Hit for 6?

(...but only in cricket).

Long-dated Treasury yields rose substantially over the past week, reversing the price action from the week before. Further evidence of strength in the US economy points to a risk that the Fed will need to raise rates further in order to mitigate demand, in line with the objective of returning inflation to target.

For now, a strong labour market and a solid consumer balance sheet continues to drive retail sales, and in turn, this is supporting business sentiment. Over the past several months, a narrative that the FOMC is at (or very close to) the end of a tightening cycle has held sway.

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.

There is a line of thinking that would argue that if 500bp of rate hikes have done little to slow activity, then why shouldn’t Fed Funds hit 6%, 7% or even higher before reaching a peak. Yet, this thinking may be naïve, as it may imply that monetary policy is ineffective. Economic history contradicts such a narrative.

However, it remains the case that policy transmission has been delayed for reasons previously covered, whilst stimulative fiscal policy is also blunting the effectiveness of monetary policy changes in the broader economy. This suggests that the wait for cuts is likely to go on.

At this point, it feels premature to even speculate when monetary policy may turn more accommodative, and it is possible that the FOMC will not deliver any rate cuts in calendar year 2024.

This 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 that case, we think that we won’t reach 6% on Fed Funds, and therefore 6% Treasury yields are unlikely to be forthcoming. A booming fiscal deficit means booming Treasury supply and we have no doubt that this has been responsible for an increase in term premia, with longer-dated bonds underperforming recently.

However, with 10-year yields up by 100bps over the past two months, this has prompted a further tightening in financial conditions, which appears to have caught policymakers’ attention. In this case, we think that the Fed will want to avoid putting gas on the fire and is more likely to lean against this move, making a November hike unlikely unless data necessitates this over the next few weeks.

Having adopted a tactical long duration stance and booked gains on part of this position, we remain inclined to maintain the remainder of this position for now. We think that yields should stabilise around current levels and although we note that real money investors have tended to be ‘long and wrong’ through recent price action, hedge fund investors appear to have adopted an opposing view. This means that positioning is quite evenly balanced.

Meanwhile, end clients we speak with appear to be making more longer-term shifts from stocks towards bonds, from an asset allocation point of view. Fixed income yields look increasingly competitive versus earnings yields, and with many investors having been structurally underweight public market fixed income, we think that flows into the asset class are likely to persist.

In one sense, a flow from stocks to bonds needs to be a given, on the assumption that the stock of government debt is set to continue to continue to grow. Essentially, we may witness some crowding out of the private sector, as a result of a ballooning government sector. Simplistically speaking, it can be understood that yields may need to rise until such a point where buyers step in and an equilibrium is restored.

We think that we may not be too far from this point, with government bonds yielding 5% and IG corporates at 6.5%. As long as inflation returns to target (or gets close towards it) over the medium term, a 5-year, 5-year forward at 5% will appear attractive. Meanwhile, long-dated inflation-linked bonds offering a guaranteed yield of inflation plus 2.5% also start to appear compelling to long-term asset allocators and those with inflation-linked future liabilities.

Meanwhile in equities, we would note that if one simplistically considers the equity market on 20x earnings as an asset with a duration of 20 years, then a 100bps rise in long-terms rates should equate to a drop in price of 20%.

Clearly there are factors mitigating against this (most importantly earnings growth in the context of an economy whose nominal GDP continues to expand at a pace >8%), yet it can be seen what a powerful headwind a rise in long-term rates represents.

In this context, should yields continue to rise, it would seem more a question of when, not if, we witness a much more substantial equity market correction. From that perspective, we continue to think that it makes sense to adopt a cautious overall view on risk assets, with a desire to remove hedges and take a more constructive view only after a more material dislocation occurs.

For now, the US continues to set the tone across global markets. European yields have moved in sympathy but continue to exhibit a lower beta versus their US peers. Meanwhile, poor inflation news in the UK has seen gilt yields close in on a new cycle higher.

We continue to have a bearish view on UK rates, as it strikes us that US inflation is getting stuck in a 3-4% range, so UK inflation is getting stuck between 5-6%, notwithstanding a more pronounced weakening of UK economic activity. We think BoE models will continue to predict inflation falling, and this will lead Bailey and colleagues to maintain rates on hold for the balance of the year. 

However, BoE models have failed to comprehend a de-anchoring on inflation expectations, which we believe has become apparent. 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 and the pound, and it strikes us that an incoming Labour government in 2024 will take office at a time of economic challenge, with parallels with what the Thatcher government inherited in 1979.

Elsewhere we wait for the BoJ meeting at the end of the month for a policy shift. Higher moves in US yields are making a BoJ policy error look even more stark, and clear action will be required to avert a further leg weaker in the value of the yen. Should the policy change we anticipate occur, then we continue to think that the yen should rally on the basis that it is a very undervalued currency.

Similarly, the dollar is at levels of particular over-valuation. We sense this is becoming an impediment to further dollar strength, and it has been interesting that the dollar has failed to make additional gains in the past 1-2 weeks, notwithstanding strong US economic news.

Looking ahead

We can’t help shaking the thought that if yields continue to rise, so we will soon reach a breaking point where a bigger equity market correction needs to take place. However, many investors have been bearish on stocks all year and have largely been proved wrong.

The S&P is broadly at the same level as it was in February 2022, when the Fed started to hike rates from 0%. If 4,000 on the index has been sustained with 4% Treasury yields, some will question whether we can see 5,000 at 5% or even 6,000 at 6%! Logic would suggest otherwise, but market valuations can often appear to defy logic (at least up until the very moment that they do not).

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. The conflict in the Middle East only adds to this and although we have been relieved that we have not witnessed a broadening of hostilities at this point, a growing concern we would express is that an Israeli war on Hamas and affiliated groups could easily become a drawn out affair.

Sadly, the only predictable outcome will be further suffering on the part of countless innocents, which may only add to the well of hate which exists between the two sides. 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.

There is certainly plenty to ponder, but if we are drawn to a conclusion, it continues to be one of safety first. There is a saying that it is often better to be safe rather than sorry. We want to take 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. That said, we hope that the only sixes we will see in the near term will come from Ben Stokes and colleagues at the cricket World Cup!