Trick or treat?

Here’s to a spooktacular Halloween!

US 10-year Treasury yields reached 5% for the first time since 2007 over the past week, with broader risk markets also starting to feel the heat. Bonds had briefly caught some respite when investors Bill Ackman and Bill Gross took to social media earlier in the week, arguing the bullish case for owning bonds, but this was relatively short lived.

Whether purely coincidental or not, it was another reminder of the current market environment we find ourselves in – of heightened volatility – where even marginal factors can have a dramatic impact on asset prices. In that respect, we are light on risk but suspect there will be a more opportune moment or valuation point which should await us between now and the end of the year.

US GDP for the third quarter printed 4.9% on an annualised basis, continuing the string of hot activity data emanating from the US. In terms of policy, we think the strength in the US economy points to a risk that the Fed will need to raise rates further in order to mitigate demand and bring inflation down to 2% in a timely manner.

Fed Chair Powell’s latest comments at the Economic Club of New York echoed these thoughts, but for now, the over-riding narrative remains that the FOMC is more or less at the end of the current tightening cycle.

Part of this narrative has been helped by the spiralling fiscal deficit resulting in booming Treasury supply, which has been responsible for an increase in term premia, with higher longer-dated bond yields having a tightening effect on financial conditions.

However, the more that strong growth persists, the more this common wisdom may be called into question, and we see this jeopardising hopes for a soft landing.

That said, we continue to hold a view that growth will slow by the middle of next year and we think that no more than one further hike from the Fed will be required in this cycle. In a sense, we just need to be patient for monetary policy to work in an economy where transmission has been delayed, whilst stimulative fiscal policy is also blunting the effectiveness of monetary policy changes in the broader economy.

In general, we think that the Fed will want to avoid putting gas on the fire and is more likely to lean against the recent moves in longer-dated bonds, making a hike next week unlikely but December still live and hostage to the data.

In the eurozone, the ECB held deposit rates at 4% as expected. We feel most ECB council members are now content with where policy sits, choosing to wait and see how the economy evolves and digests policy moves over the past year before taking further actions.

Notably, the recent Bank Lending Survey released by the ECB pointed towards another leg down in credit and demand conditions, with ongoing central bank balance sheet reduction contributing to tighter lending conditions cited as one of the key reasons. Should the eurozone economy perform ok from now until year end, and given where core inflation is, we suspect discussions around further balance sheet reduction will be a centre of attention in early 2024.

Elsewhere in the dollar-block the Aussies certainly aren’t getting any treats this Halloween after Q3 inflation printed at 5.4% this week and showed quarter-on-quarter figures gaining pace. It draws to question whether just one more hike is enough for the Reserve Bank of Australia to navigate its ‘narrow landing’ or if more is needed? One thing is for certain – the market isn't giving governor Bullock the benefit of the doubt which the Bank of Canada enjoyed this week as it decided to remain in the 'preference to pause' camp and keep rates on hold.

Ahead of the Halloween Bank of Japan (BoJ) meeting next week, latest Tokyo CPI numbers will provide little comfort to policymakers that inflation is on a sustainable path back to 2%. The ex-fresh food and energy ‘Core’ measure printed above 3% for the tenth consecutive month, and with US yields moving towards a higher range, a potential BoJ policy error looks even more stark.

Moreover, with the yen at critical levels versus the dollar, the tussle between intervening in the FX market as well as the bond market, easing and tightening simultaneously, is starting to strain BoJ credibility. Recent speculation in Japanese paper Nikkei that BoJ members are seriously considering a further tweak to YCC next week comes as no surprise, and we think should the policy change we anticipate occur, rates will climb higher and the yen should rally on the basis of undervaluation versus the dollar.

Meanwhile in the UK, the Bank of England (BoE) meets next week where we expect Bailey and colleagues to hold rates at the current level. However, we think this could be a mistake, given BoE models have failed to comprehend a de-anchoring on inflation expectations which we believe has become apparent. After all, if the government has promised the public to ‘halve inflation’ to ~5% by the end of the year, you shouldn’t be surprised if the public start to believe that that’s the new inflation target.

As a result, we continue to attach an elevated probability towards a stagflationary outcome in the UK, of high inflation coupled with economic contraction. This leads us to maintain a bearish view on UK assets, particularly longer-dated gilts and the pound versus the euro.

Corporate credit has drifted wider and is largely being led by macro and rates volatility. Credit investors generally remain cautious, and this is underscored by a lack of material selling, despite the weaker tone across risk assets.

It’s notable that we are starting to see disappointments causing more severe spread moves in single issuers, with the likes of payments provider Worldline, and energy technology leader Siemens Energy both 100bps wider during the week.

We maintain a small long bias in credit with a view to potentially increase this on further weakness but are wary that the level of macro uncertainty can continue to keep credit spreads under pressure.

Looking ahead

The big question for now is whether 5% on US 10-year Treasury yields is the peak, or merely a staging point on the journey to 6% and above. We are starting to see signs of cracks appearing in equity and credit markets but can’t help shaking the thought that if yields continue to rise, so we will soon reach a breaking point where a bigger market correction needs to take place.

Trying to predict the future can often be a humbling experience and it is only fair to conclude that there is plenty of uncertainty for now. Visibility at the macro level is very low, there are too many variables, too many unknowns and too much volatility is being generated as geopolitics careens from one crisis to the next.

In this context, a conflict may follow an unpredictable path and there is a sense that financial markets are a bit complacent in this respect, for the time being.

Back to central banks, it’s a big week ahead as the Fed, BoE and BoJ all meet, with the two former institutions expected to keep policy on hold. The latter, however, is in much more of a dilemma given the cross currents mentioned previously – does the BoJ stick or twist? Or are markets in for a nasty Halloween surprise – trick or treat!?