November binge may make for a leaner December

A Christmas feast.…or famine?

As we enter the last month of 2023, so investors can reflect on a bumper November, in which the 9% return from the S&P 500 Index represented the seventh best single month of returns in the past 100 years. Similarly, fixed income benchmark returns were the highest seen for any month over the past 15 years, and so it seems worth reflecting whether this year’s festive cheer has arrived just a bit too early?

In reviewing recent price action, it strikes us that not very much has changed in underlying fundamentals that would warrant such extreme moves. For sure, markets had been depressed at the end of October, and at the time we thought that the prior sell-off in long-dated yields appeared overdone at that point. October’s FOMC struck a dovish note, with Powell reflecting on the tightening of financial conditions at the time.

However, in the rally across markets in the period since, this tightening of conditions has been fully reversed and, in this context, one might think this would see Powell push back against an overly dovish narrative at the upcoming December policy meeting.

Economic data over the month saw inflation a touch softer, yet we have noted that core CPI remains at a rate which is double the Fed’s target, at 4.0%. Consequently, it is likely to be some time before inflation reaches a level when a more dovish stance will be warranted.

Moreover, our understanding of the Fed policy reaction function is that the Committee would deem it acceptable to make an error by holding rates too high for too long, thus slowing growth. If this occurs, there is scope to course correct and lower rates from a starting point which is well above the Fed’s neutral assessment.

However, it is deemed unacceptable to become too dovish too early, should this see a renewed uptrend in price pressures. In this case, re-starting a policy tightening cycle would be seen to have much more damaging consequences. From that point of view, Jerome Powell does not want to have his legacy as being the modern-day Arthur Burns, the Fed Chair who allowed inflation to run away under his particular watch.

This analysis leads us to conclude that Fed rate cuts are only likely in the second half of 2024. As for the growth aspect of the equation, we would note that the Atlanta Fed Nowcast is running around trend growth at 2% in the current quarter. It is clear that data could surprise to the downside in the coming weeks, and this could lead to a revision in view.

However, if we fail to see much material weakness at this point, so we think that yields are priced for some disappointment ahead. We have already witnessed several occasions in the past year when markets have sought to discount rate cuts prematurely and investors and models have wanted to jump on a trend. Yet, with investor surveys indicating that consensus positioning is most definitely long duration at this point, so we see scope for yields to retrace, if these hopes are disappointed.

Furthermore, with liquidity dropping as we move through the coming month, it is not too difficult to imagine a scenario where yields could be back towards their recent highs again by the end of December.

In light of this thinking, we have switched to a tactical short duration bias, looking for 10-year yields to rise above 4.5% in the coming weeks. It is striking to us that just a few weeks ago we had adopted a long position at 4.85% targeting the same level, before booking gains. Should the recent rally extend down towards 4.0%, then we may be inclined to add to this position further.

However, if we do see confirmation of a softer economic trajectory or weaker inflation data, we would be more inclined to close risk and were we to add to duration, then we think this may be more attractive towards the front end of the yield curve, on a view that the curve will steepen once the time for rate cuts draws closer.

Better November inflation data in Germany and Spain have helped euro yields to rally over the past week. These yields have largely tracked Treasuries over the month, albeit with a somewhat lower beta, in line with lower absolute yields. The ECB had been sceptical that inflation would return to target too quickly and so incoming data will be welcome.

However, from this point forward, so the year-on-year base effects become less favourable than has been the case more recently. In that case, the trend towards lower inflation rates may now start to stall, with many prices linked to regulated changes in the Eurozone. This dynamic makes inflation stickier there than it is across the Atlantic.

Elsewhere in the bloc, Italy BTP spreads have outperformed of late, as yields have moved lower. With political trends benign for the time being, so fears relating to debt sustainability may be positively correlated to absolute yield levels. That said, with 10-year bunds now at 2.4% when euro cash is at 4%, it’s hard to feel too excited about bund valuations at this point in time, and so it’s hard to see yields much lower for the time being.

Gilt yields also rallied over the week, as has also been the case for JGBs. It seems that global investors have been closing out short duration positions on a more bullish global duration view, yet we would continue to emphasise that Japan is at a profoundly different point in the economic cycle, than is the case in the US or the Eurozone.

From this point of view, we continue to hold strong long-term conviction towards higher JGB yields. We also remain convinced that gilt yields should be higher than long-term Treasury yields, given that we are fully convinced that inflation remains at an elevated level in the UK, relative to the position in the US.

With markets moving in a risk-on fashion over the last month, so the dollar has slipped against all other currencies in recent weeks. Yet with the euro rate now around 1.10, we see little to drive this level much higher, noting that the US economy continues to outperform many of its global peers.

Indeed, we seem to have seen the dollar sell-off losing some momentum in the past few days, even as yields and equities have kept moving. From that point of view, we have been closing out a number of EM-related short dollar positions in Chile, Indonesia and China in the past couple of weeks. However, we have become more constructive on the Canadian dollar, on a view that this has lagged other peers in the recent FX moves.

Elsewhere, the yen has gained, with US yields dropping. However, we continue to think that a stronger trend in the Japanese policy will require the BoJ to adjust policy and we continue to look for inflation as a trigger for this. In that context, we will be watching Tokyo CPI data for November when it is released at the start of the coming week.

In the same way that we think that the recent move in Treasuries has run too far, we are also at levels where we may want to increase the level of hedges with respect to credit-related positions. Spreads have rallied a long way in a short time. CDX high yield, for example, stands at 400bps today from 525bps at the start of the month.

Even correcting for one default in the basket, which has been removed, this still means that spreads have rallied by 100bps in just four weeks. We now stand at valuations not seen since spring last year. From this point of view, markets have really moved to price out a hard landing, recession scenario – yet it is likely to be difficult to fully discount this possibility, against a relatively uncertain macro backdrop.

Truth be told we have seen how our ‘year ahead outlook’ became trash just two months into 2020, in the wake of Covid, and similarly in 2022 with the Ukraine war. In the same vein, we are struck by how difficult economic forecasters have found it to predict the trajectory of growth and inflation with any accuracy at all over the past couple of years.

Therefore, any medium view which seems to embody too much of a confident conclusion should certainly be questioned and challenged, in our eyes. Although a hard landing in the US currently looks unlikely, who knows how this will look by spring next year.

Consequently, we think it may be more sensible to try to make a closer-term assessment – in a sense seeking to assess whether this hard landing probability is likely to increase or decrease over the coming one or two months as, in a sense, this is what will drive upcoming movements in prices.

Looking ahead

With the advent countdown now underway, we still feel there is plenty to ponder in the next couple of weeks. With markets seeking to discount a turning point in the policy cycle, so we are at a point when economic data will be closely scrutinised.

Similarly, central bank comments will be analysed endlessly, looking for clues to substantiate positioning. With that said, we would observe that the market is now discounting a first Fed rate cut in May / June time and with the yield curve substantially inverted, the burden of proof now sits with the bond bulls.

From this point of view, we feel that markets are currently more vulnerable to disappointment if economic data remains relatively upbeat, or if Fed comments fail to deviate much from prior Fed meetings.

In this case, we wonder whether, just as shoppers return unwanted goods bought in an online spending binge over Thanksgiving, so we may see markets give back some of November’s impressive benchmark returns before the year is out. Certainly it feels like Christmas may have come a bit too early in our eyes….even if, in saying this, we would hate to come across as too much of a Christmas Grinch.