Financial Update from Brewin Dolphin - 6 October 2023

October 2023

The Weekly Round-up

Friday 6 October 2023

In her latest weekly round-up, Janet Mui, Head of Market Analysis, discusses the latest bond market rout and a forecast-busting US jobs report.

Bond market – shaken not stirred

The bond market rout remains in sharp focus for investors as some critical thresholds were breached this week. Both US and UK 30-year government bond yields topped 5%, and global bond yields surged across geography and maturity. This is problematic and may exacerbate financial risks somewhere, sometime (remember the regional banking stress?). The longer the duration of a bond, the bigger the loss suffered with each percentage of yield increase. Most recently, longer-term bond yields rose more relative to shorter-term ones, resulting in what the market refers to as the “steepening” of the yield curve. As a result, the yield curve (ten-year minus two-year bond yield) is now at the smallest inversion of the year.

When good news is bad news

Wednesday’s weak US ADP employment numbers calmed expectations of a strong official jobs report and helped to cap the surge in yields, as did the sharp retreat in oil prices (didn’t we say last week that the cure for high oil prices is high oil prices?). But the brief stabilisation in the bond market in the middle of the week didn’t last long.

The jaw-dropping strength of the US nonfarm payroll report for September, which was released today, provides fresh impetus for a further ascent in US bond yields. The state of the labour market is far from recessionary and that lends support to the Federal Reserve keeping interest rates elevated for longer.

While the resilience in jobs is to be celebrated, market psychology has flipped to “(too) good news is bad news” mode. The bond market is currently allergic to data that is too hot, especially coming from the labour market.

The 336,000 job gains exceeded even the most bullish estimate. Despite the Federal Reserve’s aggressive interest rate increases and some pockets of weakness in the US economy, this report raises concerns that the labour market will remain too hot for too long.

Perhaps the only solace, from a market perspective, is that wage growth has slowed modestly and came below estimates.

But with the recent rebound in US jobs openings and a lack of increase in the labour participation rate, the Federal Reserve may remain concerned about the impact of underlying inflationary pressures on the economy.

There are multiple headwinds facing US consumers (exhausted savings, student loan repayments, higher debt servicing, to name a few) but sustained positive real wage growth is helpful. The jobs report, while strong, is not completely faultless. For instance, there is at least one indicator that shows some signs of softening in the labour market. The temporary help in services, which is seen as a leading indicator for the unemployment rate, edged lower.

Traders have boosted the probability of another Fed rate hike by the end of the year from a third to around 50% after the report.

From a business cycle perspective, unless the US economy slows sharply, rate cuts are premature so bond yields will remain at elevated levels. With rising bond yields and falling stock prices, US financial conditions have tightened, which will eventually take some heat off the economy, though that moment of capitulation keeps being pushed back.

Bond vigilantes back in full force

For the “higher for longer” interest rates regime, US economic resilience and the hurdle for Fed rate cuts are just the cyclical part of the story. Perhaps more thought-provoking are issues relating to structural factors – these are slow-moving and initially hard to quantify, but highly impactful for decades to come. Bond vigilantes come and go depending on the state of the economy, but they are back in full force as they are increasingly worried about fiscal sustainability.

There is a reason why investors have been ignoring the US’s budget deficit and debt for some time. After all, US government debt is considered a safe haven, and the US dollar is the world’s reserve currency. It is as if the US government has the privilege to issue debt to finance spending, in an indefinite way with few consequences. This has been the argument given by proponents of modern monetary theory (MMT), which gained popularity during the pandemic as governments around the world pumped money into the economy by borrowing at near zero rates. The return of high inflation, nevertheless, has kept them relatively silent for a while.

That privilege is seeing some signs of exhaustion. Worryingly, the US budget deficit as a percentage of gross domestic product (GDP) stands at 8.5% currently. While this a huge improvement from the 18% during the pandemic, it is abnormal to have such a high percentage when the economy is still in expansion territory, because deficits tend to widen during recessions. For instance, ahead of the financial crisis, the US budget deficit as a percentage of GDP was only about 2%, which widened to as much as 10% in 2009.

At the same time, quantitative tightening is in full force and the Federal Reserve is expected to reduce its stock of bond holdings by $1trn in the next 12 months, after already offloading $1trn in the past year. As Kevin McCarthy became the first ever House speaker to be ousted, it adds to concerns about the dysfunction in Washington and its grip on fiscal sustainability. All in all, investors are now demanding higher compensation to hold longer-dated government bonds, which resulted in term premium returning to positive territory.

The structural arguments are reasons why markets are increasingly thinking bond yields can stay high irrespective of the business cycle. On that front, some historical perspective can be helpful. If a recession does occur, central banks will likely cut rates significantly and bond yields are likely to fall in that environment. Even if the US experiences a soft landing, the odds are high that the Fed will cut rates on the back of subsiding inflation. In the three historical US soft landings, the ten-year Treasury yield dropped by a median 251 basis points. One caveat is that with inflation still above target, the Fed would be unlikely to cut as much as the historical median in a recession.