lower yields again. So, it seems there is a solid portion of negative sentiment already in the market. The Budget, remember, came out in October and in November gilt yields had retreated quite notably. It is only now that the market seems to be worried, and we have seen many times how market sentiment can also turn as well.

JL: In the UK, long-end yields are now higher than they were 18 months ago. So, would you say that, you know, we want to go longer in terms of duration in the UK, and maybe lock in those yields that, you know, at face value, at least, feel or look pretty attractive?

MV: Yeah. I mean it seems counterintuitive if we are not screaming for going longer duration, or preferring longer duration at this point of time, given that yields are higher than they were back in 2022, when we suggested this approach. But we always, you know, get these questions. What is your target rate? What if rates are higher? Wouldn’t you then be more confident to take on this duration? Now, markets do not work in that way. You know, rather than purely focus on levels, we also have to acknowledge the sentiment, what I just mentioned, and the stage of the cycle.

Now, unfortunately, markets have less patience and politicians seem to have more patience, and this is not a good recipe in general and means that probably there is more volatility ahead. We don’t see an LDI crisis, like in 2022, as pension funds, you know, they have already adapted their strategy, they seem less vulnerable now, but, potentially, also less willing to take on more duration hedges, so somewhat higher yields are a probable scenario, at least in the short-to-medium term.

But then, as mentioned, we see some limits here as well. As mentioned so often, such as in our recent ‘Outlook’ and before, yield rises due to fiscal uncertainty are usually a more temporary phenomenon. So, once these storms disappear, markets focus on the stage of the cycle and the growth outlook as well.

So, we would probably expect some higher yields from here, but then we would also think the market could turn around at some stage once again.

JL: Great. So, let’s say that an entry point is forming. It might not be the best one just yet, but clearly something worth monitoring.

Now, let’s move on and talk about central banks, because, of course, what’s happening in the bond market is, in part, linked to what central banks have been doing, but also what they’re expected to do, I guess. 

So, what is your view in terms of the next step for the Fed and the Bank of England? I think we can leave the ECB on the sideline for now, because the path there seems to be clearer. But let’s focus on the Fed and the BoE.

MV: Yeah. You have mentioned it already, Julien. The market rightly expects less cuts from the Fed. Now, two cuts seem to be not written in stone anymore. The market, as you said, has now priced in the first cut for the back-end of this year, and the Fed may indeed only stick to one cut for now.

Now, on the other hand, the Fed’s favoured, or preferred, inflation measure, the PCE, core inflation is at 2.8% and, as you mentioned, wage growth as we learned is coming down and is not putting much more pressure on inflation. So, there’s still justifications for lower yields and overall three cuts until the end of next year are very much likely for the Fed. 

But as you said, you know, things can change. We may see some lower inflation ahead, after we see maybe first a bump, with the new Trump administration, depending on the growth path and the jobs market growth. So, the threshold for having maybe the odd cut more or less is currently very low as well. So, we think one cut definitely is on the cards for this year, maybe even two.

In the UK, the BoE emphasised during the last meeting that gradual cuts should be expected. Now, overall, we could see over 100 basis points of rate cuts from here until the end of 2026, bringing the base rate potentially to 3.5%, which seems a fairly likely scenario. On the data front, we expect inflation to be kind of more trending sideways, around 2.6%, and core CPI to probably ease towards 3.4%. And that is probably a more gradual approach and the BoE needs to be very data-dependent from here as well, but more cuts, at least in the US, seem likely, given growth is much, much lower than in the US.

JL: Yeah, and I think you were right in flagging that things may change. I mean, if we look back at 2024, we started the year with the expectation that the Fed would cut six or seven times. By the summer, the market thought that we could actually see a hike in 2024 from the Fed, and we ended up the year with four cuts, so let’s see.

All right. Let’s just wrap up. And I think it would be useful for our listeners to better understand, or to have a short reminder, how you think investors should be positioned this year and maybe highlight things that may have changed since we published the ‘Outlook’ in November 2024.

MV: Yeah. I mean, look, we haven’t changed our view. We still prefer to remain cautious, but also happy to take carry positions. So, what does it mean? First of all, we believe remaining short and neutral duration, as I just said earlier, in the current market sentiment, that seems to be a proven strategy. 

However, especially in the UK, but partly in the US, some drip feeding into some duration exposure can make sense, again after the high yield rise, without now changing positioning entirely. We like taking carry within investment grade bonds and would also expand the universe to take onboard emerging market corporate bonds. 

Within the investment grade space, you can get 6% or even more with actually very solid credits. Now, we still like taking carry with short-term solutions within the securitised credit market as well, and we’re also happy to take some exposure in short- to medium-term BB-rated bonds, in addition to enjoying higher carry returns without going into excessive risk on the credit side here as well.

I think overall it is important to work with the bond market, not against it. So, if the bond market wants to see higher yields, don’t bet against that whole strategy. But if there are carry opportunities, stick to carry, stay close to the market and react to higher yields once they appear.

JL: Excellent, Michel. Thank you. Thank you so much. We’ll monitor the developments in the fixed income market over the next few weeks and we may have you back if we see any more volatility, but I think the message was clear and one where we really need to be selective, tactical and nimble in the current environment.

Now, moving on to the week ahead, a few things for us to keep an eye on. We’re going to get US inflation data starting with the producer price index, the PPI, for December on Tuesday, followed by, on Wednesday, the US inflation data. And, towards the end of the week, we’re going to get some data out of China in the form of the Q4 GDP figures, as well as the industrial production and retail sales for December. 

When it comes to US inflation, just to give some context, the consensus is looking for a 20 basis-point acceleration on the headline rate, so around 2.9% year over year, while core inflation should hold steady at 3.3%. 

But this week will also be marked by the first salvo of Q4 earnings in the US, with the likes of Citibank, Goldman Sachs, JP Morgan, Wells Fargo, Bank of America, Morgan Stanley and others reporting. So, we’re going to get the chance to hear from banks as to how they see the US economy doing. 

The reality is the sector should see a strong increase in terms of earnings simply because last year the last quarter of 2023 was quite challenging. So, headline numbers should look good but, as always, what we’re going to be focused on is the guidance that those companies will give. Recently, they sounded fairly optimistic, if you listened to what they said at various conferences, so we’ll see if anything has changed since then.

Of course, we will be back next week to debrief all that. And, in the meantime, we wish you all the very best in the trading week ahead.