RBC BlueBay: Which economy has a lot of fizz left in it?

22 sep 2023

Many market participants have been investing on an assumption that rates would decline shortly after reaching a peak. However, with economic activity remaining relatively robust and the labour market tight, there is more of a sense that rates may plateau at or close to current levels for nine months or more, before inflation declines sufficiently, in order to allow the FOMC to endorse a more dovish stance.

Against the backdrop of an inverted yield curve, this is weighing on yields. At a time when many investors are already long and wrong in the duration trade, so the market could continue to trade relatively heavy for the time being, in the absence of a catalyst to drive yields lower.

Looking at the US labour market we continue to be struck by strength in weekly jobless claims data. Meanwhile, we would observe ongoing pressure on wages, notwithstanding a slowing of hiring activity. The auto workers strike by the UAW union is a further anecdotal example of this and although this strike may lead to weaker activity data for a period, this will be reversed if the dispute proves short-lived.

Generally speaking, we continue to believe that inflation may remain stuck between 3-4% for some time, until policy tightening takes more of a toll on the economy later next year. We also would question longer-term assumptions with respect to the natural interest rate, R*. For the time being, this is still seen around 2.5% by a majority of Fed participants. However, it is now coming under increased scrutiny.

In our assessment, the longer rates remain at elevated levels, the more estimates of R* could be revised higher. Arguably, we could easily make a case for inflationary pressures remaining elevated on an ongoing basis, such that the neutral level of interest rates is now closer to 3% or 3.5%. Were thinking to shift in this direction, this could be another factor weighing on sentiment for long duration assets.

Within Europe, the UK grabbed most attention over the past week. A downside surprise on monthly inflation saw the BoE hold rates at 5.25% this month. Base effects should also see further progress on inflation in the next couple of months and with the economy slowing, this gives weight to the view that the Bank is now on hold.

However, it should be noted that this month’s inflation data were influenced by some temporary effects. Moreover, core CPI in the UK remains above 6%, with wages growing at more than 8%, and on an accelerating trend. From this point of view, a renewed move up in inflation at the end of the year and in early 2024 cannot be ruled out.

In this regard, rising oil prices are a cause for concern. Our meetings in Riyadh last week suggested to us that the Saudis are happy with their level of control over OPEC and oil prices and are eager to sustain recent strength. Moreover, at a time when US economic strength continues to push the dollar stronger, this oil move is having an even larger inflation impact away from the US.

We were also interested by higher Canadian inflation data in the past week. Canada is an economy which looked to have a soft landing within its grasp just a few months ago. However, following a period when rates were on hold, a re-acceleration in inflation has required the Bank of Canada to start to raise rates once more.

We wonder if this experience may be repeated in other economies. In the UK, we hold a view that stagflation remains a real prospect. We believe that economic growth is likely to struggle, but that price growth could end up stuck between 4-5%, leaving the BoE in a difficult situation. Ultimately, we have been looking for the BoE to pursue a dovish path as its models look for soft growth to cool rising prices.

However, with inflation expectations having de-anchored to a degree already, we feel less confident in this trajectory and continue to look for the pound to take the strain, as policymakers seek to support growth.

Elsewhere in Europe, yields have tracked movements in the US, with bunds at new highs since 2011. Meanwhile credit spreads have pushed wider, as new highs in yields push risk assets weaker across the board.

Following heavy supply earlier in the month, investors may now be relatively full on credit risk, though to this point, market moves weaker remain orderly. Common wisdom has held that it made sense to own credit on a duration unhedged basis, on a view that if economic growth weakens and pushed spreads wider on recession fears, then this will see underlying government bond yields rally.

Yet, this stance does not allow for an outcome where inflation remains more problematic and yields need to rise further. In this context, we saw in 2022 how a stance long in duration and long in risk assets can deliver materially negative returns, should common wisdom start to unravel.

From this point of view, we would note that we are now at a point where returns on the US Aggregate Fixed Income Index have moved into negative territory for the first time this year.

In Japan, we have approached the BoJ meeting with pressure on Ueda continuing to build. Higher global yields and robust data continue to see global rates diverge relative to Japan, adding to the carry shortfall experienced in owning the yen.

Although we think the yen is a very undervalued currency, the BoJ have been undermining the currency by adhering to an overly dovish stance, which means they have been adding to monetary accommodation, by adding to bond purchases.

This is becoming untenable, and we also perceive that yen weakness is feeding into yet more underlying inflation pressure and creating the risk that the BoJ is slipping even further behind the curve.

Policymakers at the MoF have sought co-operation from US authorities in trying to stem the yen’s slide, but surely the answer lies much closer to home. Unless the global backdrop does not soften materially in the near term, we only see pressure on the BoJ growing and we also see the risk that Ueda will ultimately be forced into needing to tighten policy too aggressively, if the BoJ remains too complacent, for too long.

Looking ahead

We feel that we are reaching a decisive moment across markets. We think that higher yields could see a position capitulation on a break of 4.5% on US 10s, or 5.25% on 2-year maturities. Meanwhile, should recent downward moves in equities persist, then this could give way to a more broad-based break lower in risk assets, in general.

In this context, higher Treasury yields and wider credit spreads feel like the pain trades in markets and should a capitulation occur, then this could create interesting entry opportunities. Initially we may look to take advantage by closing credit CDS hedges, but for the time being we are happy to sit and wait to assess market developments a little while longer.

Elsewhere, we think that the relative valuation between long-dated gilts and US Treasuries has moved out of line, and we are inclined to look to sell gilts versus Treasuries on an RV basis, should the yield on the former move 20bps below the latter.

We remain convinced that inflation will remain stuck at higher levels in the UK than the US over the medium term, and this will require higher rates from the BoE than the Fed. The fiscal position of both the US and UK are in a poor state. Yet, in the US, a stronger growth dynamic and position as a reserve currency are both strong mitigants.

Meanwhile in the UK, we are seeing a country which is needing to come to terms with the reality that there is not enough money to spend on all of the agenda items, which governments or broader society would like to see addressed.

In a sense, there isn’t the money to simultaneously pay for a levelling up agenda, green initiatives, investment in infrastructure and a functioning health service and so choices will need to be made. In this sense, a roll-back of the green agenda can be sold as politically expedient.

Meanwhile, political calculus that a backlash from ‘Just Stop Oil’ may lead to public anger should this disrupt everyday life could actually be designed, as a hope that the Tories might find support by embracing more of an anti-woke and populist agenda….but then this feels rather like Sunak clutching at straws. 

Across the Atlantic, whilst some of the Trump agenda may find sympathy with some of these political sentiments, the underlying macroeconomic picture looks profoundly different. By comparison the US can be said to be facing champagne problems, when put in the context of those overseas. Certainly, the US economy seems to have plenty of fizz left in it for the time being.