Markets Weekly podcast – 9 October 2023

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

As usual, we will start by looking at the week that was before moving on to our guest segment. And, this week, I’m pleased to be joined by Michel Vernier, Head of Fixed Income Strategy here at Barclays Private Bank, to discuss the quite puzzling moves we’ve seen in rates in recent weeks.

But before that, let’s look at last week’s events. It was another challenging week in markets with yields continuing their move higher, and with global equities remaining on the back foot. The only bright spot really was the broadly defined technology sector in the US, which basically helped cushion the S&P and the Nasdaq.

We saw the German 10-year bond yield rise above 3% at least temporarily, a level that we haven’t seen since 2011. The US 30-year bond yield touched 5%. That was the first since 2007, not great memories there.

Why did we see that move? Well, the comfort was the US job market which, according to the JOLTS and the NFP data remains impressively resilient. In September in the US, there were 9.6 million jobs opening, up from 8.9 million in July, and far ahead of the consensus, which was looking at 8.8 million.

In addition, the US economy, according to the BLS added 336,000 jobs last month, way more than expected, almost twice more than expected. The consensus was looking for 170,000. And it was also miles above what the private firm ADP said on Wednesday. According to its data, the US economy added only 89,000 jobs.

But it wasn’t all that bad as wage growth in the job report cooled to 4.2% in September. That was down from 4.3% in August, and the household survey showed that only 86,000 jobs were, in fact, created last month and that’s why we have this unchanged 3.8% unemployment rate.

I know it can sound a bit confusing, but the reality is those two datasets run on two separate surveys, the establishment survey where we get the nonfarm payroll data from, and the nonfarm payroll number, and the household survey which helped figure out what the unemployment rate is.

There are some differences between those two surveys. Of course, one is asked to companies and the other one is asking questions to households, but the increase in yields appears to be due to more than just inflation and jobs. Indeed, many investors are starting to be concerned about the ballooning US deficit and debt pile. 

On that front, it will be interesting to watch this week’s Treasury auctions, which could be an important catalyst for markets, both fixed income and equities. And maybe this is actually a good time to bring you on, Michel, since we’re talking about fixed income and the recent moves.

We’ve seen what is a remarkable sell-off in bonds. Some commentators were comparing the performance of bonds versus the performance of equities, and it looks similar to what we experienced during the worst of the great financial crisis from a stocks perspective.

It seems that this was mainly driven by long-end yield. I mean the Fed hasn’t really done much recently. So, is that what we were expecting? Is that coming as a surprise to you? What are your initial thoughts on that move?

Michel Vernier (MV): Yes, hello, Julien, and our listeners on the podcast. Now, admittedly, I think the pattern has surprised almost everyone in the bond market, otherwise we wouldn’t have seen such a harsh move. So, it’s given lower trending inflation. US inflation declined from over 9% to now 3.7% and at the same time the Fed has increased the policy rate by 5.25%, lifting the real rate based now at the highest level since 2007. 

So, that’s clearly a restrictive level which should put a lid on growth and inflation which, in turn, should normally provide some certainty for long-end yields. Now, historically, and that includes the 1970s, in this late part of the hiking cycle we usually see the front end of the yield curve leading the upward trend, but not the long end.

And looking at the yield curve pattern, so short-end yields against long-end yields, it’s very important as it provides you a better sense where peak in overall yields are. Now, on this basis of historical patterns we argued, and we still argue in fact, that the peak will be determined by the shorter end, not the longer end. 

Now, up until September this has also been the pattern during this cycle. The US showed, and still is showing, an inverted curve with short-end yields being higher than long-end yields, and just as a reminder as investors often rightly question such a dynamic, why would long-end yields be lower anyway than short-end yields? 

It’s the idea that higher central bank policy rates will eventually lead to a cooldown in growth, inflation and finally lower yields.

And while higher rates at the short end still persist, the long end of the curve is already trying to anticipate a cooldown, leading to the situation of higher short-end rates and lower long-end rates, so a yield inversion. 

Historically, the inverted curve would reverse into a normal curve with lower front-end rates, so central banks cutting rates again down to a point when short-end rates are lower than the long-end yield into a normal yield curve. And that’s the historical playbook.

Now, what we’ve seen during the last week was, indeed, a bit out of the ordinary because the curve has started to reverse the deep inversion, but the recent dynamic was not driven by lower central bank yields as we’re still far away from the Fed to cut rates, but it was rather higher trending long-end yields.

In the US, the long end surged overall 70 basis points to 4.8% while the short end surged only by 20 basis points since the start of September to 5.05%. So, in a way, it’s a bit out of the ordinary pattern.

JL: So, we’ve seen this steepening of the yield curve maybe driven by a different end from what we normally would expect but what, in your mind, is the real reason for that sell-off on the long end? I mentioned that maybe this was linked to the debt pile in the US and the fiscal deficit. Do you share that view?

MV: Yeah, absolutely, and it’s one factor which really drives yields as well. So, bond analysts take various factors and they make the, what is called term premium responsible for the rise of long-end yields.

It’s simply the premium bond investors demand for holding long duration. That sounds quite intuitive, you know, longer bonds, I want to have more yield. Interestingly, for over a decade this premium was, in fact, negative. So, whatever the prevailing fair value of long-end yields was in the past, investors would accept a lower yield than that fair value.

Now, this theoretical term premium has surged in the recent past, and literally looks at various factors, some which we have mentioned and which you have mentioned.

So, first of all, of course supply of bonds, and more specifically today, it’s about the creditability of the US as an issuer. Now, this has clearly taken a hit. Already after the downgrade of the rating by Fitch as a result of the debt ceiling discussion, and this reminded investors that the US has accumulated a very high debt pile. 

US Federal debt is now at over $33 trillion compared to $16.5 just 10 years ago. So, even if you take this into context and proportion of a growing GDP, that has surged. Back in 2007, US debt to GDP stood at 65%. Now it’s 130%. One other interesting aspect here is that each crisis lifts the debt to GDP quite substantially and it does not recover again from there.

After the great financial crisis, debt to GDP rose to over 90%. After the pandemic crisis, the debt to GDP surged from 105% to almost 130% where we are now.

And it doesn’t seem that we see a reversal of the trend. For example, within the first 11 months of the fiscal year, so from October 22 to August 23, the deficit was $1.5 trillion compared to $900 billion for the same period the year before. As a percentage of GDP, that means it’s now 5.7% versus 3.8%. That’s just the deficit over the year.

Now, higher debt translates immediately, as you already mentioned, Julien, into higher Treasury supply, which needs to be digested by the market. Now, the Treasury forecasts private borrowing to be at 1 trillion in Q3 alone, $1 trillion that be. Only during the COVID-19 pandemic did the Treasury borrow more in a quarter. Now, for the full fiscal year the Treasury estimates private borrowing at $2.7 trillion.

Now, I mentioned all these numbers which may sound very frightening, and one would argue higher debt can only lead to higher yields, but that’s wrong. In fact, the relationship between debt levels and yields have been very weak in the past. Higher debt, especially during periods of crisis, led to lower yields given the negative growth repercussions of these crises.

So, investors in such situations like the GFC or pandemic crisis, they would be buying long-end bonds at such times regardless of the debt increase. But today, we obviously have passed this crisis and now investors may argue, what happens with this higher debt in normal times?

Now, here comes another factor into play which can also be allocated to term premium as per literature, Kim and Wright for example, so reduced buying from less price sensitive buyers.

Now, first the Fed was a long time, you know, a large buyer of treasuries but they have reduced the buying during the quantitative tightening process. The so-called SOMA portfolio of T-bills and treasuries, that has declined now from 5 trillion in the high to 4.2 trillion.

The last time the Fed reduced its portfolio, it was only from 2.3 trillion to 1.9 trillion. So, we’re talking quite big numbers here.

The Fed is reducing this by 60 billion a month, potentially another 720 billion for the next 12 months alone. But this was well telegraphed, and we think the reduction in the balance sheet as such by now is well priced in the current market levels.

Now, this may also be a concern. It’s another factor around foreign buyers like Japan and China. These are the two elephants in the room when it comes to US Treasury buying. Now, Japan holds more than $1 trillion and China holds more than $800 billion in US treasuries. 

Japan announced a more flexible approach in its yield operations, which may potentially lead to less buying of US treasuries, and China on the other hand may need to sell US treasuries in order to support its own currency, so another pressure point.

But what should be said is a large majority of these holdings are also treasury bills, so not long-end bonds necessarily, and it’s more likely that both would rather dump T-bills than US treasuries, which are deeply in loss right now in the books. So, any reduction of these two players would not necessarily translate one to one to a yield increase at the long end.

JL: So, I guess, bringing it back to what we think investors should think about, do you think we need to revisit our prevailing view that peak rates are led by short-end yields and not by the long end? What I mean by that is do you think investors should be prepared basically for much higher rates at the long end?

MV: Yeah, look, we can’t rule it out, and rate volatility may well persist, but we would not expect that long-end rates shoot well over short term rates. Also, not in this cycle.

Look, we’re not entirely in agreement what the bond market is doing now. The bond market is throwing basically the baby out with the bath water. What does this mean? It means that bond investors link any factor right now to term premium, so, and then selling long-end bonds.

This was clearly visible during the Friday move, which you just mentioned. The job market data was extremely strong, and this immediately transpired into higher long-end yields. They once more rose faster than short end on Friday, and this is where things in our view don’t add up really.

So, three months ago strong job data, as much as any economic upside surprise, would have resulted in an upward move in rates but led by short-end rates. Why? This is because investors would have expected the Fed to respond with more hikes, and we have seen some repricing on Friday, as well of Fed hike probability but rather modest so far.

We pointed to the possibility of a further hike towards 5.75%, so another 25 basis points, and the market completely dismissed this so far. I think the market has to re-evaluate possibly after the job market data and despite a somewhat higher term premium we may see the peak defined by short-end rates and not the long-end rates.

Does this necessarily mean longer end yields now? So, referring to your last part of the questions. We think long-end yields will be anchored around the short end and not initiate its own dynamic for a sustainable time.

So, what is our call? Well, 5.75% in policy rate in November seems likely. Rate volatility is probably to remain also at the long end, which could lead to 10-year yields over 5% potentially, still lower than the short end. But if anything, you know, growth repercussions will be even greater with these higher rates for the US economy. 

And eventually going perhaps into 2024, the long end will refocus on the prospect of slower growth, lower inflation, and potentially lower policy rates by ‘25, if not earlier.

JL: So maybe we get the last opportunity to lock in yields. Great. That clarifies a lot of things. But, to me, it still feels that the market is trying to justify the price action with fundamentals, rather the fundamentals necessarily driving the price action at this stage.

Anyway, I wanted to ask you a question on emerging markets simply because we have released our Market Perspective publication for the month of October and you’re exploring emerging markets from a fixed income perspective. So, if you had to summarise your views and your take on this particular asset class, what would that be?

MV: So, look, in the year to date, US seller denominated emerging market bonds, also like US investment grade bonds, they have shown subdued performance admittedly. Negative contribution came from duration, of course, that was the main driver, while spreads remain relatively stable and still trading inside of a 20-year average level.

So, we have seen outflows out of the EM region, which is often seen during times when global yields are rising. So, instead of higher US rates historically the economic backdrop was an important driver for spreads. So that’s what we would look at. And, overall, we see shallower growth going into next year which could lead to somewhat higher spreads within the emerging market segment.

Still, in a two-year period, we looked at it since 1993 when we had the data, so at US Fed peak rates EM bonds have then performed in the subsequent two years 25% on average, so you can get quite nice performance from emerging markets.

For now, we still see the risk of higher spreads, but this should be more contained in more resilient segments like India for example, potentially Brazil. So, carry opportunities remain, but being selective in this more uncertain situation with regards to growth in various regions where a distinction has to be made is key in the emerging market segment.

JL: Great. Thank you so much, Michel, and again much more detail in the Market Perspective article you wrote for us this month.

But if I have to summarise our discussion and our view, broadly speaking, definitely higher long-end rates remain a major headwind for stocks and we shouldn’t underestimate the pressure that this rate volatility is putting on stocks. But in the near future, rates should stabilise. As you were mentioned there’s probably one more hike coming from the Fed but we’re pretty much there.

And we shouldn’t forget that, you know, catalysts come and go. We are upon the third-quarter earnings season, which will actually start later this week with US banks, JP Morgan, Citigroup, Wells Fargo, will be among the ones reporting. So maybe we’re going to get a bit of a reprieve from the macro picture and we’re going to get a chance to focus on the micro and what companies are doing and seeing which, ultimately, is what will drive stock price higher or lower in the medium term.

Now aside from earnings. It’s going to be a busy week from an inflation data standpoint. Clearly, the big focus for this week will be US CPI number for September that will come on Thursday. We will get others, some inflation datapoints including the New York Fed consumer expectation survey, that’s Tuesday, the ECB inflation expectation survey, that’s Wednesday, as well as the US PPI, that same day. 

China is also going to give us some inflation figures. If you remember not too long ago, China experienced some deflation so we’re going to get the CPI and the PPI for September on Friday. Also, important to pay attention to are the minutes from both the FOMC, which we’ll get on Wednesday, and the ECB on Thursday. So, another pretty busy week ahead.

Of course, we will debrief all that next week but, in the meantime, as always, let me wish you the very best for the trading week ahead.