As we approach the day of the dead, the massacre in money markets continues.
A prominent hedge fund apparently suffered huge losses and capitulated from being long the front-end vs. short the long end. In the last week alone, money market yields across developed markets have moved to price in further multiple rate hikes over the next 24 months, including a noteworthy 200bps over in the next 12 months in New Zealand.
At the same time, longer maturity bonds have fallen. The market has clearly been positioned on the wrong side of this trade, particularly in the UK.
Taking a step back, we are of the view that while to some extent the moves are justified by rising inflation risks in the global economy, the market is clearly in overshoot territory, particularly in the UK and Europe.
But as we know, the Day of the Dead holiday is actually a celebration of life. For years, politicians and bond traders alike have been asking how we can survive the massive increase in debt burdens around the globe and why inflating the debt away is impossible. Now, with up to 8% nominal growth, deficits around 4% expected for 2022 and refinancing rates mostly below 1.5%, it suddenly feels achievable.
Sure, this is a rather festive interpretation; underlying growth dynamics are most likely not as robust in the medium term, despite high saving rates and potential second-round effects in the labour market; current inflation is higher than the GDP deflator, with negative consequences of higher energy prices; and government expenditures are also partially linked to higher inflation making low deficits more difficult to achieve.
But for the sake of the real world, central banks should be very careful not to lift off too early and be in the way of higher inflation, as long as real rates are not starting to move substantially higher.
For bond vigilantes, this is arguably not an optimal outcome. As we have been highlighting for some time, real money investors are trapped in low-yielding government debt, with a significantly higher weighted average maturity.
In the UK, the average debt maturity is close to fifteen years, but real yields are ranging between -2.5% and -5%. LDI and insurance investors had to cover their short positions again on Wednesday, when the UK DMO announced a significant reduction in supply which led to a major rally in cash bonds forcing these investors to carry the burden of this otherwise positive debt deflating trend.
In that regard, the ECBs Lagarde answered the market’s question about the inflation and rates outlook in Europe quite directly – hikes are not on the cards until the projections of medium-term inflation of 2% are met, which will not be anytime soon.
For now, the market and bond vigilantes do not like this outcome and continue to push against it.
As highlighted, the rates market remains volatile as investors manoeuvre ahead of the Bank of England (BoE) meeting next week. Expectations are already riding high, with market probabilities assigning a greater than 50% chance of a rate hike and for interest rates to rise to 1% by mid-2022. This is consistent with recent communications from the BoE, where concerns over the ‘de-anchoring’ of medium and longer-term inflation expectations have had members scrambling to defend the institution’s credibility.
We expect CPI to top 6% next year and envisage policymakers in the UK will come around to this view. We continue to think Gilt yields at 1% look too low given the inflation backdrop. The UK budget this week was mildly more expansive than expected, with the key policies being an increase in minimum wages and a reduction in the forecast for 2022 borrowing, which should help demand for long-end Gilts at the margin going forward.
However, the overriding economic picture for the UK remains unclear, with the inflation dynamic squeezing real incomes and rate hikes from the BoE likely to increase mortgage costs. This in turn raises the prospect of stagflation, making a recession later in 2022 a much more material possibility, compounded by government policies.
In that respect, the recent OBR projections for growth in 2022 to be as high as 6% look wholly optimistic. It looks like we have a ‘Nightmare on Downing Street’ ahead and we have added to our short sterling position.
In contrast to the wild moves in rates curves, fundamental newsflow in the US has been relatively benign. Economic data points (mostly second tier) have been firm without being spectacular – the earnings season continues to deliver a relatively upbeat message about the health of the corporate sector and policymakers continue to edge towards a deal on the spending package. If anything, our expectations for the size of the package have improved somewhat, despite the often-tortuous path the process has to take to get over the line.
All this emphasises the technical nature of the move we are seeing in interest rate markets. Indeed, if we look more broadly at how financial markets are trading, we observe that US equity markets have continued to grind to fresh highs and currency markets are relatively becalmed.
Corporate credit volatility also remains subdued, with spreads on US and European cash indices unchanged for the last two weeks. Primary market activity remains light due to the ongoing reporting season, where the aforementioned upside surprises have helped stabilise sentiment further. There had been concerns coming into earnings over how cost pressures may impact company outlooks, but this really hasn’t materialised.
Despite this benign backdrop, there has been a pick-up in idiosyncratic dispersion of late. This week saw some big moves across the capital structure of Banca Monte dei Paschi as negotiations with Unicredit appeared to fall apart.
Additionally, European real estate issuers saw more volatility, driven by contagion from the German issuer Adler, which was impacted by allegations of balance sheet inflation by Viceroy Research. Yesterday’s non-event ECB meeting shouldn’t provide a catalyst for increased corporate credit volatility, but any adjustment relating to corporate purchases will be keenly observed as we move forward.
The main event next week is the US Federal Reserve meeting, where expectations for any surprises are low. Unlike some central banks, the Fed is not playing the game of chicken and its clear commitment to announcing the taper of QE purchases will not be seen as grasping for credibility. It will be welcomed, not least as money market liquidity has deteriorated and front-end rates are trading very close to the lower bound of the Fed Funds target rate.
The taper announcement should come as a relief to the front-end market here and the benign supply picture next year has taken the pain out of expected taper commencement for the time being.
Frights in money markets might look more trick than treat as we move into next week – happy Halloween all!