Markets Weekly podcast – 22 April 2024
Where next for US interest rates?
22 April 2024
In this week’s podcast, Michel Vernier, our Head of Fixed Income Strategy, examines the outlook for interest rates in the major regions and particularly the US. Other topics include bond yields, declining inflation and potential opportunities for fixed income investors. While host Henk Potts explores China’s growth prospects, the latest UK employment figures, inflation in the eurozone, and other key investor topics.
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Henk Potts (HP): Hello, it’s Monday, 22nd April, 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. 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 rates and the prospects for fixed income. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
Last week, the fallback in global equities broadened out as escalating geopolitical tensions, mixed corporate results and a hawkish tone from Jerome Powell negatively impacted risk sentiment.
In terms of performance, the S&P 500 was down. In fact, it fell 2.7% over the course of the week, its biggest weekly decline since the middle of September last year. It’s now 5.3% below its 52-week high that was achieved on 28th March. The Nasdaq delivered its biggest weekly drop since November 2022.
We also saw weakness in European equities. The STOXX 600 fell 1.2% over the course of the week and is now 3.2% below its 52-week high that was set at the start of this month. Along with the macro environment, earnings will be a big driver of equities over the course of the next couple of weeks.
It’s still very early days of course. So far, 14% of S&P 500 companies have reported first-quarter results, 74% of which have been above EPS estimates, which is in line with the 10-year average. The average ‘beat’ so far has been around 7.8%, according to FactSet data.
However, when you look at the downward revisions that we saw in the healthcare sector, which has been offsetting the positive earnings surprises from the financials, the blended earnings growth rate for the first quarter now stands at just half of 1%.
This is a big week for tech earnings, and they’ll be grabbing the headlines as we get results from Microsoft, Meta, Alphabet and Tesla. Bloomberg data forecasts first-quarter earnings for the ‘Magnificent Seven’ will rise by 38%, that compares to the first quarter of last year.
Moving on to crude prices, which drifted lower at the end of last week. So far, we’ve not seen the dramatic surge in oil prices that some commentators had been predicting. Despite Iran being the third largest Opec producer, at around three million barrels per day, which as we know equates to around 3% of global supply, traders appear to be taking a relatively relaxed view of the chances of a full-blown regional conflict and seem comforted by the fact that Opec+ continues to have a large amount of spare capacity. In fact, it’s currently estimated to be round about five million barrels per day, which should help to alleviate any shortfall that we see in the market.
Now, on the macro front, the focus last week was on Chinese GDP, UK inflation and employment data, followed by the latest eurozone inflation report.
China’s first-quarter growth figures came in significantly better than expected. The world’s second-largest economy grew by 5.3% in the first three months of the year, versus the market consensus of 4.8%. Growth was driven by a surge in industrial production, fixed-asset investment and exports.
Given the positive first-quarter performance, we now think that China will be able to achieve its annual 5% growth target. However, the rebound that we’ve been seeing has been uneven. Recent activity data suggests that momentum is already slowing and risks still remain to the downside. In fact, if you look at the data for March it shows that retail sales still remain underwhelming, growing at 3.1% year on year. That’s versus the 5.5% that we saw in January.
Industrial production eased in March. It came in at 4.5%. That compares to the 7% that we saw in January and February. Infrastructure investment softened. Contraction in the housing market deepened. We think that the first-quarter growth trajectory is unlikely to be replicated throughout the rest of this year as the economy struggles with the subdued labour market, softer demand for corporate and household credit, and the continuing risk of deflation along, of course, with that persistent slump that we’ve been seeing in the housing market.
Given the negative wealth effects, hopes of a sustained rebound in services and consumption looks unlikely. China’s economic outlook is also tainted by some long-term underlying issues, such as its low birth rate, elevated debt levels and slower rate of urbanisation. So, the deleveraging process will need to continue and further fiscal and structural reform is required if authorities are to deal with the fundamental imbalances that you see within the economy.
In terms of the UK, well, inflation moderated in March. CPI print came in at 3.2%. That’s down from the 3.4% that we saw in February. In fact, the lowest that we’ve seen since September 2021, compared to the peak of 11.1% at the end of 2022. However, price pressures eased at a slower rate than markets and the Bank of England were expecting, as rising fuel costs offset some of the benefits of moderating food inflation. Core inflation printed at 4.2% driven by services.
So, what does that mean for our inflation forecast? Well, we still expect further moderation to shine through in the upcoming print with UK inflation set to fall below the 2% level in the second quarter. In terms of the annual averages, we see CPI averaging 2.4% during the course of this year, and then below the target level, coming in at 1.9% for 2025.
The UK labour market report provided further evidence of a softening of employment conditions. The unemployment rate increased to 4.2% in the quarter through February, which is the highest ever that we’ve seen since the middle of 2023. There are some clear signs that firms are now reducing their workforce. The redundancy rate has been picking up. The vacancy rate stood at 916,000, which is still, actually, elevated by historical standards but, remember, that compares to a peak of around 1.3 million that we saw in May 2022.
Policymakers have closely been watching the inflationary impact of pay growth levels, and there were some tentative signs that that measure is starting to ease as well. But pay growth moderated and come in at 6%. That compares to 6.1% in January, although this still remains higher than policymakers, I think, are comfortable with.
In terms of the outlook for rates, the MPC is likely, I think, to be laser focused on the incoming inflation, labour market and growth data. These should pave the way for a rate cut, currently expected to be in June, followed by three further quarter-point reductions at subsequent meetings, putting the base rate at 4.25% by the time that we get through November.
In terms of eurozone inflation, well, that eased to 2.4% last month, helped by an easing of food, alcohol and tobacco price pressures. The core reading dropped to 2.9%, though service inflation still remained elevated at 4%. Inflation appears to be sustainably heading back towards the targeted level by mid-2025. Activity levels have improved but only from a low base and continues to be pretty anaemic. Policy levels remain restrictive.
Data shows credit standards have been tightening and loan demand for investment still remains very weak. So, we think the European Central Bank is still on course for a June cut, followed by consecutive cuts in July and September, taking the deposit rate down to 3.25%. After this, we expect the Governing Council to space out future cuts as they manage the divergence between euro and US rates and deal with a possible FX effect. So, after September, the next cuts are projected to be in December, then in March and June of 2025, taking the deposit rate to 2.5% by the time that we get to mid-year 2025.
So, that was the global economy and financial markets last week. In order to help us navigate the ever-changing world of rate expectations and how to be positioned in fixed income, I’m pleased to be joined by Michel Vernier, Head of Fixed Income Strategy for Barclays Private Bank.
Michel, great to have you with us today. Let’s start off with bond yields, shall we? Do you expect yields to top their respective highs that we saw during the course of last year?
Michel Vernier (MV): Yeah, absolutely. I think there is some scope for yields to reach these levels, but we doubt it would be long lasting, if at all, if it reaches these levels, is the short answer. But I think we have a couple of more minutes, so I’ll extend my response a bit.
Just to recap perhaps, 10-year US yields reached almost 5% back last October and from then we have seen a tremendous rally towards 3.8% in the US 10-year yields. Now we’re back again at 4.6%. Ten-year UK gilts had a similar ride since August and are now trading at 4.25%, compared to the highs of 4.7% last October. Now, what has driven these huge swings?
First of all, it was the aforementioned adjustment of the policy-rate expectations. We’ve talked about this numerous times. It’s the complacency which regularly pushes the market to extreme levels in either direction, making the market and the rate market swing. When the US 10-year reached yields at their lows in December, the market expected 200 basis points of cuts by the end of this year, towards 3.5%. At this time, core inflation stood at 4%. A real yield that would have translated to 1.5%, reasonably restrictive.
But what was more in focus for the market is that rapid decline of inflation back then. The CPI core declined from 5.6% to 4% in a matter of six months. So, it seems the market extrapolates this dynamic into the future, at least to some degree, and economists would point to the most recent low month-on-month changes of inflation, which were annualised extrapolated core CPI at only 2.5%, but that has very quickly changed again. And this is also where complacency starts, so this extrapolation of that rapid decline.
The Fed during this period, so back in September and before, was not as excited and pointed to the stickiness of inflation. So, credit to the Fed back then. But then in January, February it seemed even the Fed got carried away, with some higher inflation prints again. The Fed declared these as ‘bumps’, as much as they declared higher inflation two years ago as ‘transitory’ as well.
Now, we believe that inflation will retreat further, but it will take time as much as higher policy rates take time to be fully felt in the US economy. Now, will there be room for the Fed to cut rates just lately? Yes. I mean the market is pricing out almost two cuts, or probably one and a half, by year-end. That looks a bit more balanced and we see some room for pricing potential over the coming three months to the upside potentially. Why? Because the Fed has sharpened its rhetoric. They even seem to have revisited their own plan of cutting rates.
Now, just reading out Jerome Powell’s last statement, he said the reason data had clearly not given us greater confidence and instead indicates that it’s likely to take longer than expected to achieve that confidence. And that’s actually very important. So, it seems like they have changed their own trajectory. Now, the last projection from the Fed itself, the official ‘dot plot’, pointed to three, four cuts. I think the June projection will show only probably two cuts max, if at all. So that’s going to be very important here.
If we add the risk of the odd CPI bump, then one cut seems actually reasonable. And the market is not fully priced for that, as I just mentioned, so some room for higher rates probably from here but, again, the air is definitely getting thin. Now, this is the first factor.
The second factor is also the long end. The upcoming election, for example, in the US is likely to provide maybe some tax presents, some social security presents for whichever party you look at. And it all comes at a cost of a higher deficit to a certain degree, and this is not something that the bond market particularly likes. We’ve learnt that during the Liz Truss period last year. We saw this also in August in the US, for example. So, some volatility at the long end is apparent, with that repricing at the front end could lead to somewhat higher rates in the short term at least.
HP: Michel, as you mentioned, at the start of the year economists were predicting some pretty aggressive rate cuts through the course of this year, many of which, as you say, have been scaled back pretty dramatically. So, what makes you confident that rates are finally going to go down and by how much?
MV: Yeah, look, I mean first of all you already mentioned our expectations that inflation finally will decline, to a certain extent. And, again, expecting inflation to retreat rapidly is as complacent as expecting that the global economy and the US will not see any ‘landing’ within the next 24 months or longer. It implies that we don’t need to speak about cycles anymore. And, again, projecting resilience to eternity. We know that’s complacency at its best.
Look at the savings rate, higher rates and higher delinquencies shown in some of the segments within car loans, for example. So, we think there’s definitely the higher rates are filled to a certain degree already and the consumer is not going to be strong, or likely to be strong, forever. So, we also think once the labour market has normalised from the pandemic, it also has potential to roll over. You know, 250k and above in terms of payrolls added jobs, they won’t last forever if we look at the historical evidence.
But by how much will they fall? So, that’s a good question. Well, there’s a good possibility that core inflation retreats towards 2.5%, but only by the end of 2025 and probably not much earlier. This, in turn, would justify Fed rates as low as 3%, potentially 3.5%, so ending there, which also depends on what the Fed would have said has been a neutral level.
Now, it’s difficult to translate this into 10-year yields, as there are also these big supply questions and the term-premium questions as well. It shouldn’t be much far away from around 4% or lower, would seem to be a reasonable figure to talk about.
However, it would imply a world of no recession and again, as I said, there’s also a possibility of that within the next 24 months, at least on a global level and maybe some spillover effects of the US, we see much weaker growth coming in, and that’s something which, currently, the market doesn’t seem to price in at all.
HP: OK, Michel. Let’s try and broaden out the conversation to consider fixed income from an investment strategy perspective. So which part of the rate curve when it comes to maturity seems the most attractively priced?
MV: Yeah, considering our points, what we just mentioned, I guess medium duration is the short answer. And while we do acknowledge that, on a relative basis against the 2-year rates or the 10-year rates, a 5-year point may look a bit expensive, it seems more balanced for a reason. First is that we’re not positioned very long duration at this point of time as we see some short-term repricing potential. But any rate of 4.75% or even 5%, maybe a bit higher, should make us much more confident at duration back in again as much as we did back in November, during our Outlook publication.
Now, we remain neutral for now but endorse for anyone also who’s heavy in cash, or has not taken on any duration yet because they feel rates, or cash rates, are going to stay long forever, that they should revisit this position now. So, the neutral position is basically also implying that any investor would already be positioned in fixed income. So, again, it’s more about making sure you’re already positioned for potentially lower rates within the next 24 months or even longer, but also be prepared for more volatility which brings up more opportunities to engage in some longer duration again.
HP: Well, Michel, thank you so much for putting the recent movements that we’ve been seeing in fixed income into some context for us, highlighting your rate expectation and perhaps, most importantly, emphasising the opportunities that investors have across the asset class.
Let’s now move on to the week ahead where the focus will be on US GDP and PCE figures along with the UK PMI survey. We expect the advanced estimate of first-quarter GDP in the United States to show a 2.5% quarter-on-quarter increase, driven by robust consumer spending. We also look for a solid quarter of fixed investment, led by a further acceleration in residential investment and an upswing in the business equipment category, following two quarters of decline.
We think that household personal income grew by a solid half of 1% month on month in March, accelerating from February’s three-tenths of 1% month-on-month gain. We’d expect the increase in the nominal PCE to round up to a robust eight-tenths of 1% month on month, which would translate into a second consecutive half of 1% month-on-month increase after adjusting for inflation.
We anticipate that the PMIs will convey a mixed picture in April for the UK. We expect the momentum in the better performing services sector to continue to ease, after last month’s marked improvement. We also look for a slight payback in the manufacturing headline index, though the sector should continue to show encouraging signs over the course of the next few months.
And with that, I’d like to thank you once again for joining us. I hope that you’ve found this update interesting. We will, of course, be back next week with our next instalment but, for now, may I wish you every success in the trading week ahead.
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