Markets Weekly podcast - 11 October 2021
How long before US interest rates rise? Continued worries about surging energy prices and the threat of prolonged higher inflation saw bond yields spike last week. In our latest Markets Weekly podcast, Michel Vernier, our Head of Fixed Income Strategy, joins Henk Potts, Market Strategist, to discuss the outlook for US rates and what this could mean for investors.
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Henk Potts (HP): Hello. It’s Monday, 11th October 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 for Barclays Private Bank and each week I’ll be joined by guests to discuss both risks and opportunities for investors.
Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for US rates. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
It was another rollercoaster week for investors last week amid ongoing fears that spiking bond yields would create greater competition for other asset classes, persistently higher inflation exacerbated by the energy component would weigh on corporate profitability, and concerns that central banks’ gradual removal of accommodative policies would infringe upon the pace of the recovery.
Although relief over the deal to extend the US debt ceiling, which helps to avert a very unlikely but potentially destructive default, and buyers taking advantage of weaker levels, helped equity markets rebound last week.
In terms of equity market performance, the S&P 500 rose eight tenths of 1% over the week. The STOXX 600 in Europe was up 1%. We do know investors are watching bond yields very closely. The yields on 10-year treasuries has jumped from a low of 1.2% in August to 1.6% last week, which is the highest in three months and trending back towards that March high of 1.75%.
Higher bond yields impact equities in two main ways. They put pressure on balance sheets by making it more expensive for companies to roll over their debt. They also undermine valuations. In absolute terms using discounted cashflow models and on a relative basis to fixed income instruments, therefore, highly valued growth stocks are seen as more vulnerable hence high yields have helped to fuel the rotation into value stocks.
We should also remember higher yields also reduces the attractiveness of zero interest bearing assets such as gold, which finished the week at $1,758 an ounce. Energy prices continued to be the headline grabber last week as European gas prices, which have risen more than 250% since January, surged to fresh record highs amid fears over the supply and demand imbalance worsening.
Global demand has recovered as economies reopen and activity has certainly been faster than anticipated and also expected to rise further as Europe goes into winter. Supply has been impacted by a range of factors including restrictions coming through from Russia, they’re both technical and political. We should remember, of course, Russia supplied 43% of gas imports into Europe last year.
We’ve seen weather disruption in the United States and falling European production levels. The investment focus has switched to renewable energy. Europe is going into the higher demand winter months with a seasonal record low level in terms of storage numbers.
In terms of the macro impact, elevated prices are starting to impact industrial production and are adding to inflationary pressures. Pressure on prices did moderate towards the end of the week just after the Russian President Vladimir Putin claimed they are ready to ease the crisis but demanding that any extra supply is linked to long term contracts.
Inevitably governments will have to intervene and that could come in the form of state loans to energy suppliers, subsidies to support low income earners, changes in VAT and excise duty, and one suspects over time there’ll be calls for the establishment of a combined European Union purchasing programme and reform of energy market rules in an effort to improve future energy security.
Moving on to the big number of the week which, of course, was the US employment report. For a second month in a row the US economy created far fewer jobs than anticipated. Nonfarm payrolls increased but only increased by 194,000 in September. The market was looking for a figure closer to 500,000. There was only a moderate rise in leisure employment and education hiring was below the seasonal average.
In terms of explaining the below consensus outturn, elevated virus cases and employers demanding employees have vaccines could have weighed on hiring over the course of the past couple of months. There was a significant drop for example in employment in nursing and residential care.
However, there was an upward revision to the August gain, up to 366,000. The September private payroll gain came in at a solid 317,000. Earnings continued to rise and there was an uptick in hours. The unemployment rate fell to 4.8%, but that was partly due to a lower participation rate.
Turning to the outlook, the labour market recovery may have fallen short of expectations over the course of the past couple of months, but that’s primarily down to supply issues rather than demand which should resolve itself in the coming months. Coronavirus cases in the US have been falling. Schools have reopened and extended unemployment benefits during the course of the pandemic have been scaled back, and that should encourage particularly the inactive younger and older populations to take up employment.
In terms of the impact on policy, well, the headline number was disappointing. The broader report is unlikely to dissuade the Federal Reserve from pushing ahead with its tapering of asset purchases. Markets still expect a formal announcement at the November meeting.
So that was the global economy and financial markets. In order to discuss the outlook for rates I’m pleased to be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank.
Michel, great to have you with us today. The recent rate surge very much suggests that we’re entering a trend of higher rates after the somewhat weaker jobs data that we were just talking about. What are the risks that the Fed decides to postpone the tapering process? What is your expectation of the next action from the US central bank?
Michel Vernier (MV): Hello, Henk, and thank you for having me. We don’t think that tapering is off the agenda but equally we don’t believe that we have entered into a longer-term upward trend in rates. So let’s take a closer look at the Fed first.
As you mentioned one would think that after the weaker job data the Fed is going to change its plans, but let’s just recap what Fed Chair Jerome Powell said in the last FOMC meeting when it comes to the tapering of the current asset-purchase programme.
He said if progress continues broadly as expected, the Committee judges that a moderation in the pace of assets purchases may soon be warranted. He also added that the job data, as reported on Friday, must be very bad for the Fed to change its intention. And the reason payroll data weren’t as bad and the lower participation rate may provide even higher pressure for wage growth and thus inflation.
So since the last Fed meeting the markets have started to anticipate what is eventually going to become reality. The Fed sits on almost an $8 trillion balance sheet. We don’t expect a large sell-off in yields on the back of the tapering exercise, as seen in 2013. Back then the market was completely taken by surprise. So today this move has long been anticipated and communicated by the Fed. As the Fed indicated many times, the tapering of purchases will be done gradually until completed by middle of next year.
Now first of all, tapering does not mean that the Fed is suddenly selling all its treasury holdings. The Fed only will lower and eventually stop purchases. A balance sheet reduction is then a result of bonds falling off the balance sheet as they mature in the period after purchases have stopped.
However, investors look at the imbalances caused by the larger supply coming from the US government. But given the US government has already frontloaded debt issuance at the beginning of the crisis, the lower demand from the Fed will also need a roughly $1.2 trillion lower supply in 2022 compared to this year. So effectively the Fed purchases would still create a demand overhang.
HP: So, Michel, given the fact that tapering is close the next debate, of course, will be on what happens in terms of interest rates. What are your thoughts around the Fed’s hiking path?
MV: So the Fed Chair Jerome Powell made it very clear that he does not intend to hike soon, but within the Fed we see increasing pressure for sooner rate hikes. The Fed dot plot shows the projections for future policy rates by each Fed member and provides a bit more insight here. As of last meeting, more members see now a first hike in 2022 compared to previous projections, but the dot plots reveal even more, as for the first time, the Fed showed the 2024 projections. Interestingly, some disconnects become obviously.
First, disconnect within the members as we have now a clear divide over where the rate level in 2024 should be, with the projection for the policy rate ranging from 0.5% to 2.5% in 2024. Secondly, the 2024 median at 1.75% is still quite distant from the Fed’s long-term projection of the policy rate, which is at 2.5%. Now this shows that the Committee, as much as the market, seems divided over the neutral rate over the longer term. The Fed acknowledged during the last decade that this neutral rate had to be revised down several times and it seems likely that the terminal neutral rate again sits well below the previous cycle.
Now this disconnect of the longer rate path will likely lead to some contrasting messages coming out of the Fed going forward, and this uncertainty eventually is likely to lead to rate volatility. The environment of generally lower yields, however, is likely to stay.
HP: So the one thing we do know it’s very hard to discuss rates without talking about inflation. The Fed seems to strongly believe that inflation will disappear once again. We’ve heard the word transitory so many times over the course of the past two months, but clearly the inflation risk is there, it can’t be ignored. How are you evaluating that at the moment?
MV: Yeah, the path of inflation is highly debated, with people like Larry Summers at the forefront expecting inflation to accelerate substantially. And we don’t argue against the risk, but equally we would like to point out that higher inflation is anything than set in stone. Again, it helps to decompose the drivers of inflation.
We have more temporary drivers like the base effects, pent-up demand and supply chain related drivers and these have been very apparent and significant since April data. Then we must look at business cycle like purchasing manager indices which point to a robust recovery, another driver for inflation going forward.
And then we have structural, more longer-term factors like fiscal deficit, new supply chains and technology, as well as costs related to the ESG transition. A lot has been written about these long term factors. A lot of our clients also state the 1970 in America when spending caused inflation but equally increased fiscal spending like seen in Japan or Europe or in the US during the credit crisis in 2008 led to lower inflation and lower yields, not higher yields and this must not be ignored.
It may also be premature to ultimately conclude that the other factors will lead to excessive inflation. So high inflation for the period to come, but we expect a moderation thereafter.
HP: OK. To finish off, what is your message to bond investors today?
MV: It’s a tricky one, indeed. We won’t rule out that yields may surge to a certain extent from here. But market implied inflation, which partly drives nominal rates, is already almost highest since the last 20 years, so the air might get thin from here.
Overall, investors should be prepared for somewhat higher yields, with potentially stickier, higher inflation and due to potential noise coming out from the Fed as explained, but not excessively higher yields. In this environment, staying with medium-term bonds, including corporate bonds or financial hybrid bonds but also private debt, seems like sensible options within the bond market in our view. But as always selection and monitoring remains key.
HP: Well, thank you, Michel, for sharing your thoughts with us once again. So it’s certainly set to be an interesting time for central bankers and investors over the course of the coming week.
And if we move on to look at the week ahead. Investors will, of course, be focusing on those US inflation figures on Wednesday, where we forecast headline CPI to have risen three tenths of 1% month on month and 5.3% year on year in September.
We also project that the pace of monthly core CPI picks up relative to August so we do not expect another strong drag from transportation and hotel prices. While supply bottlenecks and other reopening pressures should continue to drive idiosyncratic increases, we expect core goods inflation to remain elevated as production struggles to keep pace with demand and inventory rebuilding.
Rent inflation should also continue to be supported by a pick-up across the overall service sector and rising home prices.
In terms of the outlook for inflation, following elevated rates of inflation this year, we expect a significant easing of price pressures next year. In terms of our forecast, we put year-on-year headline CPI inflation at 5.6% in December this year and core at 4.4%, but by the time we look to the fourth quarter of next year, we think headline CPI will be back down to 1.9% and core CPI decelerating to 2.2%.
The risk to the US inflation forecast very much comes from a prolonged period of supply chain bottlenecks. Data shows ships waiting to offload is still quite high. Inventory to sales ratios for cars remains at historic low levels.
ISM surveys point to a backlog of orders for both goods and services, and producer prices have been moving up along with imported prices which, of course, are very high, in the case of China continued to trend higher. So markets will be focusing on those supply chain bottlenecks and for any signs that inflation is, indeed, becoming more engrained than central bankers have been pledging.
With that, we’d like to thank you once again for joining us. We will of course be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.
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