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Markets Weekly podcast – 17 June 2024
US interest rates and UK growth
17 June 2024
In this week’s podcast, Michel Vernier, our Head of Fixed Income Strategy, explores US central bank options and the possible implications for bond markets. Topics include the upcoming presidential election and US recession prospects. Meanwhile, host Henk Potts covers UK growth, the US labour market, this week’s key Bank of England interest rate decision and the latest gold prices.
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Henk Potts (HP): Hello, it’s Monday, 17th June, 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 with 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 fixed income. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
Political turmoil in Europe, and the relatively hawkish Fed overshadowed an easing of price pressures in the United States last week. European equities slumped, French bond yields surged, and investors sought safe haven in gold.
Europe’s benchmark index, the STOXX 600, fell 2.4% over the course of the week. To put that in some sort of context for you, that’s the biggest weekly drop we’ve seen since the middle of October last year. French stocks came under significant pressure – in fact, lost $200 billion worth of value over the course of the week.
It was actually a brighter picture on Wall Street where investors continued to bet on the prospect for lower rates. The S&P 500 rose 1.4% over the course of the week. In bond markets, the real action was in Europe where the reverberations emanating from President Macron’s decision to call a snap election played out in French government bond markets. The spread between France’s 10-year bond yields and its German counterpart surged by a record amount. The spread widened by 29 basis points over the course of the week to 77 basis points. That’s the highest that we’ve seen since 2017.
Moving on to commodity markets, where gold registered its first weekly gain in four as traders priced in less competition for the zero interest-bearing asset from treasuries. Investors, as we’ve been talking about, sought safety from the political turmoil that we’ve been seen in Europe. Gold closed the week at $2,326 an ounce, and is up round about 13% year to date.
Now, the main macro focus for the week was on the US inflation print and the communication following the Federal Reserve meeting. May’s US CPI print offered a welcome downside surprise to consumers and policymakers. Headline CPI came in at a weaker-than-expected 0.01% month on month, or 3.3% year on year, whilst the core reading rose just 0.16%, or 3.4% year on year. That’s the lowest reading that we’ve seen since August 2021.
The moderation in price pressures was driven by an easing in a number of categories in the services category, specifically travel, car insurance, and legal services.
So what’s the outlook for US inflation? Well, we expect further moderation in CPI to be made in the coming months, but progress may be impeded by the ongoing robust levels of activity we’ve been seeing in terms of the US economy and, of course, the labour market, which continues to be in rude health.
We have lowered year-end core CPI forecast, which we expect to print at 3.2% in December.
Now, despite the improving inflation picture, the FOMC offered a hawkish projection, reiterating the Committee does not expect to cut rates till it’s gained greater confidence that inflation is moving sustainably towards 2%. The summary of economic projections showed up an upward revision to inflation, and projected solid growth through the rest of this year.
Most importantly, of course, for markets was the dot plot, which showed a median of only one 25 basis point rate cut during the course of this year – that compares with three cuts in the prior projection.
Where do rates go from here? Well, sticky inflation continues to postpone, I think, the start of the cutting cycle. We still see one rate cut during the course of this year. September is now considered the earliest point at which that could happen, but it’s quite possible we won’t see a reduction until the final meeting of this year in December.
Now, the latest Fed projection suggests more aggressive rate cuts in 2025 where four quarter point reductions are currently pencilled in. We’ll go into more detail of this with our guest later in the podcast.
Moving on to the UK where labour market conditions continue to ease, and GDP flatlined during the course of April. Now, the UK unemployment rate rose to 4.4%. That’s the highest reading that we’ve seen since September 2021. Vacancies dropped for the 23rd quarterly period in May. The number of jobs available dropped to 904,000.
Wage growth also cooled. It came in at 5.8%. That’s down from the 5.9% we saw in the quarter through April despite, of course, being boosted by the increase in the national minimum wage.
In terms of the outlook for the UK labour market, we forecast the jobless rate will peak at 4.6% by the turn of the year, which may not bode well for domestic consumption levels which should result in lower levels of pay growth which, in turn, should help ease the UK’s inflation profile further.
Now, as we said, UK GDP flatlined in April as activity, particularly in manufacturing, construction, and retail sectors, was impacted by the miserable weather that we saw. That was partly offset by the strong performance we saw from IT and communication services, professional businesses, and entertainment.
Where does the UK economy go from here? Well, as we wrote in our Mid-Year Outlook, prospects for the UK economy, I think, still look pretty difficult during the course of this year. Economic activity levels are expected to remain below their potential. We’ve got growth of eight tenths of 1% forecast for this year, and 1% as we look through 2025.
So, that was the global economy and financial markets last week. In order to discuss the prospects for fixed income in the second half of this year, I’m delighted to be joined by Michel Vernier, Head of Fixed Income Strategy for Barclays Private Bank.
Michel, great to have you with us today. As I’ve been discussing, after the latest inflation data and the updated Fed’s own projection for the policy rate, has anything changed in your mind when it comes to our view on US rates?
Michel Vernier (MV): Hello, Henk, it’s great to be here on the podcast again. Yeah, as you said, look, much of the focus this week has been on the Fed meeting and the inflation data release on Wednesday, so that was a very important date for the bond market. And, interestingly, as you exactly said, we saw some hawkish signs from the Fed and, on the other hand, some encouraging inflation numbers.
The bond market seemed to put more weight on the inflation data and responded with lower bond yields. Looking at the two-year yields, now around 4.7 overall, more than 30 basis points lower compared to the highest seen just two weeks ago. But let’s quickly recap on the Fed and what was said, and presented actually as you just said.
So, like every three months the Fed publishes its own projections of the future of policy path through the dot plot, and it was for the expectations for 2024, which carried a bit of a hawkish message because there was only one cut pencilled in compared to the three back in March. But, still, it’s followed by 100 basis points in each 2025, 2026, so not too much of a change overall when we’re going down the line.
Now, the endpoint of 2026 remained at 3.25% upper policy rate. So another more hawkish signal came in in the form of the estimate of the long-term neutral rate. Now, this rate builds the anchor for the Fed as above that level that would be a restrictive level, and below that would show an accommodative levels.
Now, over decades this neutral rate has constantly been revised down and now, for the first time, it notably has been increased from the previously 2.56% to now 2.75%. And quite a lot of the Committee members, they see this rate actually at 3%. Now, we’ve written about this long-term rate in our March publication by the way as well.
Now, the market has not responded with higher yields and instead focused more on the inflation data, which was mentioned by you, came also out on Wednesday, and they have undershot expectations. Cool inflation means, in fact, the rate market ignored the Fed’s projection of lower cuts, or perhaps sees this as old news now.
Now, for end-of-year, the rate markets is almost three cuts again, so two or a bit more than two. We believe that this is too optimistic. The Fed is likely trying to delay the cut. That was always their message now, lately for now, and this, in fact, could bring some rate volatility in the coming months.
But let’s not also forget we have come a long way when it comes to inflation. So, it looked like the Fed preferred inflation measure now comes to, in at round about 2.6%. That’s just 60 basis points from the target. So, cuts in 2025 and 2026 towards 4.75% and possibly even lower, that seems actually very likely.
HP: Well, it’s interesting to get your thoughts on the inflation profile and what it’s likely to mean for Fed policy. Now, Michel, in our latest Outlook, you explore alternative scenarios from our base case. Can you provide us with a bit more colour on those, and perhaps how likely you see such scenarios playing out?
MV: Yeah, that’s a very good point because we’re now in an interesting junction where the Fed needs to make a very important decision. You know, once they start then that provides a big message to the rate market as well. And we have to acknowledge that there are still some uncertainties.
So, the first scenario which we were looking at would be one where yields are obviously trending higher again. The great inflation moderation may come to a hold and the Fed may need to delay cuts substantially or even hike again, so not our base case but not off the cards equally as well.
And, up until now, we haven’t talked about the big elephant in the room. Investors are likely to focus on the US election as the outcome may have consequences on the fiscal path.
But let’s be honest, both parties don’t have a lot of leeway and, independent of the outcome, bond investors are already sensitised to the fiscal situation with a budget deficit in the future of around 6%, maybe even 7%. That means treasury auctions need to be increased again somewhere next year, and that’s something the bond market will look at.
We actually explained that in a bit more detail also in our Mid-Year Outlook webcast and in our publication.
Now, the financing gap for the US is likely then to reach around $3.5 trillion over 2026 to 2029, so a big funding gap, which the price sensitive buyers need to absorb. Now, while the late cut or hike seems less likely, we have to put some weight to the volatility to these fiscal worries.
Now, the second alternative, or the alternative scenario, would be that of a recession or substantial lower growth. Now, we don’t see that the market puts a lot of weight to such risk, not at least given another part of the bond market, so another rate market, but the credit market shows spreads. So the additional yield investors would demand for going into riskier or corporate bonds, whether it’s higher quality or lower quality, and they have very tight levels, so showing almost no concerns about a recession whatsoever.
And, again, the odds are low, specifically given the low unemployment rate, robust consumer and economic activity, as you just mentioned, Henk, but as with the tides and the sea, things can turn. And the high unemployment rate, we’ve seen already some signs here that could equally put pressure on the Fed going further out, and suddenly the Fed has to cut faster than priced in.
Interestingly, the first alternative scenario with the Fed hiking would also increase the likelihood subsequently that something breaks and we have seen that the weakest link in the chain is already ailing, the commercial real estate market in the US.
While the banking turmoil last year has been contained, not at least because of the Fed support, last year the commercial real estate sector is not immune to higher rates and that still could provide pressure for the Fed to provide accommodation now, be it with liquidity facilities or lower rates. So, there’s definitely another alternative scenario which investors should consider when engaging in the bond market.
HP: OK. I want to get a little bit more practical. How should investors be positioned now given everything that you’ve been talking about this morning?
MV: Yeah, it’s a good point. The first major trend we’re looking at is at a continuation of decline in inflation and a soft landing in the US. The signals strongly point to that scenario.
Now, consequently, we remain broadly neutral when it comes to duration which means medium term bonds, and investment grade bonds specifically, they seem attractive for two reasons now. The overall yield is attractive. In the US, we are looking at 4.25% or a little bit more, in the UK even higher, and that’s apart now from the peak seen in October, still the highest level over the last 15 years and provides a real yield, so adjusted for inflation of around 3%. We find that’s actually pretty decent over the last 15 years.
Secondly, the fundamentals are quite good in the high quality space and we see no reason to take now excessive risk if you can achieve decent yields within higher quality corporate bonds. But, as discussed, it can be helpful to spend some thoughts to alternative scenarios and probably equip portfolios with additional bond segments to be even more resilient.
For example, we spoke about higher or the potential for higher inflation or not moderating inflation. Inflation-linked bonds could help and would perform well if such a situation panned out and inflation should flare up again. And also we would see shorter-dated BB rated bonds selectively because you can actually enjoy quite a nice carry return without being too much exposed when yields should go higher.
And then, on the other hand, if yields, or if we would go into a recession, usually that would be, or increase the likelihood to have a, what is called long or normal yield curve, whereby shorter yields are much lower than longer end yields and then steepener bonds would be actually quite favourable to have in a portfolio as well.
HP: OK. One of those scenarios that I think is worth picking up on that you just mentioned was steepening structures. Can you quickly explain in simple terms, if you would, what this exactly means and why this can be interesting for investors?
MV: Steepener bonds can come in various shapes but, essentially, these bond structure they perform well if the difference between the long-end yield, so let’s say, for example, the 10-year US treasury yield, but could also be the 20 or 30, for example, and the difference between that and the short-end yields, so be it a two year or maybe even three months is increasing.
Now, currently, the curve is slightly inverse. I mean it’s around 50 basis points in the US, 10 yields against two yields because the 10 years are lower. So, at first, it doesn’t look attractive, but the time is normally on your side, and we draw lessons from history that we can be pretty confident that the interest rate curve will be normal again where longer yields are higher than short-end rates. And this should play right in the hands to such steepener bonds.
Again, they come in various shapes and forms, so it’s important to select the appropriate ones, which usually investment specialists would do. You know, as you would if you go selectively into any bonds, you want to kind of get the right and resilient bonds in your portfolio, so it’s important to have that discussion as well. But such bond segments could actually make very much sense as well.
So, overall, you know, we have also quite a lot of these conversations. With all these uncertainties, different scenarios, it’s probably better to stay in cash and we would argue, well, if you look at long-term returns of cash it’s actually underperforming substantially against other bond segments as well over the very long term. So, it seems like having a good bond or mix of bond segments, various bond segments, to be equipped against various scenarios seems the more favourable choice here.
HP: Well, thank you, Michel, for your insight today and putting the opportunity in the fixed income space into perspective for us.
Let’s move on to the week ahead where the focus will be in the UK on inflation data and, of course, the Bank of England interest rate decision. We forecast a further moderation in UK CPI, look for headline inflation to come in at 2.1% year on year compared to the 2.3% that we saw in April.
We also anticipate an easing of core price pressures. We project core CPI to print at 3.5% compared to the 3.9% that we saw during the course of April, reflecting base effect, as well as an easing of core good and services.
The MPC, of course, will be monitoring the inflation data very carefully. Any hopes of an early cut have been dashed by General Election protocols and April’s higher-than-expected inflation print. Therefore, we expect rates remain on hold at this meeting. However, further progress on inflation, an easing of labour market conditions, and perhaps you could argue some pressure after the European Central Bank cut its rate could leave the door open for a potential reduction at the August meeting.
In the US, traders will await Tuesday’s retail sales industrial production figures where we expect a solid bounce back in retail sales following April’s flat reading. We look for headline sales to increase by four-tenths of 1% month on month, collecting strengthening readings in nearly all categories, although the headline will be weighed down by, we think, weakness in gasoline station sales, and mid-May’s decline in petroleum prices.
We forecast an increase of seven-tenths of 1% month on month for industrial production. That’s on the heels of the prior month’s soft reading. Much of this strength reflects manufacturing production, which we expect to rebound with strong assembly schedules for May, driving an increase in motor vehicles and parts.
We also expect the remaining two categories will also increase, aiding the rise in headline, with mining rebounding after declining in the prior month, and utilities showing another month of gains.
With that, we’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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