Markets Weekly podcast – 14 August 2023

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

As usual, we will start by reviewing last week’s events before moving on to our guest segment. And, this week, we will be joined Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank. And we have a lot to discuss with Michel; central banks, inflation, rates, China and more.

But, first, let’s take a look at the week that was. It was a slightly quieter week on the macroeconomic front. The main release was the US inflation data for July and, as expected, at 3.2% the headline figure showed a slight acceleration in year-over-year terms, and was up by a fifth versus June. On a month-over-month basis, prices climbed 0.17%, in line with consensus.

Now, the core level CPI declined to 4.7% year over year, while the three-month annualised rate fell by one percentage point to 3.1%. Air fares, used cars and lodging away from home drove most of the disinflation in June. And, again, they dipped 11 basis points from core CPI in July.

What really differed from June was that core goods reduced their strong deflation, which was spread beyond used cars, while core services inflation reaccelerated in July. But, really, the number that investors should focus on is the inflation-excluding-shelter one. Indeed, as we know by now, and as actually highlighted by the San Francisco Fed itself, shelter inflation is likely to slow down significantly over the next 12 months.

In fact, already, if you subtract the shelter component from headline inflation, the US prices were essentially flat year over year in July. Now, the Fed’s preferred measure of inflation, super core inflation, remains high though, at 4.1% year over year. And, in addition to that, with base effects fading and with oil prices rebounding recently, we could be in for some upside surprises in the coming months. 

So, normalisation is underway, but the path to get there won’t be a smooth one, and we’ll discuss what it means for the Fed, in a minute, with Michel.

Now, last week the most worrying news came from the Chinese housing market where Country Garden group, China’s second-largest housing developer, missed coupon payments and was teetering on the edge of a default. While the effect on the credit market is likely to be less than what we experienced after the Evergrande default in 2021, this could extend the contraction in the real estate market and spill over to local government finances.

And this, in turn, could further shake market confidence in the ability of the Chinese government to manage risk and stabilise growth. China also made the headlines last week for its inflation print. Indeed, consumer prices entered deflation territory for the first time in more than two years, as July CPI fell 0.3% year over year. 

The drag mainly came from food with pork prices dropping 26% in July. They were down 7.2% in June, and the reason for that is very favourable, so to speak, base effects.

So it’s fair to say, I think, that China has significant room for monetary stimulus, yet the authorities have been reluctant to do anything major so far to support the domestic economy. Maybe this is because they know that with ongoing leveraging in the real estate sector, lower rates won’t provide much help. But, a really fascinating time in China.

So, Michel, maybe that’s a good time to bring you in. And first, of course, thank you very much for joining us. There’s been a lot happening in the broader fixed income space recently, so we are really keen to hear your take. 

Maybe we can start with US inflation, and the Fed seems to be less hawkish, and recent inflation numbers, as we’ve discussed, point to a kind of continuation in the moderation of US inflation. In your opinion, does that mean that we should be expecting lower yields from here?

Michel Vernier (MV): Yeah, and good morning. Overall, it can be argued that the Fed sees a little bit less urgency to act. Now, the June CPI report, as you already mentioned, was welcomed and at the point of the meeting was only one report, one month’s data which showed a retreat. We hope that inflation will follow a lower path, but we don’t know what. We’re just going to need to see more data. That’s what Jerome Powell said. 

Just to recap, again, headline inflation in June dropped from 4% to 3% before the meeting, and also core decreased notably from 5.3% to now 4.8%. And, as you mentioned, meanwhile the Fed has another set of data to work with. This last week we saw a continuation, albeit a moderate continuation, of a disinflationary trend on the core inflation side as well.

This should provide the Fed with some more comfort that we’re heading in the right direction. Now, Fed chair Powell has entered into a new, and potentially last, phase within the hiking cycle exercise. Remember, we went from multiple hikes of 75, or 50 basis points in one meeting, back to recently 25 basis points every other meeting. The Fed rate is now 5.25% higher compared to March last year.

Powell said that we’re going to be going meeting by meeting, which, in other words, means that the Fed might be happy at the current level. While we cannot rule out further hikes, the air seems now to be getting a bit thinner. Looking one-year ahead with our expectations of further moderating inflation, yields are likely to trade lower compared to current levels.

JL: Great. So, a relatively flatter yield going forward, but maybe where do you see risk, and, more importantly for investors, what is the market not pricing correctly at this point, in your view?

MV: Yeah, there’s definitely a lot to mention here. Of course, there are risks and the last two weeks have reminded investors that volatility potentially remains. The move up in yields during the last year was so far driven by the short end, and the pattern is typically in this phase of the hiking cycle. In the last two weeks, however, rates have been selling off more in the long end. I’m speaking of the 10-year and 30-year area, for example.

In the first week in August, for example, the 30-year moved up by 25 basis points. That’s more than two standard deviations of weekly moves, so quite significant. The reason was supply and demand concerns and here, as is always the case, a couple of headlines hit the news at the same time. 

First, the Fitch downgrade of the US debt rating from AAA to AA+. Second, the perceived more flexibility in the Japanese central bank, when it comes to yield curve control. And third, the announcement that the US Treasury would increase the auction size over the next month, and we’ve seen already a couple of examples last week.

These headlines have driven 10-year yields back to their highest level since November last year, around 4.2%. But as much as one can get carried away with these big headlines, we don’t see this as long-term drivers for yields. The rating downgrade was carried out on the back of governance concerns, as Fitch, as much as all investors, are simply getting tired with these repeating debt-ceiling discussions. 

But this is nothing new, and the rating downgrade does not provide investors with any new insight. The yield cap within the yield curve control framework of the Japanese central bank may lead to higher Japanese yields, which, in turn, via international arbitrage flows, could lead to somewhat reduced buying of US Treasuries, as well.

But this is more theoretical, in our view. This leaves us with larger supply. Indeed, last week’s larger coupon auction has shown that demand is not limitless in the bond market, and this, in turn, could potentially lead to more volatility potential in the next weeks or months. But history has shown that budget deficits, or increasing budget deficits, are not necessarily the driver for yields, but rather the expectations of inflation, economic projection and, finally, the policy rate, of course.

And here we do see some limited volatility potential. Why? Well, as I said, we do believe that the Fed may go for another hike, and the market is not priced for this at all. If you dig deeper into the last inflation figures, you may realise that not all is rosy, as the super core inflation is still relatively high on a running level, as you already mentioned, Julien.

Now I would like to provide some more background information with regard to that. Effects from energy, which, so far, have been favourable to the base effects, bringing down inflation, these base effects are now fading. In addition, the calculation methodology within health costs in the US has helped to bring down inflation, as well. If we take this all into account, we’re probably still going with the 3.6% core inflation into 2024. 

In addition, there’s risk, or rather potential, that the US is not cooling down as expected and it will remain more resilient. Higher demand projection could then lead to a slower path of inflation moderation. So, we should not underestimate these dynamics here.

And this brings us to the longer path of rates. The Fed, during the last meeting, once more leaned against the market pricing, or expectations for premature cuts. We strongly agree with this here, and also see some repricing potential. But let’s not forget that the 2-year yield has twice bounced back from the 5.1% highs, and is now back at around 4.9%.

Now, real policy yields, adjusted for inflation, are at restrictive levels. So, while we may not see an immediate retreat in yields, and some repricing potential, equally yields above 5% seem to be an opportunity to engage in the bond market.

JL: Clearly there are, and we’ve talked about those opportunities for a while now, maybe we’ll have a last shot at them. 

Now, I want to change gears a bit and talk about the other key element of last week, and probably one for this week and the coming weeks, which is China. Do you have any specific view or comments on what’s going on in China, and in the Chinese bond market in particular?

MV: Yeah. I mean I think the renewed distress seen within the highly-leveraged property market plays directly into our theme that investors should be careful, going into the credit cycle. The first wave and rise of defaults was spurred by distressed Chinese property developers. Just remember, Evergrande was the big case here. Now we have the distress of Country Garden, once the biggest developer in China. 

And that shows that the challenges are likely to remain for some time, and I’m speaking years, not months. Country Garden last week seemed to miss coupon payments, and the situation remains fluid. There is a 30-day grace period for these payments, but it’s already clear that the developer struggles to find cash flow and to serve the debt.

Contracted sales, for the issue, in July were down 67% year on year. This comes after project sales have retreated significantly after a period of recovery for the issuer. On a broader level, according to Bloomberg, for example, the value of new home sales, by the 100 biggest real estate developers, fell by 33% from a year earlier. So this is not an isolated problem. The last month’s stress among smaller-end, large developers are just a reminder of that.

For the future, and perhaps the near future, it can be expected that more defaults will emerge broadly. Yes, the Chinese authorities are likely to provide some support, on a monetary and fiscal basis, as well as a relaxation of loan rules. But, finally, their hands are tied, as the focus of the government is to deleverage the sector, not help excessively with more debt.

So, as you we can see, it’s hard to imagine a deleveraging process without pain in the Chinese property market. Now, the Chinese high yield market is likely to remain very volatile as more stress and headlines in the next weeks are likely to emerge. Of course, it will also mean headwinds for the Chinese overall growth path profile, as the economy is heavily dependent on the property market.

Now, our overall message is to avoid any highly-leveraged situation in the current stage of the cycle, and stick to quality issuers where already attractive yields can be achieved.

JL: Excellent. Thank you for that. I mean there is so much that we could cover. It was supposed to be a relatively quiet summer, but it hasn’t been really so far. That’s all we have the time for today, Michel, so thank you so much. We will get you back, probably in September, because this market is moving very quickly so an update will be required, but thanks again for joining us today.

Now, before we conclude, a quick look at the week ahead. The most important macroeconomic event this week may actually be coming out of Japan. We are going to get the second-quarter GDP on Tuesday and, probably most importantly, the national CPI figure for July, that will hit the table on Friday. And this is going to be very important because investors are currently searching for clues as to what the BoJ might do next, and as we’ve seen this can have global repercussions.

In the US, the key macroeconomic events will include the July retail sales. That will be on Tuesday, and the FOMC minutes on Wednesday. While, closer to home, in the UK we’ll get the inflation data for July on Wednesday as well as the retail sales figure on Friday.

When it comes to the UK CPI, again, an important number to watch for, given the rates situation in the UK and the expectation that the BoE may have more work to do, the consensus is expecting a reading of 6.8% at this stage. That’s on a year-by-year basis and that would be both at the headline and the core level.

If accurate, this would represent a full percentage-point drop in the annual rate of headline inflation from June, and that would largely be driven by around a 17% fall in household energy bills, yet, at 6.8%, I think it will be hard for the BoE to say that they are done with hiking rates. We will see, and definitely we will update you on that next week, and you will have the pleasure to find Henk back in the host seat as he comes back from holiday, and it will be my turn to take some time off. So, thank you very much. We’ll be back next week and, in the meantime, we wish you all the very best for the trading week ahead.