A busy week of central bank meetings saw yields fall slightly in the US and Europe, but rose in Japan, given the different nature of the monetary policy stance in the context of the current session.
In the United States, economic data is more mixed. The JOLTS survey continues to indicate that the labor market is healthy, while the weaker ISM reading of 46.7 suggests that demand is slowing in many sectors, which seems supported by some anecdotal evidence coming to us from companies.
However, we believe it is too early to predict a fundamental weakness in economic activity. After a quarter of very strong economic growth in the third quarter and with core inflation remaining at around 4%, it is not surprising that the Fed has maintained a restrictive stance, and in some ways, that has just been the tightening of financial conditions recently (and thanks for that). to the increase in long-term bond yields) to reinforce the conclusion not to proceed with further increases at this week’s meeting.
Looking ahead, we are likely to see weaker economic data and as a result we believe we may have reached a peak in Fed rates, however, the restrictive stance remains in place and we still believe it is too early to consider easing policy before the second half of 2024. In light of this view of the United States, we currently continue to view negotiations on US interest rates from a tactical rather than structural perspective.
In Europe, economic data seems to indicate a more pronounced decline. Business sentiment data continues to decline, and this week in Germany highlighted notable weakness in retail sales and rising unemployment rates. We do not believe that the ECB will continue to increase interest rates, but as with the Fed, we believe that a rate cut is still a long way off. It will take some time for inflation to fall to levels that would prompt the ECB to change its stance.
However, we also note that the pace of balance sheet contraction in the euro area is faster than in the United States. In this context, the European Central Bank’s balance sheet has already fallen from €8.7 trillion to €7 trillion, and is expected to decline to €6 trillion next year. In light of this, we believe that it will not be necessary to terminate EPP reinvestments before December 2024, and that it may indeed be appropriate to extend them beyond that date.
UK data is also falling, so it was no surprise that the Bank of England left interest rates unchanged at this week’s meeting. Although inflation is higher than in other major economies, the Bank of England continues to show its dovish bias. Over the next couple of months, we may see base effects that will cause inflation to decline and economic activity to likely decline further.
In our view, any move to cut interest rates in the UK may be premature. We fear that inflation will rise early next year and that the Bank of England will eventually have to raise interest rates again in 2024 to lower them. The need for further rate hikes could also be exacerbated if the UK government announces further tax cuts in the next budget.
The UK’s finances are in a dire state, and the Conservative government finds itself in a rather desperate position. In essence, we continue to highlight that the risk of stagflation is a clear and present risk in the UK, and we maintain a bearish view on both UK government bonds and sterling over the medium term.
But in Japan, the economic prospects are completely different. Economic activity is supported by stimulative monetary and fiscal policy. Meanwhile, inflation continues to exceed expectations, sending policymakers scrambling to revise expectations upward.
In light of this, it appears that the Bank of Japan made a policy error by maintaining too accommodative policy for too long. Ueda and his colleagues also appear to have ignored the fact that real interest rates were more negative in 2023 and that attempts to limit yields led to an expansion of asset purchases, which continued to swell the balance sheet. As a result, there was pressure on the market for higher returns, which continued until last week, despite lower returns elsewhere.
At the monetary policy meeting, the Bank of Japan effectively eased its commitment to yield curve control, removing the interest rate range and signaling that it would act to buy bonds on a more discretionary basis if yields exceed 1%. We believe this is another step towards the normalization of monetary policy and we now expect the (negative interest rate policy) to be scrapped at the Bank of Japan meeting in December or January.
We still expect 10-year yields to rise, targeting 1.2% by the end of 2023 and more than 1.5% in 2024. Further fiscal easing exposes Japan to the risk of a further downgrade in creditworthiness and the risk premium on longer-dated bonds appears justified.
Ultimately, if inflation remains steady around 2%, long-term yields should be in line with this level, although it should be noted that this could lead to significant balance sheet losses on the part of the central bank.
Meanwhile, the gradual and somewhat timid approach to policy normalization has been disappointing in markets, with the Bank of Japan widely seen as lagging expectations. This continues to weaken the yen and we note that bets against the Japanese currency have continued to grow in recent weeks. The threat of intervention by the Ministry of Finance is a factor limiting significant vulnerability towards 160, and in our view, the yen remains an undervalued currency from a medium-term perspective.
We are now at a point where we believe that the Japanese authorities will have to back up their words with action if they want to reverse the weak yen. But if the Bank of Japan’s policy continues to lack credibility, one might wonder whether this is even possible.
Treasury yields and geopolitical risks
Risk assets performed better on the back of lower Treasury yields last week. At the same time, there is a sense that the conflict in Gaza/Israel is currently limited. Speaking to people in the region, there is a sense that Hamas has few friends, and so the risk of the conflict widening seems to be diminishing, despite pro-Palestinian protests and a sense of anger at the loss of civilian lives. Oil prices remain stable, and Iran seems to have realized that it would be unwise to be drawn into a direct conflict against US power.
However, we believe geopolitical risks will remain elevated for an extended period. Military spending will continue to grow significantly, putting pressure on public budgets. At the same time, the risk of terrorist attacks in Western capitals has certainly increased, in an already devastated and suffering world.
Last week we saw some discouraging Chinese data, and we still believe this will weaken the value of the RMB. Meanwhile, in corporate credit, credit default swaps (CDS) indices fell as concerns about the Middle East subsided and stocks rose.
We reduced our CDS hedges last week after spreads widened, but if indices compress significantly in the near term, we will be tempted to return these positions, as we do not want to take on too much directional risk in a more uncertain investment environment.
Looking to the future
It is interesting to note that – in the past two months – the number of interest rate cuts decided by global central banks has exceeded the number of increases for the first time in the past two years. There is a sense that we are at a turning point in the cycle, although we believe it would be a mistake to jump to the conclusion that interest rates or yields will return to levels that have been considered “normal” over the past decade.
We are skeptical that G3 central banks will cut interest rates for at least another nine months, and at the same time, we could see some concern about the scale of government debt issuance. It is not at all clear to us that policymakers feel any urgency to impose fiscal controls, and one can imagine a future in which significant bond market disruption becomes necessary to curb excessive spending.
We saw this last year in the UK, which remains the country most vulnerable in developed markets to a repeat of this eventuality. However, it is by no means the only country whose future path may be dominated by concerns about excessive debt levels.
In fact, debt concerns have been one of the factors driving the price of gold in recent weeks. It was also interesting to see the increase in gold demand in the context of central bank reserves, following the “militarization” of the US dollar with the US freezing of Russian deposits last year.
It is also true that the declining appeal of cryptocurrencies as an asset class capable of functioning as digital gold has helped reignite interest in gold. Recently, the price of Bitcoin has risen in the wake of the conflict in the Middle East.
However, we expect that growing interest in the role of cryptocurrencies in terrorist financing will drive increased regulatory initiatives in the coming weeks and months. As we have learned, there are many elements in the world of cryptocurrencies where illusion is completely different from reality. This narrative also appears to extend to Sam Bankman Fried’s drawings presented in court this week.
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