Markets Weekly podcast – 6 February 2023

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

As usual, we will start by looking back at the week that was, before turning on to our guest. And, today, I’m delighted to be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank. Michel will share with us his main takeaways after the Fed, the Bank of England and the European Central Bank all hiked interest rates last week.

If we start with the Fed, looking at last week, the US central bank decided to slow down its hiking pace further, downshifting to a 25-basis point hike. This came after four straight 75-basis point hikes and followed a 50-basis point hike move that was also largely expected. So, the fed fund rate now sits at 4.75%. 

Interestingly, there was no real change in the policy statement, although the FOMC noted that inflation remained elevated but has eased somewhat. The statement also reiterated the fact that the Committee will take into account the cumulative tightening that has occurred so far in order to decide whether it needs to hike interest rates in the future, and the only real surprise came from the press conference following the announcement. Chair Jerome Powell did reiterate some of his recent hawkish comments, saying that the Fed needed to stay restrictive for some time and that the labour market demand remains quite hot, something that we definitely saw in the jobs report. 

That being said, the overall tone of the press conference was on the dovish side, at least in the market’s view, as Jerome Powell mentioned multiple times the word disinflation. In particular, he flagged that the disinflationary process has effectively started, and the market took this as a cue that the Fed was nearly done and, as a result, yields collapsed. 

We will see in a minute if Michel agrees, but before that, a quick look at the Bank of England. Again, the outcome was very much in line with expectations with the BoE hiking the bank rate by 50-basis points, taking it to 4%, the highest level since 2008.

Again, the central bank assessment of the economy was somewhat more constructive. Although the UK is already in a recession, the downturn should be shorter and shallower than what was projected by the BoE back in November. Here, the main focus for the market was the BoE’s acknowledgement that forceful action wasn’t required any more. Instead, the central bank is planning on responding if, and only if, inflationary pressures were to persist. In fact, as the economic momentum deteriorates further, the BoE sees inflation dropping to 4% this year and returning to around 2% in 2024, justifying this more dovish approach.

Finally, turning to the ECB again, no real surprise there with a 50-basis point hike, leaving the deposit rate at 2.5%. The European Central Bank has now hiked interest rates by 300-basis points since last summer and, according to the ECB, there is more tightening coming up in the next few months. Indeed, the ECB clearly signalled, last week, that it intends to raise interest rates by another 50-basis points in March and effectively left the door open to more tightening in the second quarter of this year. 

But, although the door was left open, it will be important to watch the staff’s projections that are to be released in March in order to assess whether, according to the ECB’s own forecast, more tightening is, indeed, necessary. And although the ECB stance appeared relatively hawkish, the market did not really see it that way.

Here, again, the tone of the press conference was probably responsible for that interpretation. It wasn’t so much that the ECB President Christine Lagarde expressed dovish views, but, rather, the confusion that transpired in the central bank’s communication. The ECB appears to have dropped its meeting-by-meeting approach, mentioning the potential, or at least the intention, to hike in March. 

At the same time, President Lagarde wasn’t 100% committed to saying the ECB would still need to assess incoming data, and that it would be a pretty extreme case, or a pretty extreme scenario, for the ECB not to proceed with a 50-basis point hike. So, this sort of flip-flop and yes-but-no-but-maybe kind of narrative is a bit confusing. 

Michel will tell us, in a minute, what the ECB really meant and if we should believe what central banks are actually telling us. But before that, the other key event of the week was the staggering US jobs report for the month of January. That was clearly a surprise. The consensus was expecting the US economy to have created around 185,000 jobs last month, but the actual number came in at 517,000 jobs, a huge eight-sigma difference. 

With so many jobs created, the unemployment rate dropped 0.1 percentage points to 3.4%, which is the lowest level we’ve seen since 1969. And just like the ECB’s press conference, this jobs report was confusing to say the least. Every single day you can hear US companies, mostly in the listed space, of course, announcing significant layoffs, yet the unemployment rate is still coming down and it’s hard to reconcile these two things, but we believe a few factors may be at play here.

First thing, although they easily grab the headlines, most of the layoffs that have been announced are centred around the broadly defined technology sector, and we need to remember that during the pandemic the sector went on a massive hiring spree. So, from that perspective, the layoffs we are seeing today only reflect the normalisation of the employment in the space. In fact, over the last three years, the technology sector is still a major job creator and quite significantly so. 

There’s also the fact that most of the layoffs that have been announced haven’t necessarily been implemented yet. Typically, this process can last for a few months, if not a year, and, as such, we wouldn’t be expecting those announcements to translate into hard data immediately. Not only that, but there is still significant demand for the type of jobs that people have unfortunately lost. So, it’s not impossible that they actually managed to find a new job pretty quickly, even before they had a chance to be reflected in the unemployment figures. So, from that perspective, it will be interesting to watch the higher-frequency weekly initial claims in the next few months, as this is probably where those layoffs will most likely be reflected.

The other factor to keep in mind is that the month of January is not always reliable when it comes to economic statistics, as those get adjusted for seasonal factors and tend to be subject to large revisions over time. In other words, the numbers that we just got from January might well change and may not be a true reflection of what’s happening. 

Our assessment, though, is that the US job market has been, and remains, very resilient, but, according to some surveys and anecdotal evidence, there is some softening taking place below the surface. This is probably not enough for the Fed to claim victory, but sufficient to drive the unemployment rate higher between now and the end of this year. 

Now, let’s move on to, as mentioned, our guest segment with Michel Vernier. So, Michel, thanks a lot for joining us after what was an incredibly busy week. I’m curious to hear your thoughts on central banks and rates. Maybe let’s start with the Fed. What’s your view when it comes to the peak interest rates and how does that compare with what the market is pricing in at the moment?

Michel Vernier (MV): Hello, Julien. It’s good to be back here on the podcast. Let me reiterate some of your points outlined, and I will try to link this to the current market pricing. So, let’s get straight to it.

We’re currently with the Fed at 4.75%. The market, even after last week’s more hawkish FOMC meeting, priced in a peak at just under 5%. This has changed slightly since Friday, obviously. Now, the Fed, during the FOMC meeting, talked about further increases, so a plural. And Jerome Powell repeated further increases another two or three times during the press conference. Now, interestingly, during the press conference the rate declined and did not adjust to this communication, which can be perceived as more hawkish. It almost seems like the rate market is simply ignoring what Fed chair Powell said. 

What is even more astonishing is that the market has also not put a lot of weight to the Fed’s main message it’s put out now for several months, which is that history speaks strongly against prematurely loosening policy, and chair Powell repeatedly in the past reiterated that higher rates are here to stay. 

Meanwhile, the rate curve is steeply inverted along with the OIS forward. So, the rate markets are pointing to rate cuts from November this year. Now, should we see 5.25% as the terminal rate which was and still is our expectation, the rate market is telling us that we see an almost 100-basis points cut by February next year. You can see that the market seems not to believe in the Fed’s intention to remain restrictive at all. Now, we think it’s going to be somewhere in between at the end. 

Now, first of all a peak of 5.25% seems very likely, despite lower trending headline inflation but that’s not as important to the Fed now. We have pointed out many times that it’s the job market which is important right now and as we learned from Friday’s figures, it may ultimately take longer until the job market cools down, and that is what the Fed ultimately would like to see in order to have a better confidence that a higher trending core service inflation can be avoided. 

Now, in particular, after Friday’s jobs data, the two-year rate has some room in the next days or weeks to reprice to follow the 5.25% path in our view.

Now, with the longer end, we are entering the field of game theory and psychology in some ways, because investors have also to anticipate what the Fed is going to do. Now, we know that the Fed is not well known to adapt very quickly. Look at 2018/2019 or 2022 in fact. Once it calibrates, it sticks to a certain strategy regardless of the environment, in a way. 

Why am I saying this? There is a good probability that the Fed may not follow the cuts as early, despite possible deterioration in the PMI and the housing market etc. With that, the market may need to adjust the pricing for early cuts and with that we see also some potential for the 10-year to reprice to the upside towards Q3, maybe earlier, reverting some of the inversion. 

But, now that’s the next step, but should the Fed react too late, the consequences would be an even cloudier outlook for growth for the US thereafter, putting more pressure to cut rates later in 2024 more aggressively. So, you can see that in any case, despite some potential for volatility and muted repricing potential, the overall direction of travel is towards lower rates finally and that’s likely going to remain.

JL: So, Michel, in this context, how should investors be positioned?

MV: Yeah, now we stick to US for the time being. We still like the medium part of the curve in order to lock in yields and bridge the yield gap while we may see lower yields materialising over 2024 or even earlier. That’s my short answer really. With that, you mitigate, basically, reinvestment risks, or the risk of reinvesting at depressed yields in such a period, but also at the same time limit the duration risk by not investing in longer bonds or the price-risk really. So medium-term bonds are the answer.

JL: All right. So now I’d like to move closer to home and talk a bit about the BoE and the ECB. Although in the same region of the world, it seems these two central banks have very different approaches. Why is that, and do you think it’s appropriate?

MV: First of all, let’s turn to the Bank of England. The BoE hiked by 50-basis points, as expected, to the highest level since 2008 and it seems from here it will put on the brakes as it hinted at smaller hikes, as you already mentioned. Should we have entered now into this last phase of the hiking cycle, this would also provide a bit more comfort that the peak is close now. The market came a long way from the peak pricing of 5.75% back in October last year, and the current pricing of 4.25% seems a bit more realistic, in our view. 

The BoE is not finished and potentially even 4.5% cannot be ruled out, in particular, given the shrinkage of the labour pool in the UK and with industrial strikes putting more pressure on wage growth. 

The BoE wants to put out a clear signal with higher rates, but rate cuts towards the end of the year seems more likely given the vulnerabilities. We have a structural weakness in the housing market, we have falling PMIs, or purchasing manager indices, and a weakening consumer. We could see this with falling retail sales as well. The BoE may be well aware of this cloudier outlook and negative growth in the coming quarters may potentially call for cuts later this year already.

Now, going to the ECB, Christine Lagarde, ECB president, has changed to a very hawkish communication during the last month already, and, more importantly, she sticks to this, as she almost announced another 50-basis point step in March. We kind of may see that we are already in a very restrictive territory. And she also said we will want to stay there sufficiently. We believe a peak around 3.25% for the deposit rate and 3.75% for the refinance rate cannot be ruled out. But, also, the eurozone is unlikely to cope with yields at these levels for a long time. 

Now, the central bank’s more cautious view about the moderation of inflation, that’s also reflected, by the way, by its own forecast. So, even by means of its forecast, it seems like it’s quite hawkish and pessimistic about the inflation outlook because their inflation forecast is around one percentage point higher during the middle of 2023 and during 2024 compared to what the European inflation swap market is pricing in. That’s the biggest difference in 15 years, so there may be a bit of surprise potential on the downside later on.

The market is pricing currently around at 3.5% in the deposit rate. That looks a bit ambitious in our view, so, definitely, we see that the top-end of the yields are very close at this stage.

JL: Great. So maybe let’s wrap it up and bring it back to investments. Again, how in this context, how do you think investors should position portfolios?

MV: Yeah, I mean here we stick to our highest conviction to lock in rates. Yes, yields since our initiation of the conviction in October last year have retreated already on the back of the moderation, the great moderation of inflation. We called it the disinflation party, where spreads have come back, yields have come back, and it has helped bond performance. But, we do believe that yield levels still offer opportunities. In particular, we like investment grade bonds and actually most segments in the US, euro and sterling yields are still at around 90 percentile of the range since 2011. And in sterling and euro, in particular, although spreads are at the 90-percentile level. So, from a valuation perspective, it actually looks quite reasonable. 

So, the good news is that this yield train has not left the station yet. The bad news for yield investors is that markets and rates, as we all know, they move in cycles, so should we head into a low-growth environment with potentially even a recessionary environment, yields are unlikely to stay where they are for a long time, and the yield train offering 5% or 4% in investment grade, these don’t come along very often, so investors in the bond market should definitely consider these higher yields and make adjustments accordingly.

JL: Excellent. Thanks a lot, Michel, and really hope to have you back soon as I’m sure the next few months will bring even more surprises from central banks. Now, before we conclude, a few important items to keep in mind when looking at the week ahead.

Obviously, it won’t be as busy as last week, but we should expect central banks to be very vocal trying to fine-tune their messaging. In particular, Jerome Powell will speak at the Economic Club of Washington on Tuesday. We’ll also hear from President Biden on the state of the Union that day. Beyond that, we obviously have a few more earnings updates. Disney is highlighted in the US, and the banking sector is probably going to be the focus in Europe. Obviously, there’s going to be a lot again to pass through next week, so we will see you then, but in the meantime let me wish you all the best in the trading week ahead.