Feeling cheated in the UK?

And it’s not just because of the cricket….

A holiday shortened week has seen yields continue to push higher, led by moves at the front end of the curve, as interest rate expectations continue to ratchet higher. A firm ADP jobs report and hawkish minutes from last month’s FOMC meeting provided the main catalyst for price action. However, other economic data released this week, such as ISM, painted a more mixed picture with respect to the economic backdrop.

Meanwhile, high frequency measures of inflation, such as the Cleveland Fed’s Nowcasting model point to price growth moderating to around 3%. A similar outcome is also seen looking at recent median PCE data, as well as in softer forward-looking intentions in the ‘Prices Paid’ component of PMI surveys. This all suggests to us that the economy remains on a course towards weaker output and inflation moving back towards the Fed’s target.

Nevertheless, it appears that the FOMC is on track to hike rates to an effective rate of 5.35% later this month. In order for the Fed ‘skip’ to be a more entrenched ‘pause,’ we think we would need to seek payroll growth around 100k jobs later today, in conjunction with a monthly CPI print no greater than 0.2%.

Although Powell is aware that lags in policy will continue to weigh on the economy in months to come, with equity markets near their highs and credit trading relatively well, so the Fed is very wary of giving any signal that could act as a catalyst for strength in risk assets and a concomitant easing in financial conditions.

Given that the US yield curve is at record levels of inversion, not seen for a generation, it is proving difficult for longer-dated yields to perform, even on days when newsflow appears more supportive. Ultimately a clearer path to rate reductions is likely to be needed, before a more sustainable rally in fixed income can take place, and this may not be visible for some time.

Curve inversion also weighs on Eurozone yields, with the ECB remaining relatively hawkish for the time being. Meanwhile, riots across France have served as a reminder that populist sentiment could quickly start to build should the economy slide into recession, with unemployment rising. It is concerning to think how well Le Pen and National Rally would do, were there French elections held today.

Meanwhile in Germany, it is also striking to see AFD overtaking SPD, with a vote share now >20% according to opinion polls. Within Europe, the past several quarters have seen the economies of southern Europe perform better than northern Europe. On a relative basis, this has helped spreads within the periphery to rally over the past several months.

However, if political concerns build, with recession risks more prevalent, then there could be a risk of renewed volatility later in the year, were populist trends in northern Europe to trigger a return to more populism in the south.

Elsewhere, we have seen ongoing capitulation from investors with long positions in UK fixed income. Gilt yields have continued to rise as demand for UK fixed income continues to dry up and this has pushed market pricing for end 2023 interest rates as high as 6.5%.

UK government finances are in poor shape (partly due to rising borrowing costs on inflation linked debt) and have been further impacted by Bank of England (BoE) losses on past asset purchases. Yet at a time when the UK needs to issue debt, the dynamics of the LDI market mean that fewer long-dated gilts are needed to hedge liabilities as yields rise.

This negative convexity effect is a challenge for the UK to manage, and ultimately a reason why longer-dated yields may have further to rise.

Nevertheless, we think that at the front end of the curve, pricing for the BoE rate hikes is now over-done. This should mean that the UK has a steeper yield curve, which would be more in keeping with an EM-like risk premium, which may need to be factored into prices.

In countries such as Italy, it has been interesting to note how the government has been able to attract large amounts of domestic retail saving into bonds, such as the ‘BTP Italia’ campaign. Arguably, one issue for Rome to navigate, looking forward, is that it may have exhausted this buyer base for the time being.

Yet in the UK (and elsewhere) the direct retail participation in government fixed income markets remains relatively low. This may need to change. With governments such as Sunak’s raising complaints that banks are not passing higher interest rates on to savers effectively, then what better way to address this than to market gilts more effectively and directly to retail savers?

Of course, one corollary of this is that fewer bank savings could mean that banks have less to lend and government borrowing starts to crowd out the private sector. However, one might expect loan demand to be soft as the economy weakens and as banks raise lending standards in order to protect themselves from credit losses.

Within emerging markets, ongoing strength in the Mexico macro story saw the peso rally below USD17. However, rising US yields have started to diminish the attraction of carry trades in EM. This is becoming apparent in countries such as Hungary, where the Administration seems to be veering further away from orthodox monetary policy.

We think that this could leave the forint vulnerable and would note that this is a currency with net long speculative positioning from investors who, to date, have been happy to earn attractive levels of carry in a low volatility landscape.

Meanwhile, in credit markets, cash credit has been outperforming relative to CDS indices during the past week. Inasmuch as investors use CDS indices as a means of hedging credit beta risk, the widening of the basis between CDS and cash has been a course of underperformance in 2023, but now there seem to be signs that this process has runs its course and basis spreads could revert in the opposite direction.

Looking ahead

We are now at the point of the month where the important data, which will determine the Fed’s upcoming thinking, will be released. US jobless claims data of late have hinted at some cooling in the US labour market.

However, these claims are coming from a very low level and consequently it seems hard to forecast payrolls growth much lower than the natural growth in the underlying labour force. In this case, the unemployment rate continues to remain very low and there is little to push the Fed from raising rates again in July, unless material downside surprises are to occur.

Meanwhile for the Fed to hold, it will also be necessary for inflation data to play ball. Base effects will bring headline June CPI to 3.0% based on consensus estimates, but core will need to be 0.2% or less on the month in order for core to dip below 5.0%.

Across the Atlantic, in the UK, we are also waiting and hoping for some better news on inflation. Yet, in this context we would also note Ofgem output highlighting lower utility prices as energy costs fall, as well as large UK food retailers, such as Tesco and Sainsbury, noting a slowing in food price inflation as offering some hope.

Greed-flation from businesses ramping up prices and extracting pricing power could hold prices up, yet in the absence of monopolistic power, the ability to expand margins in this way may prove short lived.

The British public may feel like they are being cheated at the moment and it isn’t just the Australian cricket team which stands guilty of blame. However, balance should hopefully be restored before too long.  After all, didn’t we all learn that cheats never prosper….