Rates seem to be reconnecting with economic fundamentals – could higher yields be on the cards this autumn?
Last week’s strong US jobs report supported a constructive narrative with respect to the economic outlook. This was something that was also endorsed by a number of Federal Reserve speakers in the past several days.
Concerns regarding the spread of the Delta variant are a lingering issue, though there appears a growing sense that the rate of increase in Covid infections is starting to level off on both sides of the Atlantic. With hospitalisations and mortality much lower than in previous waves, the narrative that we are now ‘learning to live with Covid’ seems to be gaining traction.
In the wake of these developments, the recent trend towards lower Treasury yields appears to have been broken and we would suggest that rates seem to be reconnecting with economic fundamentals, following a period when technical factors appear to have dominated price action.
We sense that this shift in the climate may have further to run as we draw closer to a point where the Fed looks to announce a taper of its bond purchases. We suspect that once investors return from their summer break, a push towards higher yields and reflationary themes may characterise the ‘back to school’ trade heading into September.
This week’s US inflation data was more benign than the past several months, yet prices are still up by 5.4% on a headline measure and 4.3% on the core rate. Given that monthly gains in US inflation were very modest at the back end of 2020, we expect year-on-year price gains to remain around these levels, even if some of the recent transitory factors that have been driving prices higher start to retreat.
Forward-looking indicators suggest that there is further inflation pressure in the pipeline, as highlighted in PPI data and purchasing manager surveys. Shipping costs have resumed an uptrend and could easily test new highs if there is disruption at Chinese ports related to Covid closures.
Meanwhile, wages and incomes are growing robustly and there is ongoing evidence of shortages in supply chains and difficulty in hiring workers. Given this backdrop, corporate management teams are suggesting that they are in a position to exert more pricing power than has been the case for a number of years and are planning to pass on increased costs.
On this basis, we think that annual inflation may be close to a peak, but that it is likely to stay at levels materially above the central bank targets for an extended period.
Elsewhere, developments in China continue to attract attention. Here it seems that ‘zero Covid’ policies are coming under increased scrutiny as the Delta wave seems difficult to stymy without taking radical action to close the economy.
It may appear that policymakers in Beijing are shifting their stance towards living with Covid, but this is tempered by the realisation that domestic vaccines do not appear to offer as strong protection as those manufactured by Pfizer, Modena and others.
There is a push to deliver mRNA vaccines in China and a hope that these will become more widely available at the end of 2021. However, this still puts policymakers in a difficult spot in terms of balancing competing priorities over the course of the next few months.
At this stage, we think that it remains unlikely that Chinese factory output should be materially impacted, though domestic demand in China could be dented. We think that this should lead policymakers to deliver some easing and we think that the PBoC will adopt a more dovish stance, lowering interest rates even as policy heads in an opposing direction on the other side of the Pacific.
Stark divergence may also be witnessed in countries such as Australia, where vaccination rates remain well behind others in the west and where it may be some months before the vulnerable in society can be adequately protected.
More broadly speaking, vaccine availability marks the difference between high income and low income countries; Covid remains a downside risk for a number of emerging economies, even as the pandemic fades into the background in Europe and the US.
Corporate spreads have been somewhat softer over the past week on the back of unseasonably heavy new issuance. This week saw 48 new deals inside 48 hours. It may appear that some borrowers have brought forward their issuance plans from September, seeking to tap markets following the recent rally in underlying government yields.
Notwithstanding that, risk appetite continues to be well supported by the robust growth outlook and a sense that, even if central banks start to taper bond purchases, there remains abundant liquidity for the time being and it will still be some time before interest rates start moving higher. This narrative has seen the S&P post another record high during the past week, with volatility measures such as the Vix index continuing to decline. The backdrop remains supportive of spreads, even if valuations appear to limit scope for spreads to rally very far from prevailing levels.
Elsewhere, the dollar has pushed towards its 2021 highs on a trade-weighted basis, thanks to firmer data and rising yields. Within FX, we have continued to favour the Norwegian krone and Hungarian forint relative to the euro. In Asia, we are more constructive on the Korean won relative to the Chinese renminbi on a relative value basis. We sense that there are clearer opportunities in rates than FX, in terms of taking a strong directional view on the US dollar, predicated on continued US economic outperformance.
Meanwhile, in emerging markets, a widening of spreads in July – as Treasuries and Bunds rallied – created the opportunity to add to some exposures at attractive levels. Although we have some mixed views in terms of the overall performance of EM assets, we can identify a number of issuers that appear to offer attractive value, even if there are others we would be happy to avoid.
The next couple of weeks may be relatively quiet with respect to economic data and politics. In the US, Congress will be on summer break over the next month, returning in the fall having agreed the USD550 billion bipartisan physical infrastructure bill. The drive towards the USD3.5 trillion human infrastructure bill is likely to play out in September and October and will require the Biden administration to overcome objections from some of the moderate senators, such as Joe Manchin, in order to pass.
Elsewhere, as fans assemble their own Fantasy Football squads, it has been amusing to see how Paris football club PSG has managed to part pay for its new star signing, Lionel Messi, by issuing him tokens in its own crypto asset (I bet Barcelona wish they’d come up with that idea first). That aside, it is tempting to think that August may play out as a relatively quiet and benign month in financial markets.
Statistically speaking, however, August often witnesses more volatility than many other months. This could, in part, result from the fact that market depth is relatively shallow, with many market participants sitting on the beach at this time of year.
More importantly perhaps, it feels like this summer is witnessing a moment where we are seeing increased enthusiasm to take action with respect to the environment, in the wake of a series of extreme weather events. The urgency behind this was summarised in the recent UN Intergovernmental Panel on Climate Change report, which sounded a ‘Code Red’ for humanity. One just hopes that this doesn’t come too late.
As the whole anti-vax movement has shown, if society is to achieve optimal outcomes with respect to social good, policymakers need to take the lead and be prepared to make choices that may be unpopular with some but are necessary all the same.