Bond Yields Forced To Rise Higher

Week Ending, 16th February, 2024

Strong inflation data was released which forced bond yields to rise higher (i.e. bonds fell in value) as enthusiasm of rate cuts became tempered. Raphael Bostic (Fed Governor of the Bank of Atlanta) said he sees no reason right now to stop the Fed’s ongoing removal of liquidity from the market (aka Quantitative Tightening, QT). He sees no shortage of liquidity. He also said more time was needed to weigh up the prospect of a rate cut despite the progress that has been made on inflation. He said “My expectation is the rate of inflation will continue to decline but more slowly than the pace implied by where the markets signal monetary policy should be”. Reinforcing his view was the release of January’s Producer (Input) Prices which increased +0.3% m/m to 0.90% y/y. The monthly rise was more than expected. Worryingly, the core rate (excludes food and energy) jumped +0.6% m/m (Dec: +0.2% m/m) to 2.6% y/y.

What should we expect on the inflation and interest rate front? Right now, we are living a Tale of Two Economies: the US vs the Rest. There’s no doubting the exceptional progress by the former (the US) while the latter (the Rest) are all interconnected with trade being a common theme and China at its centre thereby explaining the subdued nature of any global pick up. Simplistically, the US is a big consumer nation while the others are big exporter nations. UK, German & Japanese GDP are in recession territory based on 2H 2023 – but that’s rear-view stuff. Germany has taken over from Japan for the number three spot when it comes to growth. Meanwhile, Japan is in a conundrum – the weak Yen has helped drive profits of exporting companies but a weak Yen has also raised import prices i.e. inflation (especially food & energy). The stock market is within a whisker of its all-time high (last reached in December 1989) helped by (1) improved and improving governance, (2) a weak Yen boosting corporate profits and (3) a hedge against inflation seeing as bond yields are being artificially suppressed due to the Bank of Japan’s policy of Yield Curve Control (where it targets a yield range for its bonds and steps in to sell or buy back these bonds to keep in their designated range). The Bank of Japan said it will examine whether to maintain YCC when its inflation target hits its 2% target and proves sustainable at this level.

So the answer to the above question? Given that inflation is proving problematic to the upside (tight labour markets, stable wages, slowly rising energy prices, no let-up in retail demand, persistently high rental costs), rates will stay around current levels! Reductions (if any) will be slight. By mid-year, talk of rate hikes will resurface market-implied odds will start to rise. Hedging options should be seriously considered ahead of this.

Look at the US:

The supercore services inflation, as shown, excludes housing and energy and is showing no signs of letting up. It’s averaging +0.5% m/m (over 6% y/y). This goes to Raphael Bostic’s point about not being in any rush to temper the current rate of liquidity removal (financial tightening) from the monetary system. As it stands, markets are pricing rate cut odds happening in May/June. This has been pushed out a few times and odds seem to be getting lower and lower. Now consider “the Rest”. One country that has been hit very hard is Germany ever since 2022 with the Russia-Ukraine war. That became compounded with a very slow China economy (my earlier point around trade links). However, for the first time in a long while, Germany is contributing positively to global conditions based on hard data (which has turned positive) while soft data is no longer worsening. Germany is a big component of the European Stoxx 600 index, and the latter is trading on a very cheap 12.6X forward P/E. That provides a useful hedge. Japanese equities are trading on just 14.5X. This is another hedge – though less so given how much the market there has already rallied. Contrast this with US equities on 20.1X).

MARKET SUMMARY