Financial Update from Brewin Dolphin - 3 November 2023

November 2023

The Weekly Round-up

Friday 3 November 2023.

In her latest weekly round-up, Janet Mui, our Head of Market Analysis, discusses what the steep fall in bond yields tells us about the outlook for interest rates.

Bond vigilantes are throwing in the towel

It was only a short while ago that the bond vigilantes were back in full force, pushing US ten-year and 30-year yields briefly above 5% by selling bonds in protest against a worsening budget situation and amid above-target inflation. This week they are throwing in the towel. There was a change in fortune for bondholders this week as we got more convincing signals from central banks that their aggressive rate hikes are coming to an end. The outlier here is the Bank of Japan, which announced a further relaxation of its yield curve control policy.

Historically, bond yields tend to peak as central banks are at or near the last hike, so it is intuitive that government bond yields dropped globally and across maturity. Markets have already priced in very little chance of further rate rises, but the decline in yields gives more confidence on that assessment.

The drop in bond yields was further fuelled by the weaker-than-expected US nonfarm payroll report, released on Friday. The yield moves were striking. There has been about a 25-35 basis point decrease for the US Treasury and UK sovereign yields across different maturities since the Federal Reserve’s meeting on Wednesday. At the time of writing, the two-year US Treasury rate is well below 5%.

Global equities, in reaction to lower bond yields, staged a relief rally after the S&P 500 fell into correction territory (down more than 10% from its recent high). If higher interest rates and higher bond yields spooked the equity markets, understandably an unwinding of that is supportive to stocks (all else being equal).

At the same time, US economic data is still generally holding up. As the markets cheer lower bond yields, we are likely at a phase of ‘bad news is good news’, where softer US data is welcomed. That said, data can’t be too bad because then the recession narrative can creep back in. On that front, the latest US nonfarm payroll report is giving that ‘Goldilocks’ vibe and raises hopes that a soft landing is achievable.

In addition, oil prices remain relatively well behaved despite geopolitical tensions. Inflation is also heading in the right direction in the grand scheme of things. Notably, the eurozone consumer price index (CPI) slowed to just 2.9% in October and is down from over 9% at its peak. This will give comfort to the European Central Bank that its tightening campaign is working as intended.

The latest move up in US bond yields was driven by ‘term premium’, which is the extra compensation for bondholders to lend to the US government over a longer period. Concerns about a higher budget deficit and government debt tends to drive term premium higher. Aiding the development of lower bond yields is that the US Treasury has announced a lower-than-expected debt issuance in the fourth quarter because of lower funding needs. Particularly, there will be a slower pace of increases in the sale of longer-dated bonds.

Some investors were concerned that with Japanese government bond (JGB) yields moving higher, they could drive US bond yields higher too. That didn’t seem to happen this week even though the ten-year JGB moved closer to 1%. While the Bank of Japan is inclined to normalise its extremely accommodative policy, it is obviously proceeding with a lot of caution.

It is hard to say whether the bond vigilantes will be awakened again from hibernation, as the budget deficit and debt situation in major developed economies remain dire. All in all, if inflation and growth continue to slow and interest rates have peaked, bond yields may stabilise at these ‘high for long’ levels or drift lower instead of making big, sharp moves.

Higher bond yields did some of the Fed’s job

The Federal Reserve kept rates on hold for the second straight meeting, keeping the funds rate unchanged at the 5.25-5.50% range, as widely expected. There were no new economic projections at this meeting, so all eyes were on the press conference. Fed chair Jay Powell tried to sound more balanced, but gave the impression that the Fed has done a lot already.

The key point made by Powell was that the recent surge in long-term US bond yields has done some of the Fed’s job for it. The financial conditions index (comprising things like bond yields, corporate spread, US dollar, equity market, etc) was at its tightest level in a year before the Feds’ meeting. Powell said the Fed has come far in terms of its tightening campaign and reminded us that it takes time for higher interest rates to impact the real economy.

Despite the resilience in the economy, particularly shown by the 4.9% quarter-on-quarter annualised GDP growth in the most recent quarter, not all economic data is strong. Surveys such as the Institute of Supply Management’s (ISM) manufacturing indices suggest the cyclical part of the economy is in contraction already. Consumers are arguably in good shape, but there are indications that the labour market is loosening and excess savings are dwindling.

Friday’s nonfarm payroll report was a highly anticipated event. The slower, but still healthy, job gains were in line with policymakers’ intentions. The latest report shows the unemployment rate picked up a tenth to 3.9%, again in line with the Fed’s calculus. Wage growth of +0.2% month-on-month is also more compatible with the Fed’s 2% inflation target.

The key is that the US labour market is incrementally cooling, but not falling off a cliff. It suggests higher interest rates are working but the economy is managing. Overall, this report creates even more conviction for markets that the Fed will abandon the plan (as originally stated in its September forecasts) of one more hike in December. The dilemma here is that tighter financial conditions allowed the Fed to do less. But with lower bond yields and a rebound in equity prices, financial conditions are easing again.

Climbing the Table Mountain

The Bank of England (BoE) kept rates on hold again as expected, just as the Fed did a day earlier. The vote was 6-3, with three of the nine Monetary Policy Committee members favouring another 25-basis point increase. While the Bank of England’s hiking campaign might have come to an end, it went out of its way to flag that monetary policy will remain restrictive for some time as inflation and wage growth remain elevated.

As the Bank of England’s chief economist put it, Table Mountain (a mountain in Cape Town with a flat top) rather than the Matterhorn (a Swiss mountain with a steep ascent and descent) is a good description for the Bank’s policy stance. (I recommend you search for Table Mountain if you don’t already have an idea of it, as it is a great way of understanding what the Bank views as the potential policy path.)

It is always helpful to digest the quarterly economic projections that back the Bank’s decisions, and we had the luxury of that at the November meeting. On growth, the Bank’s latest economic forecasts point to activity stagnating in 2024 with a 50% chance of a recession. Meanwhile, inflation is expected to fall to the 2% target in two years' time if rates remain at current levels.

Simply put, these forecasts suggest interest rates do have to stay elevated for inflation to come down towards the target, while further rate hikes are almost certainly going to push the economy over the edge. Why would a policymaker want to tip the economy into a recession if it is not necessary to reach the 2% inflation goal?

The key question is, when will the BoE start cutting rates? It's a difficult call and totally data dependent. The Bank said policy will remain restrictive for "an extended period of time". How do you quantify "extended"? On that, I love to put my economist hat on and go through the Bank’s inflation projections based on various interest rate scenarios.

It is quite technical, but let me explain as I have done so for a decade. Conditioned on the market's expectations for interest rates (which is 5% by end-2024 and 4.5% by end-2025), the Bank sees CPI coming at/below 2% by the end of 2025 based on the "mode" measure but only by Q2 2026 based on the "median" measure. So clearly, the BoE's assessment is that inflation risk is skewed to the upside based on the market’s expectation of a rate cut next year. That is why BoE governor Andrew Bailey was so keen on guiding the markets that we should not expect a rate cut any time soon, presumably not in 2024.

The caveat is we can't predict the future. All these forecasts are for reference only and the BoE’s forecasting record so far hasn’t been great. Simply put, the BoE's stance can change when growth weakens more than expected. The market’s pricing of a rate cut from Q3 2024 seems reasonable, as we expect the UK economy will weaken more visibly in 2024 due to the UK’s interest rate sensitivity.

There is both good news and bad news for prime minister Rishi Sunak. He will be pleased to see that the Bank expects UK inflation to halve by the end of 2023 – exactly as pledged. But the 2024 growth downgrade to 0% presents a difficult backdrop pre-election.

To wrap things up, this week has been a fascinating week in terms of central bank policy settings and the stunning moves in bond yields.