Braving the cold

Jan 19, 2024

…while the market direction becomes hazier for now.

Key points

  • US & European policymakers have pushed back on the narrative around imminent rate cuts.
  • Bonds markets have given back most of the sharp gains achieved at the end of 2023.
  • The macro economy continues to exhibit strength and the road to lower inflation is likely bumpy.
  • Unsurprisingly, geopolitical risk has ratcheted higher at the start of 2024.

Government bond yields moved higher over the past week, as key Federal Reserve (Fed) officials and European policymakers continued to push back on expectations for imminent rate cuts. US 10-year yields have retraced nearly all the moves lower since the last Fed meeting, and a March rate cut is now firmly in the balance.

Given the degree to which the market had front-run central bank actions, and with positioning surveys skewed to investors’ strong bias for owning duration, the scope for further disappointment over the coming weeks remains elevated.

It was a dovish speech by the Fed’s Waller late last November that kicked off the heightened speculation that a Fed pivot was coming, so pushback this week was important in moderating expectations. We have argued previously that with unemployment near record lows, 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.

Moreover, retail sales this week registered yet another hot number, boosting the latest Atlanta Fed GDP estimate for Q4 to 2.4%, above what many consider trend growth. Waller provided some much-needed clarity in that respect, stating that in a ‘soft-landing’ scenario, there is little reason to move as quickly or cut as rapidly as in the past.

On the inflation front, there remains considerable uncertainty, despite the recent improvement in the US. As we were reminded in other regions this week, the path to 2% inflation on a sustainable basis is not as straightforward as some might think. UK headline inflation moved from 3.9% to 4% on a year-on-year basis, the first uptick since February 2023, with the sticker services CPI also trending higher to 6.4%.

Ironically, price rises in alcohol and tobacco led the rise, on the back of policy decisions last year that were marketed as a ‘Brexit dividend’. In Canada, core inflation ticked up to 3.6%, well above where the Bank of Canada would take comfort. Given the potentially bumpy path ahead, it would seem prudent for Powell and the FOMC to be patient and bide their time.

Next week sees the ECB and Bank of Japan (BoJ) kick off their monetary policy meetings for the new year. Expectations are low for both in terms of policy shifts, but any changes in language and the path ahead will be scrutinised. We think the ECB will likely echo rhetoric from its speakers in Davos this week, giving the cold shoulder to early rate cuts, while trying to strike a more united front on key data going forward, such as wage growth.

In Japan, notwithstanding the impact of the recent earthquake, we think further BoJ normalisation in April remains on the cards, and we continue to think incoming news on Spring wage discussions remains upbeat. Given the very depressed level of yields and 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.

Corporate bonds have been in something of a holding pattern over the last week. Supply has dropped off from the heavy start to the year, as companies enter ‘blackout’, but a bit of rates and equity weakness is offsetting these supportive technicals for now.

Going forward, we think that the backdrop of inflows and light positioning, along with relatively low net supply, sets corporates up for a grind tighter in spreads. Therefore, we remain modestly constructive for now and happy to add cash corporate risk in attractive new issues, while adding index hedges on the other side to maintain a relatively modest long overall corporate risk position.

Unsurprisingly, geopolitical risk has ratcheted higher at the start of 2024. The ongoing attacks by the Houthi-led Yemen government on commercial shipping in the Red Sea has effectively closed the Suez Canal and resulted in a combined US/UK attack on key targets within Yemen.

Thus far, the impact of these events has been minimal, with the market taking it on trust that action from the Western Alliance will subdue attacks from Yemen and re-open the Suez Canal before there is a meaningful impact on global supply chains, which will ultimately feed through into higher prices.

A big year for elections globally began with the election result in Taiwan. On the one hand, the incumbent DPP party retained the executive branch but lost the legislature. Its mandate for independence seems to have lost some momentum in this election as it scored the lowest vote share in the last 20 years, after a 13%-point swing to the opposition who favoured a more friendly relation with mainland China. Overall, a relatively positive event for cross-strait peace and stability, for now.

Looking ahead

We remain cautious as uncertainty proliferates on many different levels, with geopolitical developments and upcoming central bank meetings likely to set the tone in the coming fortnight.

More tactically, we continue to maintain a short duration bias, though we have seen the risk/reward in running a short position as more attractive in the UK and Japan than in Treasuries. From this point of view, we continue to think 10-year US Treasuries look more symmetric around 4.25%, as a guide to move to a more neutral duration stance.

The first few weeks of the year have been difficult for those investors who had got ‘over their skis’ with the trends manifesting towards the end of 2023. Policymakers have reigned in expectations, while data continues to remain robust. It could be the case that investors may need to ‘brave the cold’ for a bit longer, as market direction becomes hazier for now.

In that respect, one should take heed from the dedication shown by Trump supporters in the Iowa primary, braving sub-zero temperatures, with the former president exclaiming ‘even if you pass away, it’s worth it’.

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