Markets Weekly podcast - 01 February 2021

Henk Potts (HP): Hello it’s Monday the 1st of February and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist with Barclays Private Bank, and each week I'll be joined by guests to discuss both risks and opportunities for investors.

This recording will last around 15 minutes and will be broken down into three component parts. Firstly, I will analyse the events that moved the markets and grabbed the headlines over the course of the past week.

I'll then move on to our focus section, where we’ll spend a few minutes discussing a specific investment theme. This week I'm pleased to say our special guest is Michel Vernier, Head of Fixed Income for Barclays Private Bank.

We will discuss the outlook for the rate market and how investors should be positioned. And finally I'll conclude by previewing the major events and data releases that are likely to shape the week ahead.

But let's begin by reviewing last week where high flying equity markets ran into some turbulence as investors reacted to dire pandemic developments, frenzied trading activity in shorted stocks, cautious outlook statements coming through from central banks.

Even a slew of consensus beating corporate results from the fourth quarter earnings season failed to calm investors’ nerves. One of the more interesting dynamics that played out was the so-called battle between Main Street and Wall Street as social media users tried to take down the hedge funds.

An army of retail investors tried to squeeze short sellers in stocks including GameStop, BlackBerry, and movie theatre operator AMC. The wave of money pushed prices higher, and in fact lead to some pretty wild swings in terms of equity markets.

Trading platforms tried to calm tensions and protect their positions by imposing restrictions on clients purchasing many of the stocks, which I have to say in itself raises questions around fair and open trading conditions for all market participants.

In terms of the impact well a small number of hedge funds may face losses, probably more likely that many retail investors will find themselves on the wrong side of the trade when stocks fall back to their fair value.

It has been framed in this idea of Main Street versus Wall Street but in many ways could equally be viewed through the lens of a classic pump and dump scheme. In terms of the impact for markets, well higher volatility but also increased pressure for more regulatory oversight into market manipulation.

So the market performance last week. As I say, stocks slumped. S&P 500 fell 3.3% - that in fact was its biggest weekly decline since the last week of October, wiping out those year-to-date gains. Similar falls in Europe where the STOXX 600 lost 3.1% last week. The index lost 0.8% during the course of January.

In terms of Central Banks, we had the Fed meeting and also investors reacting to a withdrawal of liquidity by the People's Bank of China. In terms of the Fed, well they kept interest rates unchanged near zero, perhaps no surprise there.

Said it would maintain its bond buying programme at the current rate, remember that’s $120 billion per month, until substantial further progress towards its inflation and employment goals has been made.

They indicated they would look through the temporary pickup in inflation expected in the second quarter due to base effects but they did acknowledge the US recovery has been moderating. Like other policymakers the Fed will be keeping a close eye on healthcare progress, the shape of the labour market recovery, along with fiscal support for households and businesses.

There are still some downside risks to the recovery: we know new COVID variants and vaccination delays may prolong the time to get to that herd immunity destination. Senate moderates on both sides of the aisle may also further water down the stimulus bill. What's the Fed's current thinking?

Well despite reasons to be optimistic the Fed is far from signalling a move to exit its accommodative stance. The Fed has emphasised it's a long way from meeting its dual mandate. What's the policy outlook?

We would expect rates to remain on hold through 2023, asset purchases to continue at the current pace through this calendar year, followed by tapering and perhaps even the end of the asset purchase programme by the end of 2022.

In terms of the People's Bank of China they withdrew $12 billion net liquidity through its open markets operation which governs the lending between the central bank and the banking system.

As a result, the interbank rate jumped 2.8% - that's its highest level since the end of 2019. Why are they making this move? Well the move is in reaction to the evidence the V-shaped recovery that we've been seeing in China - rising asset prices and fears over creating bubbles.

In the same way that China of course has been the first to emerge from the coronavirus slump, its policymakers are likely to be the first to take controlled steps to tighten financial conditions, although these are likely to be a slow and calculated process particularly given inflation remains subdued.

Policy changes are expected to target specific areas of concern, particularly the likes of the property sector.

On the data front, UK unemployment climbed to 5% in November - that's 1.2 percentage points above the year earlier and the highest rate that we've seen in four years. Beneath those headline figures, the data shows the number of people reporting redundancy remains high in November but has dropped from the peak in September.

Total actual weekly hours worked is still low but has been showing some signs of recovery. However, since February 2020, 828,000 fewer people were in payrolled employment. The vacancies recovery slowed substantially in the final three months of the year.

What's the current state of the UK labour market? Well, headline rate actually is slightly better than was expected. The pace of job cuts has slowed down. The extension of the furlough programme encouraging employers to keep staff on their books estimates something like 10 million jobs being protected by the scheme.

The scheme, of course, currently due to end in April but there is speculation the Chancellor has been drawing up plans to try and extend it yet again. Without an extension there are projections that the UK unemployment rate will surge above 9% in the second quarter before improving in the second half of the year as economic conditions normalise.

In terms of the outlook, we expect UK unemployment to be at 6.4% at the end of this year, 5.9% the end of 2022. Remember that would still be significantly higher than the 3.9% pre-pandemic level.

So that was markets and the global economy last week. Let’s now move on to that focus section. Michel, good to have you with us today.

We know that investors have been concerned about the steepening of the rate curve. Can you provide us with some insight into current conditions in the rate market?

Michel Vernier (MV): Yes of course, good morning Henk. Now everyone is concerned about a steepening of the rate curve right now. So steepening refers to the slope of the rate curve.

Usually short term rates like six months or two year rates tend to be lower than rates for 10 year bonds, for example. If this difference increases, then the rate market speaks about a steepening of the rate curve and this is currently what the market is worried about.

This steepening of the curve in the US started in August last year and the trend has picked up in pace since 2 months, and this had two reasons. First, long end rates accelerated their trend higher recently on the back of improving economic data and improving news from the vaccine front and of course in anticipation of higher debt supply with a Biden-led government.

Secondly, the commitment of the Fed to keep policy rates lower for longer, as you just mentioned, this keeps the shorter end of the rate curve anchored at lower levels. So lower short end rates and higher trending rates on the long end, lead to this steepening, which everyone is talking about right now.

HP: So how much steepening can we expect in the near future Michel?

MV: Well, here historic patterns may provide us with some more insights. So going back 45 years, the biggest difference between the 10-year rate and two-year rate for example was around 250 basis points or 2.5%.

At this moment the yield gap stands at around 95 basis points, so applying the maximum range to the current two-year rate, which is at 0.1%, the US 10-year could trade as high as 2.6%.

But here the logic ends in our view. We pointed out many times that historically the bulk of the steepening was a result of declining Fed policy rates and thus lower rates at the short end not increasing rates at the long end.

This was true in the crisis of just recently 2020, great credit crisis 2008 and the Internet bubble 2001, and even in the often quoted 80s as well.

A steepening move caused by the long end like in 2013 or 2016, what is called a bear steepening, was temporary in nature and contained between 60 basis points and 120 basis points only.

HP: Are you therefore saying that we should ignore the excessive debt build-up that's been taking place and the inflation potential?

MV: Not at all. Many bond investors argue that today we are in a very similar situation compared to the just mentioned events in 2013 and 2016. So in 2016, rates suddenly rose on the back of the Trump reflation trade, expectations of higher debt, lower taxes, so basically growth in combination with debt.

This time the debt is at unprecedented levels already and again a new administration is likely to bring higher fiscal deficits. The difference this time is that we are currently coming out of a position of weakness.

If the debt levels would not have been increased, US employees would be on the verge of a collapse. In fact, in recent history that was the last resort to get us out of crisis and this went along with lower rates not higher rates, so higher rates on the back of higher debt is possible but it's not black and white.

Also, by now markets had already a couple of months to digest the prospects of higher debt so we need to see further impulses from here. The more debated topic lately is will we see a repeat of 2013. So, back then the Fed announced their intention to pare back the then prevailing bond purchasing programme.

Only the announcement in 2013 led to a rapid rate increase at the long end of the curve. This time however, the Fed will be cognizant of that risk and will aim to prevent another traumatic surge in yields.

HP: OK, so what should investors really look for when looking at the interest rate curve?

MV: Well generally of course real economic data and also if real inflation will increase like the current breakeven inflation rates implied, sort of inflation which is traded in the market. But apart from that, the US 2-year rate has been a much better indicator for larger rate trends historically.

This has a simple reason. Ultimately, the entire interest rate curve is trying to anticipate the future rate path but the long end is in addition very much distorted by demand supply dynamics so the two-year rate is trying to pre-empt moves of the Fed and has been quite good at it, with usually a lead time of around about 18 months to two years.

So rather than a steepening, a potential flattening, so initiated by a surge in the two years, may be a good indicator for rate regime change. We've seen this in Brazil lately, for example. The central bank came out with a more hawkish stance and expectations for higher yield in the future caused the curve to flatten.

So not a steepening but a flattening may lead to much higher rates in the future.

HP: So listen, thinking from a more practical perspective, should investors buy 1% yielding 10 year US treasuries?

MV: Well from whatever angle you look at it, 1% doesn't look appealing but equally a wait and see approach may prove to be a losing proposition. The question is where to park the money if you wait.

What if yields won't reach 2% at all in the considerable future and what if we have, although unlikely, a situation whereby the Fed needs to cut even further?

We think an efficient way is to use volatility and spikes in rates and consider various parts of the bond market in order to grab yield opportunities within investment grade but also partly with high yield bonds in order to achieve that higher income.

HP: Well Michel thank you very much as always for your insights today. There's no doubt it's going to be an interesting time for government bond investors as activity starts to normalise and investors assess the impact that's going to have on central bank policy and, of course, inflation.

Moving to the week ahead, the Bank of England’s Monetary Policy Committee meeting on Thursday is likely to grab investors’ attention. We do not expect any further reduction in the interest rate at this stage but negative interest rates still remain a possibility.

January final manufacturing and services purchasing managers’ indexes in the eurozone and the UK will likely confirm the contraction indicated by the flash readings, with the renewed lockdown caused by the 3rd wave.

Weakness in services has pushed composite PMIs in both regions into contractionary territory, particularly in the UK. However, flash readings for the US were strong, showing growth in manufacturing and services.

We expect the final PMIs for both the US and for China to confirm this expansion.

Tuesday’s preliminary fourth quarter GDP for the eurozone will give an indication of economic performance coming into 2021. After the third quarter growth of 12.5%, disruption caused by the third wave and renewed lockdowns in the fourth quarter means we expect to see a contraction somewhere around about 1.5%, taking GDP for 2020 to -6.9%.

Against the backdrop of suppressed economic activity, inflation rates as we know have languished in negative territory in the euro area. Consumer prices dropped 0.3% year on year in December, the fifth consecutive month of declines. Wednesday’s January flash data will indicate whether this trend has continued through the start of this year.

The big number, of course, of the week will come on Friday when we get the non-farm payroll figure. The US economy lost a worse than expected 140,000 jobs in December. We anticipate the US economy lost a further 100,000 jobs in January.

Consensus is however for more moderate gains in terms of employment in the United States. Markets looking for a figure of around about a gain of 85,000.

With that I'd like to thank you once again for joining us. We hope that you found this podcast interesting, informative, and it's provided you with some details about how investors should be positioned from a fixed income perspective.

We will of course be back next week with our latest instalment but for now may I wish you every success for the trading week ahead.