Curve balls

Nov 10, 2023

Or….not a good look.

Key points

  • In the US, concerns about over supply and peak rates have receded and the yield curve has flattened.
  • Moves in European markets continued to mirror those in the US, with the correlation between bund and Treasury yields remaining high.
  • The Bank of Japan continues to double down on relatively dovish messaging, while inflation pressures mount.
  • We continue to operate in an environment of macro uncertainty, and it feels that there is plenty still in play before 2023 is done.


Global yields moved lower through most of the past week, with yield curves flattening on moves led by longer-dated bonds. In the US, it has struck us that many investors have been positioned for a continued steepening of the curve, following a trend seen in September and October, which had seen the spread between 2-year and 10-year Treasuries narrow from 80bps to 15bps.

Conventional wisdom has held that with short-term rates peaking, so bullish trades are best expressed at the front end of the curve, on a hope that weaker data will see markets price further rate cuts in 2024 and 2025. Meanwhile, investors have shunned longer-dated maturities, on worries related to government finances and heavy issuance, which has seen a re-emergence of term premia for longer-dated assets.

However, the fact that Powell noted the rise in long-dated yields as a factor in tightening financial conditions at the recent FOMC meeting, coupled with lower-than-expected issuance of long maturities at the latest refunding round, has seen longer-dated bonds recoup some of the earlier losses, and this has pushed the curve in an opposing direction. 

Indeed, logic might suggest that with financial conditions indices having eased, this could be a factor raising the risk of a Fed hike in December, unless economic data continues to show signs of deceleration. This could suggest further pain for steepening trades in the coming days, with the 2-10 spread back to 45bps.

Nevertheless, with 10-year Treasuries reaching our target, we have booked gains on a long duration position, which we had held on a tactical basis. We would now be more inclined to revert to a short bias, should 10-year yields approach 4.35%, without our assessment of the economy changing very much.

With respect to economic data, the past week has been relatively light as we wait for the October CPI release next week. Our analysis suggests that there could be some upside risk to the core inflation print next Tuesday and this could lead to some angst that the decline in inflation returning to target is starting to flatten out, with the pace of price growth still materially above the 2% central bank target.

However, we would note that commodity prices have been slipping in the past week with oil back to USD75 per barrel. This could suggest better news on prices to come. Meanwhile, this week has seen China in deflation with prices contracting -0.2% year-on-year and elsewhere across Asia (with the exception of Japan), inflation has also returned to low levels seen prior to the pandemic.

With respect to the demand side of the economy, we would caution against those proclaiming that US growth is slowing too rapidly at the moment. For sure, we see growth coming well off the highs of the 4.9% expansion recorded in Q3 this year, though 150k payrolls growth still suggests a very healthy economy.

In that context, we would always caution against those armchair economists, who seem prone to fit a narrative to market price action. We expect economic activity to weaken during the course of the coming year as policy restraint crimps demand. However, it would be wrong, in our eyes, to prematurely suggest that the US economy has suddenly ground to a halt.

Moves in European markets continued to mirror those in the US, with the correlation between bund and Treasury yields remaining high on a day-to-day basis. The rally in Treasuries was also partly responsible for pushing JGB yields lower over the week.

However, here BoJ Governor Ueda continued to double down on relatively dovish messaging, pushing back against expectations for further policy changes at the next BoJ policy meeting. Many within the BoJ are very sceptical around the longevity of inflation and are also convinced that a recession in the US should be around the corner, thus limiting their need to act themselves.

However, we would note that the economic dynamic in Japan is very different to what is playing out elsewhere in the global economy. Japan core prices are growing at 4% and although this level may dip in Q4, we look for an acceleration to new highs in inflation in Japan in Q1 next year, as price increases show signs of becoming more broad based.

With Kishida’s popularity falling because of inflation, we have just witnessed further fiscal stimulus in a robust economy, which continues to run ultra-accommodative monetary policy.

Meanwhile BoJ policies continue to undermine the yen, which has moved to a new multi-year low on a trade-weighted basis during the past week. All of this continues to add to inflationary pressure and so there is a risk that the yen could slip further, with the BoJ seemingly behind the curve and in the absence of FX intervention from the Japanese Ministry of Finance thus far.

We continue to think that the BoJ is making a policy mistake and so maintain conviction with respect to higher Japanese yields.

Credit markets have seen a pick-up in issuance during the past week, with European financial issuers notably active. Notwithstanding a recovery in the tier-1 market since March, coco yields and spreads remain higher on the year, in contrast to corporate high yield bonds, whose yields and spreads have moved lower.

The shadow of the Credit Suisse debacle continues to hang over this market, but as this fades into the past, this can increasingly be seen as an isolated event, in a specific jurisdiction. In that context, the UBS tier-1 debt which was priced at 9.25% this week represents a material concession from where the bank has historically priced deals (maybe a Swiss ‘I am sorry’ premium was in order).

At this level, this deal attracted a record book of more than EUR30 billion in orders, for a 3 billion deal, with investors also encouraged at steps to change the language within the instrument to offer better investor protection on a go-forward basis.

We continue to maintain a bullish stance on euro financials and owning junior debt in strong financial institutions, with yields approaching double digits, appears relatively compelling to us in a credit market offering few other very interesting valuation opportunities.

Worries relating to a wider conflagration in the Middle East have continued to ease and this has seen risk premia start to recede. In this context, we have added exposure in Israel debt in euros at a spread of 250bps relative to bunds. Israel had traded at half this spread prior to the recent conflict.

Although the situation in Gaza remains upsetting and highly problematic, looking into the longer term, Israel remains an economy with low debt levels, and over the long term we should expect an end to hostilities and a path towards greater stability in the region, if Hamas is removed from the scene.

Looking ahead

In the coming week, US CPI is an obvious focus. Our own modelling highlights a risk of a 0.4% month-on-month number for October, which would push the annual rate higher. From this perspective, we have been keen to flatten out a long duration position, prior to this data release.

Nevertheless, trying to predict data is fraught with challenges and our actions also reflect the fact that we think that the recent rally in yields will become self-limiting. In part, long-dated Treasuries have done well, as the Fed expressed some concern at an overly-rapid tightening of financial conditions. But now that this move has reversed, there is a risk that Fed rhetoric could become a bit more hawkish once more, especially if core inflation continues to look somewhat problematic.

More generally, we continue to operate in an environment of macro uncertainty, and it does not seem that compelling to add to much directional risk. As credit spreads move tighter, we have been adding back to credit hedges, which we had taken off at wider levels. We are wary of turning too bullish on risk assets prematurely, chasing recent market moves, and we think that if the rally goes too far, there will be a set-up for disappointment.

Markets have had a habit of sniffing out pain trades this year and so we are also wary of adopting consensual views. The exception to this is Japan, but in this case we continue to believe that a structural move upwards in JGB yields should occur as a function of underlying fundamental drivers around inflation and the evolution of monetary policy.

It feels that there is plenty still in play before 2023 is done. That said, the year end is coming into view, and we suddenly seem to be surrounded by festive shoppers and advertisements. From that standpoint, a cautionary mis-step by an Australian meat retailer this week caught our attention.

Perhaps this highlights the perils of what can happen if you try to take ‘Christ’ out of Christmas when trying to market your product….or it could be a metaphor for how we are all living in a broken world, where it is all too easy to be mis-understood.

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