Little to prompt early policy changes

And a government making things up as it goes along.

Yields were not much changed in the wake of this week’s eagerly anticipated US CPI release. US headline inflation rose to 3.4% in December, with core price registering a 3.9% gain, which was 0.1% above consensus expectations.

Back in November, a 0.1% miss to the downside on core CPI saw yields post a material rally, as investors grew excited that this would feed into early Fed easing. The fact that a miss to the upside has seen a much more muted response suggests that the market is quite wedded to a bullish view into the year ahead.

With positioning surveys also showing many investors starting the year overweight in duration, this could suggest some scope for disappointment.

We continue to maintain a short duration bias, though we have seen the risk/reward in running a short position as more attractive in UK gilts and JGBs than in Treasuries. However, unless there is a more major revision to the macro backdrop, it is understandable that should yields back up a bit further, and then there will be others who may have missed the year-end rally and will be happy to step in and buy the dip.

From this point of view, we think it may make sense to flatten out duration beta, should 10-year Treasuries rise beyond 4.25%. However, we would also note that maintaining a short stance remains a positive carry position, given the inverted shape of yield curves, and consequently we can afford to be a bit patient.

Eurozone rate cut expectations were tempered by robust labour market data during the course of the past week. Unemployment in the bloc declined to 6.4% during the past month, which marked an all-time low in unemployment since the creation of the single currency. Although the Eurozone economy continues to bump along, with growth hovering around 0%, the labour market has been tight.

For now, this shows little sign of weakening, as shown in Germany’s unemployment levels, which would be as low as 2.9% of the working population, based on a comparable measurement basis as used for US data. A tight labour market highlights ongoing risks to wage inflation and, in this context, Isabel Schnabel made comments suggesting that the ECB only sees a modest decline in wages as likely in 2024.

These comments were taken in a relatively hawkish light in comparison to her comments prior to Christmas, which had been quick to emphasise the progress in bringing inflation down during the fourth quarter last year. Consequently, enthusiasm for a rate cut in March has cooled, with bunds underperforming relative to Treasuries.

Sovereign spreads in the Eurozone have been supported by strong demand for new issuance over the course of the past week. This was exemplified by the book size in deals from Spain and Italy, which totalled EUR130 billion and EUR164 billion respectively, on massive over-subscription.

To give context, Spain’s whole year issuance needs are currently projected at EUR170 billion and just EUR50 billion on a net basis. In the wake of yields declining across Europe, this has helped to mitigate concerns related to fiscal debt sustainability and has helped to tighten spreads.

2024 is a relatively quiet year for politics in the Eurozone, in contrast to the rest of the world. Moreover, with a number of countries in Southern Europe outperforming their neighbours to the north, so this is also helping to compress spreads in the bloc.

We are constructive on credit quality in Spain and believe that Spain can trade closer to the ‘semi-core’ countries, including France, Belgium and Austria. We also see value in Greece on the basis that with GGBs re-entering bond indices this month, so there will be a powerful technical causing passive funds to need to buy bonds, prompting spreads to narrow further.

Indeed, if Greece can be patient on the timing of its own planned issuance, it may well find that it will be able to issue at even more compressed spreads than currently prevail, and it appears that 10-year Greece may soon trade at a premium of less than 100bps versus German bunds.

The past week has also seen a renewed compression in credit spreads, after a somewhat messy first week of the year. At the start of the month, it almost felt like there was a race amongst issuers to be the first to market with their new issues. However, practically speaking, it was notable that many investors – especially in jurisdictions such as France – were slow to return to their desks last week.

Consequently, spreads initially widened but have recouped these losses over the past few days as capital is put to work. We have noted on several occasions that the technical backdrop in IG credit looks supportive over the year ahead. Net negative supply in the coming 12 months in the US and Eurozone is a strong positive market technical which can push spreads tighter.

Although slowing growth may lead to some slippage in fundamentals for a number of issuers, unless the economy slips from a soft landing towards a hard landing, it won’t be too surprising if technicals don’t continue to dominate fundamentals.

Yet, this can create a backdrop of complacency, something we also see in a risk indicator such as VIX, at a level <13.0. In this context, it may be that we see periods of benign quiet in credit spreads where valuations richen, punctuated by shorter bouts of volatility when fear out-runs greed, pushing volatility and spreads higher.

From this point of view, we favour retaining a core long position in credit and selling gradually into spread tightening, whilst being prepared to lift hedges and take beta exposure as spreads widen.

There was little new news in Japan over the past week, though probabilities for a January policy change continued to slip, on the narrative that policymakers will want to wait for more time after the recent Noto earthquake before enacting a policy change. Pushing plans for normalisation to April has weighed on the yen and dragged JGB yields lower.

However, incoming news on Spring wage discussions continues to be upbeat and, given the very depressed level of yields and also the yen, we think it makes sense to invest on more of a medium-term horizon and be patient in waiting for policy change to ensue.

Meanwhile in China, the economic outlook remains much more depressed and colleagues visiting Beijing over the past week have returned with a very sober assessment. We think that China is likely to underperform for a number of years, in the wake of the collapse in property prices. Relying on exports and cutting prices is unlikely to work as a strategy, as we would note growing enthusiasm for enacting trade tariffs on Chinese imports in a number of countries, including the Eurozone in the case of Chinese electric vehicles.

Looking ahead

We continue to retain a somewhat cautious view from a macro perspective, on the basis that markets seems to be relatively complacent in fully discounting a soft landing. On this basis, we are inclined to book gains and add hedges where spreads rally. Now that labour market and CPI data is behind us, we are moving into the quieter part of the month from a data perspective, with limited new information prior to the next FOMC meeting at the very end of January.

As things stand, we would note that the FOMC retains a tightening bias with respect to rates and although further hikes remain unlikely, we are not convinced that the Fed will want to remove this possibility from the table entirely at this juncture.

Consequently, if a tightening bias is retained, then this will infer a need for material data surprises in the following six-week period for the Fed to even begin a conversation around lowering rates in March. From that point of view, we would expect that a first step in this direction will be the removal of a tightening bias in the first place.

Some commentators have argued that if inflation data for the latest three months or last six months is analysed and annualised, then inflation is already back at levels consistent with the FOMC target. However, we do not believe that the Fed would ever base its own assessments on such short-term measures. Others have suggested that political motivations may spur the Fed to act to support the economy into the election and thus help Biden’s cause.

However, the FOMC has always been keen to maintain its independence and so this would also seem to be a very risky approach to take. Moreover, with unemployment near record lows, the economy growing around its trend rate, the stock market close to all-time highs and credit spreads relatively compressed, it is not clear why the Fed needs to be in a hurry to ease policy just yet.

Inflation remains considerably above the Fed’s target, and it would seem to make a lot of sense for Powell to be patient and bide his time. Arguably, it is not the economy which is the issue, which explains the fact that Trump remains well ahead in the polls.

Meanwhile, in a year when we are watchful of populist political trends, it has been interesting to watch how UK court decisions are set to be overturned by the government in the wake of a public outcry over a TV dramatisation. It is true that the events of ‘Mr Bates vs The Post Office’ cover a widespread miscarriage of justice and it is pleasing to think that past wrongs are being corrected – even if it beggars belief that this process has taken half as long as it has.

However, it is constitutionally interesting that the government has felt the need to act in the wake of a media fallout, eschewing established best legal practice in the process. This creates a precedent, and it will be interesting to see whether other causes in future benefit from greater coverage in the public eye.

In a sense, it could be argued that the Conservative government has been making things up as it goes along, though at least on this occasion it is hard to find anyone who won’t say the right conclusion has eventually been reached in the end. Yet, reflecting on the sheer institutional incompetence and the lack of readiness to take any accountability, this does leave you feeling that there is plenty to go postal about…