- The strength of the US economy has continued to drive global bond markets. The US labour market is still only showing limited signs of weakness with initial jobless claims continuing to remain around the 212,00 mark and nonfarm payrolls from March coming in at 303,000, well above expectations. Retail sales were up 0.7% from the previous month in headline terms and up 1.1% in core terms. However, US consumer sentiment fell in April with the UoM consumer sentiment index edging lower to 77.9 from 79.4 in March, below the market expectation of 79. The Current Conditions Index declined to 79.3 from 82.5 and the Consumer Expectations Index fell to 77, the lowest in three months, from 77.4 in February. There has also been a drop in business activity, with the April flash Composite PMI Output Index, falling to 50.9 from 52.1 in March. The slowdown reflected weaker rates of growth in both the manufacturing and services sectors, with activity easing to three- and five-month lows, respectively. That in turn meant employment fell for the first time since June 2020, with the reduction focused on services.
- US inflation came in hotter than expected in March at 0.4% m/o/m and at 3.5% y/o/y. The core CPI rose 0.4% on the month and was up 3.8% on the year. The dollar is likely to remain supported by a still strong economy for the foreseeable future.
Yield curves
The Fed kept overnight federal funds rate at the current range of 5.25% to 5.5% at its last meeting. The expectation is that the Fed will continue to keep rates on hold until September if not later. Fed Chair Jerome Powell said that the Fed would need to see drivers of inflation weaken before cutting rates. "If higher inflation does persist, we can maintain the current level of restriction for as long as needed," Powell said. Markets are now pricing only one or two 25 bp cuts from the Fed in 2024, well below the 160 basis points and 6 or 7 cuts expected in January. The first rate cut is now expected to come in September although there are increasing bets that the first cut may not come until November. Markets are currently pricing in a 67% chance of a first US rate cut by September, according to the CME's FedWatch tool.
All eyes will be on the Fed’s preferred gauge of US inflation, the PCE deflator, due on Friday, to determine if rate cuts will indeed begin in September or be pushed even further out to November. As noted by Bloomberg news, the measure is seen accelerating slightly to 2.6% on an annual basis as energy costs rise. The core metric, which strips out energy and food, is expected to rise 0.3% from the prior month after a similar gain in February. There has also been some movement in the options market suggesting a near 20% chance of another rate rise.
The yield on the 2-year Treasury note, which is highly sensitive to movement of the Fed Funds rate, is at 4.94%, up from March’s 4.57%. The benchmark 10-year US Treasury note yield has risen to 4.64% from March’s 4.19%, while the yield on the 30-year bond has also risen to 4.76% from March’s 4.37%.
Yield swings
Treasury yields in April continued to gain ground, reaching their highest levels in 2024, on higher-than-expected US inflation data in March and strong retail sales despite dipping slightly due to a slowdown in business activity. Markets are slowly adjusting to the idea that the first Fed rate cut may be pushed out to at least September, with much being dependent on the pace of wage growth starting to slow and the core PCE reaching the 2.5% level at a minimum. Duration risk remains a concern with traders waiting on improving inflation data to determine when the first rate cut will take place.
Source: Refinitiv and EXANTE Research
Source: Bloomberg 8 am EDT 24 April 2024
Global Economic and Market Review
The global economy is growing, with the IMF’s April projections suggesting the world will grow by 3.2% in 2024. The IMF also noted that global headline inflation is forecast to fall from an annual average of 6.8 % in 2023 to 5.9% in 2024 and 4.5% in 2025, with advanced economies returning to their inflation targets sooner than emerging market and developing economies.
The UK is likely out of recession as business activity continues to improve although UK retail sales were estimated to be flat (0.0%) in March 2024, following an increase of 0.1% in February 2024 (revised from 0.0%). Inflation is decelerating, coming in at 3.2% in March 2024, down from 3.4% in February, and the lowest since September 2021. On a monthly basis, CPI rose by 0.6% in March 2024, compared with a rise of 0.8% in March 2023. Core inflation, which excludes food and energy, rose by 4.2% in the 12 months to March 2024, down from 4.5% in February. Services inflation, usually viewed as a stronger measure of domestic price pressures, eased slightly from 6.1% to 6.0%. The labour market has seen some decline with the jobless rate increasing to 4.2% in the three months through February from 4% in the period through January. Annual growth in regular earnings (excluding bonuses) declined from February’s 6.1% to 6.0% in March. Although the marked fall in the services output prices balance may make the Bank of England more inclined to consider a rate cut before August, there remains the risk of services inflation remaining too high. BoE Chief Economist Huw Pill has cautioned against premature policy easing, despite observing recent dips in headline inflation. He emphasised the need for a "restrictive" monetary policy stance to combat persistent inflationary pressures.
In the eurozone ECB policymakers have pretty much agreed that the first rate cut will take place in June. However, this June rate cut by the ECB is not guaranteed. The current disinflationary environment could be upset by a possible shock to energy prices from a sudden increase in tensions across the wider Middle East that impacts production directly. There seems to be growing disagreement among ECB officials about the timing of further cuts as well despite signs of improved eurozone growth. The preliminary HCOB Composite PMI for April rose to 51.4. This marked the second consecutive month the index surpassed the crucial 50 threshold, which separates growth from contraction. Service sector activity gained further momentum, with the flash services PMI soaring to 52.9 from 51.5 in March. The services new business index climbed to a robust 52.1, representing an 11-month high. Although the manufacturing PMI dipped to 45.6 in April from 46.1 in March, German business confidence, according to the Ifo Institute’s business climate index, has risen to its highest level for almost a year, by 1.5 points to 89.4, reaching its highest level since May 2023. It appears to have been lifted by hopes that lower inflation will boost household spending.
However, Services inflation, driven by wage increases, remains a concern for the ECB, as indicated by ECB board member Isabel Schnabel, who outlined a scenario where persistent demand for services could keep inflation up due to low productivity growth. Other officials, such as Bundesbank President Joachim Nagel have said that "Given the current uncertainty, we cannot pre-commit to a particular rate path."
German government bond yields have risen to a lesser extent than US yields, widening the10-year yield differential between the US and Germany to around 209 basis points. The gap between Italy and Germany's 10-year yields, a gauge of investor sentiment towards the eurozone's more indebted countries, is, according to Worldgovernmentbond.com, 132.9 basis points(bps), -0.7 bps this month.
As the likelihood of rate cuts by the Fed gets pushed back to at least September, there is a stronger risk of divergence in central bank policy with the ECB more likely to cut first. This will have a consequent impact on returns. Other risks that shouldn’t be ignored that may have longer term consequences for inflation and yields include: ongoing and rising geopolitical tensions with increasing trade fragmentation, demographic shifts affecting the composition of labour markets, the tightness of those markets in terms of labour availability and participation rates, and the consequent impact on wages, particularly in the services sector. In addition, regulation aligned to the low-carbon transition may result, in the short to medium term, in higher energy prices. All of these factors are likely to make inflation more volatile in the medium term.
Markets are still counting on a softer landing as being the base case scenario although there are increasing concerns that we may face a “no landing” scenario which implies maintaining a much higher rate environment than experienced in previous monetary policy cycles. Given the growing degree of volatility, with bond markets seemingly more sensitive to all economic data, shorter duration bonds may continue to be preferred by investors. However, investors may wish to consider how they add exposure without taking duration risk. They may therefore consider adding exposure through yield-spread, targeting the difference between two countries’ bond yields in the same maturity. Another tactic may be targeting the difference between the same country’s bond yields in different maturities.
Key risks
- Inflation fails to fall in line with projections, weighing on asset prices. It is becoming apparent that there is going to be a divergence in central bank policy rates as inflation may not fall in line with previous projections. Unlike in Europe, US inflation is continuing to be pushed by demand side measures, which means that the dollar will remain strong and yields may continue to rise. There are also risks that headline inflation may rise due to commodity prices rising as global demand increases. We may also see the correlation between the eurozone and US curves continue to weaken, particularly at the short end, as the growth narrative for the two regions still differs due to the structural differences and differing geopolitical and resource access risks. Most European central bank governors highlight the eurozone's weaker economy compared to the US as a rationale for different monetary policies, with Belgian central bank governor Pierre Wunsch stating that "The US and eurozone economies have decoupled.”
- Policymakers mistiming on credit loosening leads to recession or reinflation. The different causes for the inflation experienced now, demand push in the US vs supply related in Europe, could cause the euro to continue to fall against the USD as policy divergence comes to the forefront. In the US the still tight labour market is helping to maintain dollar strength. Therefore ECB policymakers may begin to worry about the possible inflationary impact from cutting before the Fed.
- Geopolitical tensions and events. These include not just the ongoing tensions in the Middle East with a lack of a ceasefire between Israel and Gaza but other factors including: the continuing threats of attack from Yemen’s Iranian-backed rebel Houthis as well as the ongoing war in Ukraine, which has resulted in increasing tensions between NATO and Russia and contributed to total global military expenditure increasing by 6.8% in real terms in 2023, according to the Stockholm International Peace Research Institute to reach $2443 billion. There is also the likelihood of increasing tensions between the US and China as the US moves further into its election cycle and both Presidential contenders seek to outline potential further actions against Chinese industrial policies, notably in the tech sector.
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