Smoke and mirrors

Nov 24, 2023

A combination of higher volatility and lower seasonal liquidity….

Key points

  • In the US, CPI data was announced as having been below expectations across the board, however, inflation remains at a level which is double the Fed's target.
  • We think that a December hike remains unlikely and that moderation in economic data probably ensures that rates have now reached their peak.
  • In Europe, market moves have continued to track developments in the US, while German budget woes were in the headlines.
  • In our judgement, the Japanese economy is evolving on a positive trajectory and this is set to continue in 2024.
  • Risk assets have had a strong month and valuations seem slightly rich. We are more inclined to book gains on assets which may have rallied too far in the short term.


The recent rally in global bond yields showed signs of running out of steam over the course of the past week. FOMC minutes from the October meeting continue to affirm a tightening bias from the Fed and it is questionable whether much has changed to alter its assessment of the economy in the weeks since.

The latest inflation print came in marginally lower last week and there have been a few indicators suggesting some slowing in the pace of growth. However, in the central bank’s eyes, these will have been more than offset by the easing in financial conditions since the Fed last met.

We think that a December hike remains unlikely and that some further moderation in economic data, in the coming months, probably ensures that rates have now reached their peak. However, we remain a long way from a situation where any easing in policy will begin to be discussed.

From that point of view, where markets push to price earlier rate cuts, then there may be scope for disappointment, as we have already seen on several occasions over the past year.

In a sense, market participants have seemed overly eager to jump on a bullish trend in rates, when this is not supported by underlying fundamentals. For all the excitement over the last CPI report, core inflation remains at a level which is double the Fed's target. We doubt rates will fall before this rate drops below 3% and this still seems unlikely before the second half of next year.

Meanwhile, some commentators were suggesting that a soft print in last week's jobless claims figures were suggestive of labour market weakness. Yet this narrative has quickly been debunked, in the wake of a notably strong outcome in the same series this week.

Meanwhile, with the US celebrating Thanksgiving holidays, we will be very interested in retailer reporting in the week ahead, following on from Black Friday and Cyber Monday. Data in the last couple of years has shown some consumer weariness with respect to these retail events. Nonetheless there may be important clues to consumer behaviour in the figures we see, and from that point of view, this information may set the tone for markets as we head into December.

In Europe, market moves have continued to track developments in the US. Meanwhile, on the political front, there has been a good deal of interest around Germany's fiscal plans following a negative ruling from the country's Constitutional Court. This body announced that the Federal Government's reallocation of EUR60 billion in unused Covid financing, to support the country's green transition is unconstitutional.

The ruling also has implications for other spending plans, which have been moved off the main government balance sheet, and have similarly been excluded from debt metrics and requirements which are enshrined to ensure that Berlin delivers a balanced budget across the cycle. Since a two-thirds majority in the Bundestag would be needed to change these 'Black Zero' commitments and this appears politically unobtainable, so this ruling is seen as posing quite a headache for the Schloz administration.

One wonders how much of a sense of Schadenfreude exists in capitals across southern Europe at Germany’s budget woes right now. Certainly in Rome, it might appear that the stock of Georgia Meloni continues to rise, with the Italian premier becoming an increasingly influential and respected voice in the Eurozone.

Indeed, if there is a political risk in Europe at the moment, it could be that this very fact is not lost on French voters. It is possible to extrapolate a narrative as to how a populist right wing female leader is outperforming her sceptics, suggesting that Marine Le Pen could be a more acceptable choice than had previously looked possible.

Meanwhile, in the UK, the government announced its Autumn Budget, with some think tanks describing measures as comprising the biggest cut in tax on work since the 1980s. However, Chancellor Hunt emphasised that these would be paid for by a reduction in government spending through 2027/8, with much of this burden clearly timed to fall well beyond the date of the election due next year.

This math may be enough to satisfy accountants at the OBR, but it remains to be seen whether financial markets will be as generous in their assessments over the coming weeks. Meanwhile, for all of the self-congratulation for cutting inflation in the UK from 10% to 5%, it appears that bringing price growth back to the central bank’s 2% target is seeming pretty overlooked as a priority.

Our meetings with policymakers in Japan this week reaffirmed our sense that the Japanese economy is evolving on a positive trajectory and this is set to continue in 2024. Core inflation remains at 4% and we highlight scope for price pressures to continue to become more broad-based. The BoJ chooses to look more at domestic inflation and there has been a sense that Ueda still wants to take his time in normalising policy.

However, a preoccupation with downside risks is now switching to increased focus on possible upside risks. Once the perceived balance of risks tilts, it is suggested that a risk-averse BoJ could switch its thinking quite quickly. Certainly, there is a sense in which Ueda does not want to be seen to be characterised as a dove.

Politically, a change in prime minister is looking increasingly likely, with Kishida under pressure following poor approval ratings. There is a sense from some we meet that a more dynamic, positive and enthusiastic candidate should take the reins.

Indeed, in several meetings, policymakers bemoaned the generally pessimistic narrative around the economy in the Japanese media, and they actively encouraged us and others to do more to talk the economy up and help change this mindset.

We have highlighted scope for an end to Negative Interest Rate Policy (NIRP) in January, following a fourth consecutive upward revision to BoJ inflation forecasts at its quarterly meeting. Indeed, it was gratifying to be acknowledged for our own inflation forecasting, which seems to have picked up trends better than the central bank’s model.

Following the end of NIRP, we look for a scrapping of YCC by April and interest rate hikes in each of June, September and December next year, lifting cash rates to 0.75% by the end of the year. Although policymakers pushed back on the extent of rate hikes and our timing, it was apparent from discussions that this direction of travel is now clearly the baseline view.

Ongoing policy normalisation should see JGB yields trend higher over time. In the short run, Japanese yields have fallen, with macro investors stopping out consensus positions after losing money on US curve steepening bets. However, we expect 10-year JGBs to return to 1% by the end of this year and head to 1.5% in the year ahead, making this a structural trade we maintain with a degree of medium-term conviction.

Elsewhere globally, Milei's election in Argentina promises some radical change in the country. There remains substantial uncertainty over some of the President's plans, though a strong margin of victory may give a mandate for more decisive action which the country sorely needs.

Elsewhere, right wing populists have also done well in the Dutch election, with Gert Wilder’s Freedom party topping the polls. Very broadly speaking, it may be tempting to highlight a bit of a theme rejecting 'woke' and liberal policies from the ruling elites in a number of developed countries, and as economic challenges build, it will be important to monitor whether populist sentiments continue to grow in the months ahead.

Looking ahead

We are rapidly reaching the point where the year-end will be suddenly upon us. Sometimes we can see positive trends build in the run up to Christmas, though this year we remain more circumspect. Risk assets have had a strong month and valuations now seem slightly rich. From this point of view, we are more inclined to book gains on assets which may have rallied too far in the short term.

There also remains plenty of macro uncertainty into the year end and this is a driver of volatility. We are often asked when the pattern of daily volatility in Treasury yields will moderate. It strikes us that it is sometimes coming from those whose career experience has been formed in the markets post 2010, when central banks did much to control yields and dampen volatility.

For those of us with longer memories, we will recall current market conditions as not dissimilar to the 90s and we think this may continue to be the case as we look ahead. Nevertheless, the combination of higher volatility meeting lower seasonal liquidity will have the capacity to catch some unsuspecting investors out.

From that point of view, December could prove to be a more interesting month in markets than has typically been the case, so we would caution any premature celebration….

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