Time for a change in tune

….or maybe Shake It Off?

The sell-off in global yields continued during the past week, taking 30-year Treasury yields to 5%, up more than 100bps since the end of June. The extent of this re-pricing is being felt by other long duration assets, with stocks and credit under pressure. In part, risk assets need to deal with materially higher discount rates for future cashflows.

In addition, these moves raise renewed fears around recession risk in 2024. Thus far, price action in risk assets has been relatively orderly, suggesting some investors continue to put cash to work, seeking to buy the dip.

However, given that consensus positioning in rates and in risk assets has been long and wrong since the end of the summer, we may be close to a point of capitulation, which would see a more rapid dislocation in price action.

In this context, a further move up in rates could end up becoming self-correcting. From this point of view, we think that the move up in yields may have gone far enough for the time being and we might expect a period of consolidation.

With 5-year, 5-year forward US treasury rates now at 4.8%, there is now some value to be found in longer dated bonds, even if cash rates normalise at levels materially higher than the 2.5% estimate of R* (the real neutral rate), which we have thought is too low a projection.

Although a path to lower interest rates will be needed for a more structurally bullish view on US rates, we could see 10-year yields heading back towards 4.5%, should growth worries start to build.

For now, economic activity remains relatively upbeat, as suggested by business sentiment surveys and a rebound in the number of job openings, in the wake of weaker data last month. Anecdotal discussions in the US this week have also highlighted a shortage of housing inventory (in the Connecticut area) and shortage of new autos for sale (in Minnesota).

It is interesting that such discussions remain much more prevalent than worries related to rising credit card bills or fears of economic slowing. However, sentiment can quickly shift, as we saw in March of this year.

Meanwhile, we think that it would be wrong to conclude that monetary tightening is not having an effect. Rather this effect continues to be delayed, but it will come nonetheless.

Meanwhile, incoming news on inflation could move to the upside on recent higher oil prices, though we have been a bit more encouraged that inflation in core goods and services could be slowing a little further.

At least with the US Federal shutdown averted, we will have economic data to analyse this month. Over time, we continue to think that evidence of slowing economic activity will become more apparent. We just need to be a bit patient in this regard.

We have highlighted concerns around private credit as rates rise. In this context, we see companies in this space offering 12% yields, yet these are entities which are 6-7 times levered, on interest cover multiples of 2 or less. IPO pipelines continue to be barren, meaning there is no obvious ‘out’ for private asset owners and we see stress continuing to build, as rates continue to rise.

By contrast, leverage is much lower in high yield bonds. Elsewhere, we saw how quickly sentiment could sour in the wake of the SVB collapse earlier this year. Although regional banks now have much stronger liquidity positions, it is still the case that as volatility builds, so this will stress the weak links in the system.

Ultimately, it strikes us that many investors bought into a soft landing scenario during the course of the summer. However, such an outcome may always be difficult to expedite. An analysis of past cycles continues to suggest that a recession is a more likely scenario, and we think that the way which policy works is non-linear, insomuch that further rate increases from current levels risk having a much larger impact than earlier in the hiking cycle.

This analysis suggests to us that a stabilisation in rates is likely to occur before a stabilisation in risk assets takes place. From this point of view, we still think it is premature to remove credit hedges, notwithstanding recent spread weakness.

First, we think it makes sense to slowly increase duration as yields continue to rise, with a view to capturing a retracement to lower levels. Turning more constructive on risk assets probably needs to wait for a more significant moment of capitulation and elevated volatility.

Similarly, the trends driving US yields have continued to drive the US dollar stronger. We think we remain in a strong dollar regime for now, until rates turn. Consequently, flattening a bias on the dollar can probably wait for the time being.

Meanwhile, a number of currencies are breaking through technically important levels, which could lead to an acceleration in price action. In the case of Japan, this has prompted speculation around BoJ intervention. Indeed, the BoJ continues to be under some pressure to rethink its policy stance, if it is not to undermine the country’s currency even further.

European yields have followed moves in Treasuries, albeit with a lower beta. At the same time, yield curves have been steepening, on the basis that central banks are about done on rate hikes. On a relative basis, we continue to think that gilts could be vulnerable to weaker demand, and we remain sceptical that UK inflation will manage to decline below US inflation any time soon.

Elsewhere, EM assets continue to be vulnerable to higher US yields and a strong dollar, but again, it is important to differentiate within the asset class. In this sense, we look at some assets, such as Mexico rates, having overshot to cheap levels. Elsewhere, other stressed sovereigns may continue to be exposed to further pressure on the back of these global macro trends.

Looking ahead

Today’s payrolls data will be watched carefully, as always. At this point in time, strong data is bad news for both rates and risk assets. However, a softer print could see some stabilisation and retracement of recent moves into the end of the week.

Assessing and identifying turning points in markets can always be tricky. Our sense that rates could be reaching such a point is reinforced by the fact that the pain from higher rates is now spreading. Investor discomfort has been increasing and stress is building.

A continuation of recent trends seems likely to bring us to a moment of capitulation, when volatility could spike. Consequently, having adopted a more bearish view on rates up to this point, we think that extending duration has merit on a risk/reward basis.

That said, we would still hold this view as more of a tactical than a structural consideration. A structurally bullish trade needs a more significant slowing in growth and inflation, portending to a change in the macro environment. This remains a way off for the time being.

Yet, for now, it seems like we may be getting as bored watching yields move higher as we have become bored seeing pictures of Taylor Swift and everything she is up to. Enough already….it may be time for a different tune – at least for a little while.