Bear market - or just a fake?

You don’t want to wait to get bitten, before you find out….

Treasury yields continued to push higher over the past week, led by moves at the long end of the yield curve. A Fitch credit downgrade put a renewed spotlight on the US fiscal position against a backdrop of elevated Treasury supply. Meanwhile, economic activity continues to expand at a trend-like pace, showing little sign of slowing. A landscape of declining inflation has recently fed a Goldilocks narrative in terms of the US economy.

However, indications on inflation, such as the Cleveland Fed CPI Nowcast, suggest a robust 0.4% gain in core prices in July. If this data is confirmed, it may be troubling inasmuch that it paints a picture of inflation becoming stuck in the 3-4% range. If this is the case, then further monetary tightening may be necessary and the more painful part of the tightening cycle may lie ahead of us, not behind us.

We have observed over the past month how many market participants have been adding exposure to risk assets and removing downside risk hedges, on hopes that the Fed is nearly done, and that the US economy can avoid a material slowdown. With Treasury yields moving higher, this has seen positions under pressure and a degree of softness across risk assets. Stocks have retreated lower, with credit spreads pushing wider.

We are inclined to think that these trends could have further to run, should the move in Treasuries persist. The high in 10-year yields in the current cycle sits at 4.24%, and should this level be breached, then a technical break could be a catalyst for more widespread weakness. Should that occur, a flight to quality would probably then stabilise yields, and in that context we might want to look to position long in US 10-year rates, should yields breach 4.3%.

Meanwhile, we continue to be content maintaining credit hedges via CDS and running modest amounts of directional beta exposure to risk assets.

A weaker economic backdrop in the Eurozone has seen yields across the region little changed over the past week, despite the rise in Treasury yields. Relative outperformance of Bunds versus Treasuries has been a factor in pushing the dollar strong against the euro.

Meanwhile, larger-than-expected interest rate cuts in Chile and Brazil over the past several days have seen the dollar stronger across EM currencies, with the DXY Dollar Index recovering its losses from July. Otherwise, Europe has been relatively quiet over the past week, with the continent continuing to bask in a summer heatwave.

The Bank of England raised rates by 25bps to 5.25% this week, helping the yield curve to steepen as the front end of the curve continued to make gains, with further rate hikes being priced out. A peak in rates is now priced between 5.5%-5.75%, which is not far from where we see fair value, and consequently we have been reducing conviction in our bullish view on short-dated UK yields. It is striking to think that UK peak pricing was as high at 6.5% only around one month ago, at which time UK rates appeared to offer a compelling asymmetric trade opportunity.

Elsewhere, the Bank of Japan (BoJ) continued to be in the news, in the wake of last week’s tweak to Yield Curve Control. Unscheduled interventions to support yields appeared to be aimed at slowing the move in 10-year rates above 0.50%. However, the main implication of this intervention has been to weaken the yen.

Ueda needs to be careful not to give a green light to FX speculators to pile on the carry trade and push the yen materially weaker above 150, by over-emphasising a dovish monetary policy stance. Previously, we have seen the MoF intervene around 145, but FX intervention is not going to be credible if the market hears the BoJ giving the opposite message.

In this context, it should be increasingly clear that Japanese policymakers can either seek to control the level of 10-year yields, or the level of the yen, but not both. Higher US Treasury yields continue to add pressure to this dynamic as interest rate differentials move wider, and we suspect that the BoJ will realise over the coming weeks that they need to allow 10-year JGBs to rise to a range between 0.75%-1.0% from 0.65% today.

Over the medium term, we think that the yen is a very undervalued currency. However, the BoJ risks undermining the currency’s valuation, which ultimately will only serve to push inflation higher and force a more material policy adjustment at a later point.

For now, we continue to maintain a short stance in JGBs and a long position in yen, with the sizing of the former materially greater than the latter. For now, we are hopeful that the BoJ will shortly identify the shortcomings of its recent intervention efforts on 10-year yields. If it steps back from purchases in the next couple of weeks, then we think that yields will end up stabilising at higher levels and the yen can ultimately trade stronger.

Looking ahead

Today brings the focus back to the US labour market. Data appeared to suggest a robust demand for labour, with the picture not greatly changed. Against a backdrop of a tight labour market, we think that the Fed will focus particularly keenly on wage gains. Stronger wages risk triggering additional inflation pressures, with some commentators highlighting the risk that higher price expectations are becoming embedded, as elevated levels of CPI persist.

Meanwhile, the coming week will see attention back on inflation data itself, with markets potentially vulnerable to an upside surprise. June’s core CPI of 0.2% fed hopes that inflation is headed back to the 2% target. Yet it is worth remembering that this data was the first monthly figure below 0.4% for the past six months.

Once CPI is out of the way, the data calendar quietens, and market volatility could calm down. However, the last couple of weeks have witnessed some interesting macro developments, which may have caught the investing consensus offside. Higher yields and weaker risk assets would appear to be the pain trade for many at this time, and in relatively illiquid summer markets, it is possible that prices could overshoot given a sufficient catalyst.

Yet, the outlook remains uncertain, and we might sympathise with the patrons of the zoo in China this week, left debating whether they were witnessing a bear or just a fake. Problem is that you don’t want to wait until you get bitten, before you find out….