Stronger than titanium

….with rate hikes yet to bite.

Government bond yields chopped sideways over the past week, in a relatively quiet week on the data front, notwithstanding several key central bank meetings. The over-riding theme in macro markets continues to be the durability of the US economy, with the S&P 500 hitting a new record high, despite high interest rates, geopolitical uncertainties and global growth concerns emanating from China.

Moreover, markets continue to push out the start of the hiking cycle in the US, with the pricing of a March cut now just 40%, from a high of 85% just a few weeks ago. However, a plethora of potential risks ahead keep us sceptical and grounded, particularly in an environment where directional views are very consensual. In that respect, we like to take a more tactical approach to risk-taking in the current market environment, in anticipation of clearer asymmetries ahead.

With the Fed in blackout, it’s worth taking a step back and assessing the current data the FOMC has at its disposal going into next week’s meeting. Inflation is on an improving path, but uncertainty remains high. The Fed’s preferred measure, core PCE, is likely to fall to 2.6% in December’s release later today, but with ‘super core’ measures continuing to show underlying inflation running above 3%, there is still plenty to do towards the 2% target.

Initial claims are below 200k and displaying little immediate stress in the jobs market, while wages according to the Atlanta Fed have stagnated at 5.2% for the past quarter. Financial conditions have loosened recently, providing survey indicators and activity data a tailwind, with the latest GDP data surprising to the upside for the second quarter running.

Overall, we think a robust economy, coupled with favourable disinflation trends, means the FOMC can afford to be patient and bide its time in the monetary loosening process, and we expect Powell to take a similar tone.

The ECB kept policy unchanged, opting to wait for disinflation trends to continue and Q1 wage developments to materialise before drawing any conclusions. In that respect, next week’s CPI print will be important, but we think the next ‘live’ meeting is likely June, when macroeconomic forecasts are updated to incorporate a broader range of data.

We think this means we would need to see the 2025 inflation forecasts at or below 2%, to satisfy the council that policy needs adjustment, well below current ECB forecasts. It was also interesting to see the number of questions fired at Lagarde regarding a recent ECB staff poll, in which more than half the respondents said she was doing a poor job as president. She fought back valiantly, but it goes to show how important the year ahead is for the ECB not to repeat mistakes of the past.

Much like the ECB, the Bank of Japan kept policy unchanged, as expected, but there were a few noteworthy items from the outlook report and press conference. The outlook report kept the core-core measure of inflation at 1.9% for fiscal 2024 and 2025, but the inclusion of a new phrase ‘the likelihood of realising the price stability target has continued to gradually rise’, we think raises hopes that this measure could be revised up to 2% in April, setting the stage for policy rates to rise thereafter.

Governor Ueda also made the comment that signs are pointing to higher wage increases at the upcoming union wage round intentions in the spring, where we believe a figure of around 4% will provide enough evidence that a wage-price spiral is in motion. The press conference was perceived as being a little more hawkish, and we remain patient and convicted yields in Japan will continue to rise.

In the UK, it was interesting to note that recent disruptions in the Red Sea are finally feeding into business costs and the outlook. The latest PMI noted that supply disruptions in the Red Sea have led to the longer journey times lifting factory costs, at a time of still-elevated price pressures in the service sector.

We continue to believe the UK remains a region where inflation will remain volatile and structurally higher, and coupled with the disruptive political backdrop, requires a higher risk premium attached to it, particularly from a gilt perspective.

Turning to FX markets, we believe 2024 will be a year where carry compression – rather than just static carry – comes into focus. There are a few emerging market central banks that will be cutting rates aggressively this year, as growth concerns come to the fore and inflation recedes into the background.

At the forefront of this dynamic are Hungary and Colombia, where the respective central banks are priced to cut a mammoth 500bps. Moreover, both currencies screen as over-valued and over-owned, due to the strong carry-seeking inflows of last year.
Corporate credit had a strong week, driven by lighter primary market activity, more stability in rates, and very strong flows into IG credit. European IG slightly outperformed vs US IG, where the gap between the two is the biggest since 2022 and historically wide.

Sectors with the most focus were financials, where valuations are generally accepted to be the most attractive but also where we are seeing the newest deals in senior bonds, and real estate which continues to recover from the extreme valuations reached in the past 18 months.

Valuations are starting to look a bit stretched and continue to battle against favourable supply and demand dynamics. We remain constructive but would look to reduce into strength or increase hedges while the bond-CDS basis looks attractive.

Looking ahead

There is a familiar pattern developing in 2024, to what we saw at the beginning of 2023. The potential for idiosyncratic landmines remains high. From a macro perspective, there is much uncertainty regarding the macro data as we roll through a difficult transition phase in which disinflation is questioning the level of monetary restrictiveness among developed market central banks.

We do not place much store in anyone’s ability to accurately call the trajectory of growth and inflation through the next 6-12 months, and as a result, we continue to look for more tactical, reactive exposures to extract value from core rates markets, except for Japan, and the UK to an extent.

We came into this year expecting pushback in the market pricing of rate cuts from central banks, and this has largely materialised. However, the next phase could be much trickier and could largely depend on how the US economy develops over the coming months.

One thing for sure, for now, is that the US economy is looking as solid as Kanye West’s new USD850,000 titanium dentures. No signs of rate hikes biting on his spending!