Markets Weekly podcast – 23 September 2024

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

It was a busy week for central banks, and that’s why we’re going to focus on this in today’s podcast. And in order to do so and to analyse what the more recent central bank action means for investors, I will be joined by Michel Vernier, Head of Fixed Income Strategy at Barclays Private Bank.

But, before that, a quick look at last week, which was another strong one for risk assets, with the S&P 500 registering its 39th all-time high of 2024 and climbing 1.4% over the week.

Meanwhile, Treasuries were mostly lower with the curve steepening, and now positive by about 15 basis points. Now, of course, the main event of the week for markets was the US Federal Reserve meeting, which we will discuss in a second with Michel. 

But beyond the Fed, the market processed a smattering of generally upbeat economic reports, which helped further support expectations for a ‘soft’ landing.

August retail sales were positive, headline sales were slightly positive, versus expectations for a decline, with favourable weather and solid back-to-school shopping trends helping. The September editions of the New York and Philadelphia Feds’ manufacturing indices unexpectedly flipped positive. And finally, weekly initial jobless claims printed at their lowest level since May, with continuing claims dropping as well.

On the housing side, we also had positive news with August housing stock beating expectations while the September homebuilder sentiment survey rose after four consecutive monthly declines. And this is why markets took the move by the Fed so positively. Easier monetary policy and a strong set of macroeconomic data is the perfect backdrop, or so-called Goldilocks scenario, for investors.

In other words, the best case for markets is increasingly a soft landing of the US economy, just like in 1995. And while the Fed may be able to pull this off, it won’t become obvious for another few months and, in the meantime, setbacks could materialise. 

As such, we do remain somewhat prudent, especially ahead of an uncertain US presidential election. So, we think investors should stay invested, of course, but well diversified and probably with some dry powder on the side in order to capitalise on opportunities that will, no doubt, emerge between now and the end of the year.

Now, let’s move on to you, Michel. The Fed cut interest rates by a larger-than-expected amount, at least if you believe economists, 50 basis points, while the Bank of England and the Bank of Japan kept interest rates unchanged last week.

So, how do you think markets have taken these latest rate decisions? And maybe we start with the US Fed, and you can explain from your perspective, what you took away from chair Jerome Powell’s press conference?

Michel Vernier (MV): Yeah, as you mentioned, the Fed delivered a 50-basis-points cut, finally. The rate market for a while could not conclude between a 25-basis-points or 50-basis-points cut and during the last trading days already leaned towards a 50-basis-points move. So, the move was pretty much anticipated in the end and, therefore, we haven’t seen a large reaction on the basis of this particular decision.

Interestingly, we’ve seen some bearish steepening with longer yields trading slightly up compared to shorter yields as a first reaction. Now, this was probably on the back of the Fed’s own projections for the future rate path, which the Committee published in the very same meeting.

But you asked about the impactful comments from Powell. First, I would argue it’s probably the rationale for the larger cut. To provide some context, one of the main reasons why 25 basis points could have been a possibility, that’s because there was a broad concern of the market that a 50 basis points would signal that the Fed is, indeed, very concerned about the US economy so, in essence, spooked the market.

Remember, the dynamics of the US economy has changed notably over the summer on the back of signals of a cooling job market. And, in order to avoid spooking the market, Powell showed confidence in the economy by saying we don’t think we’re behind. He said, you can take this as a sign of our commitment not to get behind. And he added the labour market is actually in a solid condition and our intention with our policy moves for the 50 basis points today is to keep it there.

Now, one comment showed that the Fed seems very much alerted and open to larger cuts if needed potentially. So, he said, to me, the logic of this, both from an economic standpoint and also from a risk management standpoint, was clear. Now, as a central bank, you know, you don’t have to need to talk about risk management if you wouldn’t see some possibility of a harder landing. So, the Fed at this critical juncture of the cycle will need to be razor sharp.

JL: So, if the Fed is razor sharp, what do we think they’re going to do next? I mean how much is priced in for this year and next in terms of rate cuts? And in your opinion, is that justified?

MV: The market is pricing in 125 basis points roughly worth of cuts from the 5% upper target today by end of this year. Now, given we only have two meetings, that implies another 50-basis-point-step at one meeting and for 2025, the market implies another four cuts, so 100 basis points towards 3% potentially, or lower.

Now, this is entirely aligned with the Fed’s own projection. The FOMC participants see two cuts, not three, in 2024, and four cuts in 2025, which results in a somewhat higher rate. The median for 2025 at the end of next year is around 3.4%.

Now, our own baseline projections look at a somewhat higher rate of 3.75% by the end of next year. However, admittedly, we do acknowledge that we may well see two cuts more if, indeed, we see some continuation of the cooling of the labour market, which is the pillar of the US economy. 

So, job hiring is cooling as we know. The payrolls, the hiring, three months’ average at the lowest since mid 2020. In August, we’ve seen the largest downward revision when it comes to hirings since 2009, and the number of vacancies per unemployed worker, an indicator the Fed watches closely, declined to 1.1%. That’s the still the lowest in three years.

So, while the Fed is expected to make gradual adjustments and won’t call victory over inflation, we also must bring another angle to this conversation. 

So, let’s assume you’re a central banker having lived on Mars for the last five years without any mobile reception. You’re landing straight into the Fed office and look at the current dataset and you look at the job market, which may be still healthy but cooling notably. You look at inflation at 2.5%, 50 basis points away from your target, and you compare this with the current policy rate of 5%. So, basically a real, so inflation-adjusted, policy rate of 2.5%.

Now, this is a very restrictive level in historical terms. So, as Fed chair, you order in all your FOMC members immediately and instruct them to cut rates by 100 basis points in order to be closer to neutral, but still be reasonably restrictive. So, that’s another angle to look at it.

As we pointed out in our last publication, a 3% Fed rate, as implied by the market today, would not necessarily reflect a hard landing of the US economy as some commentators seem to suggest. 

Now, this would imply a nominal Fed rate of 2.5%. Now, in a hard landing scenario that, if we would that bring up, the Fed will have to lower the real policy rate even well into negative territory. 

So, overall, I think 3% that’s priced in today is basically just reflecting a soft landing and a chance of a hard landing, which suggests fairly balanced pricing in the market. Certainly, the Fed will need to consider the election to some extent as well.

JL: Well, so on that, to pick up the US presidential election, obviously a major unknown going into year-end, how does one look at the possible outcomes from a fixed income perspective?

MV: Yeah, I mean first of all, it’s essential to look at historic patterns. And while certain changes in legislation may impact certain sectors, be it healthcare, energy sector etc, we’ve rarely seen that the markets were directed by politics on a longer-term basis.

But let’s perhaps look at what we can say. In this case, I would actually quote our colleagues from Barclays Investment Bank. They argue that in a Republican sweep, investors would likely focus on the extension of Trump tax cuts, the risk of higher across-the-board tariffs. And, on balance, this could imply somewhat higher yields due to implied growth and inflation projections as they say.

Now, if we explore the other end of the outcome and a Democrat sweep, the proposed budget could be deficit neutral. At the same time, we may see higher taxes and spending. So, net net, it could lead to similar or slightly lower yields as a scenario of a fiscal expansion, rate shock would be off the table in that case.

Now, we would caution, however, trying to adjust the investment strategy based on political outcomes for two reasons. First, the outcome remains very uncertain. We haven’t even talked about a shared Congress as well. Now, secondly, the past has shown us that ultimately, it’s the economic cycles which dictate the broad direction of rates.

Now, having said that, the fiscal situation in the US is stretched by all means and any noise could lead to some volatility regardless of the outcome. Let’s remind ourselves of the fiscal situation. Back in June, the Congressional Budget Office said it expects the budget deficit and debt-to-GDP ratio to rise to $2.8 trillion and 122% by 2034.

Now, these forecasts assume that Trump tax cuts fully expire, and the Fed eases aggressively with interest on debt averaging about 3.4% over the next 10 years. So, consequently, we argue some premium for the long end seems to be justified today, which would enforce the current trend towards a steeper curve, ie lower trending short rates, which would not be fully reflected at the long end of the curve.

JL: OK. Now, let’s move on to the UK for a while. The Bank of England has not cut its policy rate, contrary to the Fed last week. Do you think this is a divergence that is going to last between those two central banks and maybe, therefore, between the two bond markets?

MV: Yeah, it’s a good point, Julien. I think the dynamics, at least over the shorter term, they point to such a scenario. But we think the UK economy stays in a fairly tenuous recovery, which should lead to a gravitational pull for inflation eventually.

Besides, the UK rate landscape won’t be able to ignore the US trend entirely, so potentially another 50-basis-point cut, for example, in the US surely would pull down UK rates due to global arbitrage flows.

Now, having said, for the next month at least the inflationary concerns seem to dominate in the UK, which was also clearly expressed with the BoE statement, which said monetary policy will need to continue to remain restrictive for sufficiently long, until the risks to inflation returning sustainably to the 2% target in the medium term, until they have dissipated further.

Now, there’s some optimism, as Governor Andrew Bailey added. I think we’re now on a gradual path down. That’s good news, I suppose. But, interestingly, the BoE other than the Fed does not face this job market weakening aspect and also, in fact, would see the structural shortage of labour in the UK as a reason to potentially use these higher rates to bring weakness to the UK economy.

I’m saying this because this is particularly a scenario, which was laid out in the latest MPC statement. So, taking this into account, it means the UK rate market cannot price in a rapid rate-cut cycle just as in the US yet, not at least as the BoE needs to see a cooling off in the core inflation level and this, in fact, has surged again to 3.6% as shown last week.

Now, on the medium-to-longer run however, the subdued economic growth path that’s mentioned will lead to lower inflation and lower yields and a base rate level of 3.75% by mid next year seems plausible.

Now, of course, also here in the UK, we cannot have a conversation about the bond market without discussing the fiscal situation. Last week, we’ve been updated about the current situation. The national debt hit 100% of GDP for the first time since 1961. The public sector net borrowing hitting £13.7 billion in August, that’s the third highest August on record, and £64 billion year to date as such continues to run ahead of the OBR’s expectation. 

So, all eyes will be on the budget. Chancellor Rachel Reeves likely prepares to announce tax rises in her budget on 30th October but also, rightly or wrongly, relies on UK growth. 

So, the gilt market will likely be sensitised to the supply pressure on the longer end of the curve. And having said this, there may be some relief from the demand side, however. The fact that BoE is now sticking to its £100 billion a year reduction in its balance sheet is good news, and that’s because we have a large redemption out of the BoE gilt portfolio, so large redemptions of £87 billion, which means the BoE will only need to actively sell £13 billion in the next fiscal year.

So, our view for the UK as to why rates may not decline as fast as potentially in the US and the fiscal situation may provide some volatility potential, the broader direction is also for lower yields over the medium to longer run.

JL: Great, excellent. So, look, we’ve covered a lot already, but I just want to make sure that we spend some time on investment implications because you’ve been very vocal over the past, let’s call it couple of years, about locking in rates, especially whenever we saw some spike in volatility on the bond side. So, what would be your message today to investors? Do you still see bonds as an interesting opportunity?

MV: Yeah, it’s this broken record, I’m getting reminded all the time, very true. So, admittedly, the time window of locking yields was long given the post-pandemic dynamics. The historic patterns, as we’ve pointed out many times by now, have not changed. You know, bond yields they peak around and have peaked around the time when central banks stop hiking. 

Now, as you rightly say, bond yields have declined substantially already, but rightly so inflation is now close to 2% in the UK, Europe and the US, so lower yields are very much justified. So, if we take the 2% or let’s 2.5% inflation and take, for example, investment grade bond yields in the US at 4.7%, then you still have 2.5% real yields, so that’s after inflation. In the UK, investment grade bond yields are still well above 5% in the corporate bond segment investment grade.

Now, in our view that’s still pretty good value when comparing this to levels we’ve seen over the past 20 years, for example. Now, furthermore, with such higher yield entry points, the diversification benefits kick in again especially mitigating the hard landing risk. And one thing is for sure, in such a scenario the Fed nor the BoE would leave their respective policy rates at about 3%, so anyone who would think that cash rates will stay higher for longer, I guess that train has definitely left the station and there’s still some value in the bond market, I guess.

JL: Right. So, there is still value in fixed income and bond markets, but this is a very large market. So, where actually do you see value within the bond market?

MV: Yeah, of course, I think after having been very excited when investment grade bond yields reached over 6%, we’re now a bit more neutral in our duration stance owing to the last decline in yields. But, as mentioned just before, we’re still constructive and would perhaps favour more four- to five-year duration generally, also because of some fiscal and policy uncertainty.

As for the bond segments, we continue to like investment grade bonds, but would also see some value in higher quality within the high yield sector. In the absence of a hard landing, which is our base case scenario, and with lower trending yields, that segment should actually also do reasonably well, so we get nice, attractive carry returns.

Another segment to highlight is the securitised market. In particular, we like that bonds are backed by collateral and that’s mostly mortgages, so mortgage-backed securities.

JL: Just on that point of mortgage-backed securities, don’t you think that people might be a bit scared after what happened 2008, 2009 in this space? Do you still think, given what we see from a macroeconomic standpoint in the US, for example, it’s a good place to be?

MV: Yeah. Of course, we have to kind of acknowledge that, but the market has also changed dramatically. We’re now on 2024 and, you know, first, there’s been a large regulation overhaul with now very tough and transparent rules implemented. And contrary to 2009 on the market side, the residential housing market, especially in the US, looks incredibly healthy. 

Loan-to-value house values are very low, and we have a high equity value within the mortgage portfolio. So, that is underpinning the valuation. And thirdly, we see spreads variable compared to investment grade given current supply-and-demand dynamics. So, mortgage-backed securities and similar security bonds seem actually a great segment when looking for portfolio diversification.

Now, for investors who also look to lock in yields above 6.5%, I would also bring in emerging market bonds which generally do well in times of cutting cycles. So, I’ll leave with that for now. I think it’s fair to say that the time to pick the low-hanging fruit is slowly running out, of course. We enter now into a phase where there’s still a lot of value to be found when you observe the bonds closer. So, plenty of reasons to be fairly optimistic and constructive about bond investments.

JL: Excellent. Thank you so much, Michel. We covered a lot, but I think it was important, and it was a very busy week for central banks and, therefore, major implications for the fixed income market. And I guess you’ll be busy again this week as we have many more central bank meetings, although possibly less relevant for the broader market. 

We have the RBA rate decision on Tuesday, the Riksbank decision Wednesday, and the Swiss National Bank decision on Thursday. But of course, before that, today we have the Flash PMI for September and we will finish the week with inflation data from France and Spain, as well as the US PCE for the month of August.

So, quite a lot to digest and to analyse when we’re back next week. But, as always, in the meantime, we wish you the very best in the trading week ahead.