RBC BlueBay: A hurting world

Oct 13, 2023

Last weekend’s atrocities in Israel cast a pall over financial markets over the past week, with investors digesting an escalation of geopolitical risk, which has global ramifications. Arguably, Hamas has knowingly sought to bring about its own destruction through its actions. This is based on a calculus that distressing scenes will lead to an escalation of hatred, which pulls in other participants to a broader conflict under a banner of Jihad. It is earnestly hoped that these twisted objectives fail spectacularly.

Certainly, our sense is that there is little appetite for war in Iran or the US. In the context of the wider Middle East, another way of assessing events in the recent days is in light of the recent rapprochement between Israel and Saudi Arabia, which may be seen to have weakened the Palestinian cause. 

Nevertheless, emotions are raw and events over the coming days will be unpredictable. What is clear is that Hamas is now ISIS in all but name, and so it is understandable that there can be no place for the organisation to survive nor thrive, on a forward-looking basis.

It is also clear that a time will come for peace talks and negotiation, once this objective has been fulfilled. Yet in the short term, the path will be towards military escalation. It is only to be hoped that a sense of humanity and proportionality can be preserved through what promises to be an ugly period of time.

These events have helped to push Treasury yields lower over the past week. However, in assessing price action to date, it is notable that movements in oil prices have been relatively contained and risk assets themselves have broadly stabilised after a dip at the start of the week.

In fact, a larger cause for a rally in US rates could be attributed to a subtle change in Fed rhetoric over recent days. Here there has been an inference that the recent rapid tightening in financial conditions has gone far enough for the time being and may obviate the need for additional rate hikes.

Comments from several Fed speakers have been construed in a somewhat more dovish light – but on an objective basis, we would question whether the Fed’s outlook or thinking with respect to the economy has changed very much in the past several weeks, and so this could be more a question of interpretation than anything else.

This week’s inflation data were broadly in line with market estimates. Core CPI remains above 4% and with the economic outlook remaining relatively constructive, we think that further progress towards the 2% target may come at a slow pace.

This all points to rates staying at elevated levels for an extended period and whilst a soft landing remains a possible outcome, we still see a mild recession later next year as a higher probability, relatively speaking.

With respect to the bond market, we have recently been struck that some managers, who had previously held long duration trades, had been implementing a view with respect to curve steepening, expecting longer-dated bonds to continue to underperform.

At the same time, hedge fund investors had been adding to short positions on long-dated rates. Therefore, price action over the past week, which has seen 10-year yields fall by 30bps since last Friday’s robust payrolls release, is seen as something of a pain trade.

During the past week, we articulated that we had switched to a long duration stance in US rates. This was in response to yields rising too far, in too short a time, without much necessarily changing in the macro landscape.

However, we have noted that this view is more tactical than structural in nature. Consequently, as yields have rallied, we have been booking gains on the back of these moves and may position flat in rates should we breach a target of 4.5% on 10-year notes.

As mentioned before, in order to have a more structurally bullish view on bonds, we think we will need to see more evidence of growth slowing and this creating a pathway towards lower rates. 

In the Eurozone, bunds have continued to broadly track moves in Treasuries. In the wake of supply, sovereign spreads have pushed wider in recent weeks, with the Italy BTP spread rising to a level in excess of 200bps. However, we don’t see a strong catalyst to drive price action in spreads much wider than this, and we are inclined to think we should remain in a range trading environment over the coming week.

We are also awaiting the upcoming sovereign review of the Greece credit rating by S&P on 20^th October. We anticipate an upgrade to BBB-, which will take Greece into sovereign bond indices. This could act as a catalyst for spread tightening, given that passive investors will need to buy Greece at this time and the free float of available Greek government bonds is relatively small.

Elsewhere, newsflow has also been relatively quiet in the UK. The Labour Party conference has portrayed a party ready to take power when UK elections are called next year. A change in government is broadly expected and we doubt that Starmer will undertake many radical policies, meaning that any impact on financial markets is relatively modest for now.

In FX markets, an inference of a somewhat less hawkish stance from the FOMC saw the dollar trade slightly softer over the past week. In many respects, it was surprising that the dollar failed to be lifted much by a flight to quality on geopolitical worries, and with the greenback also failing to gain in the wake of last week’s strong payrolls data, it may be tempting to think that the trend towards a stronger dollar has run its course for the time being.

Meanwhile, in Japan, all eyes are on the BoJ meeting at the end of this month and so there is a sense that we are in a period of quiet before the storm. We think that either the BoJ adjusts policy and the yen rallies, or it fails to take action and could weaken further. In that sense we are currently in something of an unstable equilibrium, though just over the past few days, investor focus has been elsewhere.

With respect to the Israeli shekel, this traded lower over the week as may be expected, in light of recent events. However, price action has been contained by central bank intervention. We have closed a long stance with respect to the shekel and do not favour taking directional risk at this time.

Elsewhere in EM, a turn in the dollar and US rates have provided some respite to some EM currencies which had recently been under pressure. Consequently, we have been closing a short position with respect to the Colombian peso and had also booked gains on Mexico peso shorts.

From a credit perspective, markets remain nervous, though have taken their lead from equities. Inasmuch as higher long-dated US yields had been putting pressure on stocks, so a reversal in price action in Treasuries has helped to benefit equities and credit spreads.

However, with volatility increasing against a backdrop of elevated macro and geopolitical uncertainty, we think it makes sense to proceed with caution and we have generally maintained CDS hedges, meaning that net beta exposure to spreads remains relatively modest.

Looking ahead

Events over the past week have injected additional uncertainty into an already opaque landscape. Broadly speaking, we remain content to maintain risk at modest levels and look to take opportunities to add or reduce exposure, if short-term price action appears to overshoot in either direction.

Generally speaking, it may be more difficult to generate returns from more tactical types of trading positions. However, we think that we can position on the right side of volatility and importantly, if we witness a large dislocation in markets, or the emergence of a more powerful structural theme, then we want to be well placed to take advantage of this.

We also think it could be wrong to be too complacent with respect to geopolitical risks at this juncture. At times in the past there have been moments of tension, which markets have been correct to fade, on an assumption that risks would remain contained.

Yet this narrative clearly was not the case when Russia invaded Ukraine last year, and the same may apply now with respect to the Middle East. The scale of civilian casualties in Israel and the depraved nature of these attacks by Hamas has drawn shock, horror and condemnation. The subsequent rage and fury felt within Israel in the wake of this is easy to understand.

However, one hopes that some restraint can be exercised, as the Israeli military executes its objective in hand. Across the West, governments have rallied to the Israeli cause, but footage of suffering in Gaza will provoke outrage elsewhere and it is not hard to imagine a group like Hezbollah feeling compelled to act.

Hopefully a broadening of conflict can be avoided and a humanitarian crisis can be contained. Yet, conflicts can follow an unpredictable path and it seems sensible to reserve judgment for the time being. In this sense, maybe it is best to keep our heads down and pray for peace in a world which is hurting on many fronts right now.