Head of Fixed Income Strategy
Summary: An environment with elevated inflation and low interest rates is not sustainable. Hence, long term yields need to soar to catch up with price pressures. Following last week's ugly 10 and 30-year US Treasury auctions, Wednesday's less popular 20-year bond sale could be a catalyst for more volatility in the long part of the yield curve. In the UK, we expect Gilts to remain volatile as tomorrow's jobs number might put a brake on interest rate hikes expectations for 2022. Yet, a rally could be short-lived as inflation numbers will be released on Wednesday. Chinese real estate junk bonds show signs of recovery as news suggest the government is working on measures to support developers to tap the debt market. Yet, the sector remains in bad shape amid a slump in property investments.
Interest rate hike expectations continue to be a focus as investors keep their eyes on inflation and economic growth. Although central banks on both sides of the Atlantic appear comfortable sticking to their average inflation-targeting frameworks, investors cannot ignore inflation soaring. The US core CPI hit a 30-year high in October. The spike in energy prices has now leaked to fertilizers, thus food. Households, which are now preparing for Thanksgiving and Christmas, cannot help but look horrified as inflation rates outpace wage growth. Hence, the reason why the Michigan consumer sentiment dropped to a 10-year low this month.
Inflation is now driven by supply-chain disruptions exacerbated by continuous accommodative monetary policies. Hence, investors expect central banks to respond with interest rate hikes to avoid the economy from overheating. As rate hikes expectations advance, yield curves bear flatten as a response.
However, something begins to worry credit markets: it’s becoming clear that an environment with elevated inflation and low interest rates is not sustainable. Many have highlighted that long-term rates remain stable because higher interest rates in the short term might be detrimental to growth in the medium to long term. According to that logic, the yield curve would flatten or even invert as the front part of the yield curve will continue to soar, but long-term yields would barely budge on the prospect that stimulus will shortly be needed for the economy to recover. This idea led many to conclude that the marry goes round continues. If 10-year yields, which are a benchmark for mortgage rates and credit spreads, remain stable, that means that long term borrowings will continue to be cheap.
Yet, last week’s 10-year and 30-year US Treasury auctions sent a troubling message: investors need higher yields across the whole yield curve as inflation keeps rising. A few days after seeing 10-year US yields dropping more than 15bps to 1.41%, yields rose back to 1.56% amid weak demand during the US Treasury auctions. The 20-year tenor is far less popular, suggesting that demand could be even lower than what we saw last week, with the potential to send shockwaves in the long part of the yield curve.
Tomorrow's retail sales will also be in the spotlight; however, they might play a minor role in moving yields.
During the latest Bank of England's meeting, the central bank indicated that it needs more information on the strength of the UK labour market before hiking rates. Wage subsidies ended in September; hence it's critical to see whether that caused unemployment to rise in October. A surprise on the upside in unemployment numbers might lead the market to push back on current rate hike expectations. Despite the recent Gilt rally, investors still expect the BOE to hike four times in 2022, double what is expected in the US. However, a rally might be short-lived as inflation is released on Wednesday and sales figures on Friday.
Overall, we expect Gilts to remain volatile for quite some time. Investors should focus on the Gilt yield curve, which is already inverted between 15 and 30 years. It's in the interest of the BOE to have a steeper yield curve before entering into an interest rate hike cycle to avoid an inversion. Concerning 10-year Gilt yields, they remain in an uptrend. A short-lived rally might see them testing resistance at 0.82%. Still, it's most likely to see them rising above 1% before December's BOE meeting.
The data released from China this morning might also drive sentiment in bonds worldwide this week. In October, consumer spending and Chinese factory activity surprised on the upside, pointing to a less severe economic slowdown than economists were anticipating. However, the slump in property investments and news related to continuous Covid outbreaks are clear signs that it will take longer for the economy to recover fully. Thus, monitoring development relating to the real estate sector crackdown continues to be crucial.
Last week, Chinese real estate junk bonds recovered the most since March 2020 as news spread about the possibility that the government may be working on measures to support developers to tap the debt market. Yet, the sector is not out of the woods, with more than 60% of junk real estate bonds still trading in distressed territory.
The virtual meeting between Joe Biden and Xi Jinping today will also be a focus as markets wonder whether there could be a resolution to the ongoing trading tension.
Monday, the 15th of November
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Wednesday, the 17th of November
Thursday, the 18th of November
Friday, the 19th of November
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
