Markets Weekly podcast – 20 November 2023
Bond markets and falling inflation
As global inflation falls, Michel Vernier, our Head of Fixed Income Strategy, explores key insights from our recently released ‘Outlook 2024’ report and the possible impact on bond investors. Other topics include US debt, rising yields and the role of central banks. Host Julien Lafargue also explores inflation in the major regions and upcoming manufacturing data.
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Julien Lafargue (JL): Welcome to a new edition of Barclays Private Bank’s Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist at Barclays Private Bank, and I will be your host today.
As usual, we’ll look briefly at what happened last week before going into a bit of a deeper dive on our ‘Outlook 2024’. And, this week, we wanted to focus specifically on the fixed income side which, for us, is a big call going into next year. So, I’m very pleased to be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank, to discuss his view going into next year.
But, before we do that, before we have a little chat with Michel, a few things to mention from last week. I think last week was quite interesting in the sense that we got the confirmation that globally, but more specifically in the US and in the UK, inflation remains on the downtrend.
That was a big question mark for investors, and the market was really pleased to see that headline CPI in the US was flat month on month. The market was expecting a 0.1% increase. On the headline basis, on a year-over-year basis, inflation was up 3.2%. That’s a massive 50 basis points lower than it was in September. So, at least on the headline basis, we’re getting closer and closer to this 2% target that the Fed may have in the US.
If we look at the core inflation, the picture is similar, maybe a bit more sticky in terms of the figures. On a year-over-year basis, core inflation is still at 4%, so that was still 10 basis points disinflationary impulse from September but 4%, arguably, is still twice what the Fed would like the core inflation to be. So, we’re getting there, slowly but surely.
And the picture is the same in the UK. In the UK, we did get headline CPI as well. It decelerated sharply from 6.7% year over year to 4.6% last month, which was below the consensus expectation, below the BoE’s projection and, basically, helped the government fulfil its promise that inflation would be halved by the end of the year, or halved at least from the peak. So, we’re still far away from the 2% target, but we’ve made significant progress.
And really this positive developments on the inflation front were welcomed by markets. So, what we saw is yields coming down quite significantly and equity markets rallying. This correlation is the reflection of the fact that markets believe that the Fed in particular, but most developed central banks, whether it’s the BoE or the ECB, are done hiking rates. And, in fact, the markets are starting to price in earlier and earlier cuts going into ’24, so something that we can discuss with Michel in a second.
But that has proven to be a boost to equity markets which, I would argue, is potentially misplaced, at least to some degree. If inflation comes down, it could be just the reflection of the fact that whether it’s the US or the UK, economies are slowing down.
If they are slowing down, yes, the Fed is not going to hike any more and could potentially cut, but really earnings, from an equities side, could be challenged. So, one could challenge the recent bounce back in equity markets really.
Are we being too optimistic on the soft landing scenario? Potentially. But for us, clearly, the focus, as we highlighted in our ‘Outlook’, at least in the very short term, remains on the fixed income side, so maybe that’s a good time bring Michel into the discussion.
Michel, thanks again for joining us. Excellent piece you wrote for the ‘Outlook’. I want to chat with you a bit and discuss a few points that you made in that report. So, I think maybe we can, you know, delve on what I was just mentioning around the sharp drop in yields that we’ve seen over the past few weeks. Do you think that we’ve seen the peak? Are we turning around? Are yields going down from now?
Michel Vernier (MV): Well, hello, Julien, and hello to all listeners on the call. Despite recent dynamics, we believe policy rates remain the key driver for the entire bond yield curve. Historically, at least two thirds, if not more, of the level of bond yields was determined by policy rates and this is quite natural.
JL: So, why do you believe central banks’ rates are so important?
MV: Well, it’s quite intuitive, if you look at it now. Finally, three-month rates, if we take three-months rates, for example, they’re trying to anticipate the move in policy rates. And the two-year rates, they try to anticipate the move of the three months, and the five year for two year, and so on and so on, and then suddenly we have a yield curve.
And we have to acknowledge that we are now in a very different situation compared to 12 months ago. As you just alluded to back then, we’ve seen inflation in the US at 9%, or a bit more than 12 months ago in fact, and in the UK and in Europe over 10%. Today, headline inflation in the US was confirmed at 3.2%, and is likely going to fall even further.
Now, in order to assess if policy rates have reached its peak, real rates provide a good indication. At 5.5%, policy rate in the US and a PCE core inflation of 3.7%, that’s the preferred inflation measure of the Fed, the real inflation adjusted rate is around 2%, let’s say. Shall we see PCE inflation retreating towards 3% in 2024, which we see is likely, the current Fed rate would imply a policy rate of 2.5% on a real basis, adjusted for inflation.
So, from 2008 to 2018 this was negative, by the way, this real rate. Unlikely that we will go back very soon to such negative rates, but 2.5% in the current environment can be definitely defined as restrictive already.
JL: I think that’s a very interesting point and people underestimate, when we talk about real rate, the importance of a falling inflation, right? Because, naturally, as just inflation falls, even if your actual nominal interest rates stay the same, you know, real rates are increasing, meaning potentially more tightening in the economy.
Now, the market seems to believe that we’re done with interest rates for this cycle. What’s your view on that?
MV: Well, look, I think the war on inflation is not won yet. We think there’s a fair bit of complacency in current market pricing. You just mentioned it, Julien. The market is not pricing in any rate hikes and, in fact, after last week’s inflation data, 3.2%, this was just a surprise by 0.1%, by the way. The market suddenly is expecting the Fed to cut by 50 basis points by the middle of next year, and by end of 2024, the rate market implies that the Fed will be back at 4.5%, and this may prove to be a bit optimistic.
I don’t think the Fed Chair Jerome Powell sat in front of the screen last week, looking at this 0.1% surprise, and saying, oh, that is truly a gamechanger and let’s cut rates now quicky. We’re prepared to raise rates further if appropriate, and we intend to hold policy at a restricted level until we are confident that inflation is moving down sustainably towards our objective. That’s what he said during the last conference.
Now, our take is that the Fed may lean towards another hike even. Now, economic data in the recent past, they have pointed to a more resilient economy and this, in turn, could slow the moderation of inflation… significantly, if not hold even.
Now, the Fed would have to act quickly before inflation expectations implied by the market break even inflation. They would get unanchored. For now, the market is pricing inflation to settle at 2.3%, and the Fed would not sit back if that implied pricing suddenly trends to well over 2.5% again, or even higher.
Now, the last mile during a marathon is always the hardest, I believe. I only ran one, and for me every mile was the hardest. But, anyway, we would not, overall, be surprised if the Fed hikes one more time, bringing the restrictive rate then towards 3%, that’s the highest since the peak in 2007.
JL: I think people often forget about the fact that the key asset on a central bank balance sheet, if I can put it this way, is their credibility, right? And if the market starts to be too complacent, the Fed may want to make a point that, you know what, we’re not done yet, as we said.
And we’re going to prove to you that we’re not done simply by just hiking once more. At the end of the day, those 25 basis points are not going to change the face of the US economy, but it will make a strong point that we have to respect the Fed and that its credibility hasn’t been damaged by all that. Anyway, very fascinating times.
So, in short, what’s your message with regards to policy rates? We’re going higher/lower?
MV: Yeah, absolutely. Look, we’re not arguing about the general direction. You know, as we, like the rate market, we believe in lower rates to come. I think the point is here we would challenge is the timing and the magnitude for now. And, as you exactly said, Julien, just now, it took a long time for the Fed to build up that credibility and they won’t just let that slip away very quickly. And they would rather err on the side of being kind-of too tight for now and really, then being sure that inflation is tamed, rather than facing inflation flaring up again.
JL: Well, let’s move on from rates. I think we cannot discuss fixed income markets today, especially in the US, without spending some time discussing what’s happening in terms of US debt, you know, raising yields, insurance from the treasuries. These have been important factors. At times they’ve been more important than the macroeconomic picture in dictating where yields are going. So, how concerned should investors be about those issues, the US debt and raising yields?
MV: I think, look, I think investors should, at any point, be concerned about increasing debt levels of the bonds they own, of the issuers of the bonds. Now, back in August, US treasuries forecast a $2 trillion finance needs for the fiscal year 2023, and a more aggressive path of turning out the debt, so more duration coming into the market. So, that’s an incredibly much higher level than the $1.3 trillion prior.
And the US stands now at over $33 trillion debt, which equates to roughly 100% debt to GDP. Now, back in 2000, the US government sat on $8 trillion, debt to GDP was at 40%, and it’s probably increasing, probably to 120% even.
JL: Who’s buying those bonds?
MV: I mean that’s exactly the crucial question here. I mean we have, what are so-called price-insensitive buyers, and we had price-insensitive buyers like Japan, China and, of course, the Fed. They have all bought treasuries increasingly, and that’s now less compared to the past. From the recent pandemic peak to now, $9 trillion at the peak, it returned back to $7.5 trillion, and it’s probably the Fed is going to reduce that balance sheet towards $6.5 trillion by end of 2024.
So, price-sensitive buyers now, like the private investors, they are likely to start to demand higher premiums, and they have already done so. So, since July, the real rate, for example, so we’re not discussing about inflation here, has increased by roughly 80 basis points, in the peak.
JL: So, I guess, if we remove those price-insensitive buyers and we’re left with people who are actually paying attention, not only to price but also fundamentals, and we look at the trajectory on which the US debt pile is on, shall we expect a further increase in yields then?
MV: I think, look, this is the really interesting point here, and let’s put out one interesting fact here. The relation of higher debt leading to higher yields never upheld in history, in fact. We have written about this in our ‘Market Perspective’ publication back in August 2020.
In fact, the correlation between these two, in reality, was negative. So, higher fiscal deficit led often to lower yields, the most recent example being the pandemic crisis or the great financial crisis. Now, what happened? Governments, they supported with extraordinary measures funded by debt, obviously, and the central banks, they eased on the monetary side, leading to these lower yields.
And if you look at it from a growth angle, during times of economic expansion, governments usually are in a better position to reduce fiscal deficit and debt. But it’s also at that time when central banks increase policy rates which, in turn, drive yields up.
So, while the announcement, so that’s the other side, the demand side. While the announcement of higher debt or lower buying by central banks can lead to spikes in real yields, and we’ve seen this in 2013, taper tantrum, 2016, Trump reflation, and 2022 in the UK with the Liz Truss government. That and supply dynamics are less of a dominant factor compared to economic cycles.
So, these announcements, they can temporarily lead to a premium, but then it’s the economic cycle which dominates. So, while uncertainty remains, I think the bulk of bad news, higher supply is now, to a large extent, reflected in current yield levels. Yes, we may see some more volatility, some premium, but it doesn’t necessarily translate into much, much higher yields from it.
JL: Fascinating only that, how much of a macro story, fixed income tends to be, but also how specific and unique the times that we are in are at the moment. You know, the historical relationships are being broken and then reinstated makes for quite a challenging investing environment, I should say.
Now, let’s bring it back to investment, I think. So that, you know, we discussed the bigger picture, what we think about rates, what we think about the debt pile. If you’re an investor today looking at fixed income, where should you be focused on?
MV: Yeah, look, I think we’ve been a long time arguing about the peak rates and that investor needs to lock in yields at these higher rates and I think now, I think what is quite interesting and what investors should be aware of, is currently we’ve seen a huge shift within the market.
Economists all over on the street, they’re now reducing their yield and inflation forecasts, and we, as a bank, right now, we’re actually a bit more on the upper side. We do believe that some more volatility is coming because of that stickiness of inflation, potentially. So, we are at a very interesting path here right now.
Now, first of all, we may still face some volatility in the rate market, but at levels over 5% for long-end yields is getting thin, as we’ve seen. Now, at this stage of the economic cycle when it is expected that we land, it’s still a landing in fact, whether it’s soft or not. We feel, in fact, more confident to use such phases of volatility when they occur to extend the duration. Buy selectively some longer-dated bonds as well.
With longer duration bonds, in fact, you would, in turn, benefit if the landing is not as soft as many believe today and, currently, we still favour investment grade bonds, which yield around 5.5% partly, even 6% depending on which market we are looking at.
JL: So, you mentioned BB-rated bonds and, at the same time, I remember you said that you were cautious when it comes to high yield. How do you match the two? Should people think about those two things similarly, or are they actually very different things?
MV: Yeah, that’s a very good question, and I’ll probably not get away without explaining myself here. But look, I think in times of a soft landing, that seems a bit now more likely, we also feel a bit more comfortable taking on some BB-rated bonds, which yield around 6.5% to 7% even. So, a lot of the BB-rated bonds, they were also able to term for the issuers, they were able to term out their funding. So, basically take on longer debt when yields two years ago were much, much lower. And they also show some better credit matrix compared to the rest of the lower-rated high-yield issuers.
So, a softer landing, combined with lower trending yields, they could actually spur some more hunt for yield flows again and provide a tailwind for this part of the segment.
JL: I see. Very interesting. Look, I have so many more questions for you. We could have this podcast last an hour. Let’s just keep it there for now. I will probably have you back because I think 2024 is definitely going to be a year where interesting things happen in the fixed income space, so we’ll get you back on the podcast to discuss all those.
Now, just before we conclude, a quick word on the week ahead and what to look for. Well, it’s going to be, at least in the US, a slightly shorter week this week. In terms of biggest, most relevant macroeconomic releases, we’re going to get the FOMC minutes on Tuesday. We want to see if the FOMC was all in agreement at the last meeting, and if we can learn anything from the discussions that they had.
And then really the only other major piece of data that we’re going to get are the Flash PMIs for the month of November. They will hit on Thursday for the EU and the UK, and on Friday for the US.
And then the other set of minutes that we’re going to get are from the ECB, and that will come on Thursday.
So, a few things to look forward to. In the meantime, as always, we wish you a very successful trading week ahead.
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