Fixed Income Briefing November 2023

• There are signs of the US economy slowing, with retail sales falling 0.1% m/o/m in October, industrial production declining 0.6% m/o/m in October, and existing house sales dropping 4.1% in October, hitting a 13 year low. The labour market is also cooling with the unemployment rate tickingup to 3.9% from 3.8% in September. Job growth is falling with the economy adding only 150,000 jobs in October and previous months being revised lower, suggesting the economy is not quite as strong as thought. However, the US economic outlook was somewhat buoyed by Congress averting a government shutdown with the passage of a stop gap spending bill which ended this year’s third fiscal standoff. This does set the next deadline to 19 January, shortly after the Iowa caucuses signal the start of the 2024 presidential campaign season, thereby increasing the likelihood of further political grandstanding and threats of shutdown.
• Fed officials said they expect economic growth in the fourth quarter to “slow markedly” from the 4.9% increase in Q3 gross domestic product. They said that risks to broader economic growth are probably skewed to thedownside, while risks to inflation are to theupside.
• US inflation was flat in October, but increased 3.2% on a y/o/y basis. This is far below the 6.5% average in 2022. Excluding volatile food and energy prices, the core CPI rose 0.2% and 4%. The annual rate was the smallest increase since September 2021.

Yield curves 

Rates across the US Treasury yield curve fell in November. Softer-than-anticipated inflation data, with headline inflation falling to 3.2%. Core inflation, which excludes food and energy costs, fell to 4.0% from 4.1% in September, its slowest rate in two years. However, both rates remain well above the Fed’s target. The yield on the 2-year Treasury note, which is highly sensitive to movement of the Fed Funds rate, is at 4.87%, up from 4.4% at the start of the year. The benchmark 10-year US Treasury note yield is at 4.38%, while the yield on the 30-year bond is 4.52%.

Although the Fed decided to keep rates on hold in November, it is clear from the minutes of the meeting that the Federal Open Market Committee members still worry that inflation could be stubborn or move higher, and that more may need to be done. “In discussing the policy outlook, participants continued to judge that it was critical that the stance of monetary policy be kept sufficiently restrictive to return inflation to the Committee’s 2% objective over time,” the minutes said. 

Yield swings

US government bond volatility, 2015-2023

Source: BlackRock Investment Institute, with data from LSEG Datastream, November 2023. Notes: The chart shows volatility in US Treasuries based on the MOVE index. The series is shown in standard deviations from average during the period shown.

Treasury yields remained lower in November as the market still anticipates inflation will decelerate to levels sufficient for the Fed to cut rates in next year. Even though the market appears to be thinking that the Fed is done hiking rates, it may be premature given the potential headwinds raised by some Fed officials. The Fed will likely continue to wait for further evidence of moderating inflation or softening growth before it starts lowering rates, with the expected timeline more likely to be further out than traders may be currently anticipating. However, if the Fed is indeed done with its hiking cycle, then we may see a change in the level of return from bonds vs cash. However, upcoming Treasury debt sales will likely continue to weigh on the market and impact bond yields.

Global Economic and Market Review

In the UK, headline inflation fell to 4.6% in the 12 months to October 2023, down from 6.7% in September, driven by the impact of falling energy prices. On a monthly basis, CPI did not change in October 2023, compared with a rise of 2.0% in October 2022. Core CPI (excluding energy, food, alcohol and tobacco) rose by 5.7% in the 12 months to October 2023, down from 6.1% in September. It is still the highest level of inflation in the G7. The labour market is starting to loosen, with the number of estimated vacancies falling by 58,000 to 957,000 in the August to October 2023 period. However, vacancies are still well above pre-pandemic levels. Wage growth remains a focus for the Bank of England as it may contribute to inflationary pressures with the annual growth in regular pay (excluding bonuses) coming in at 7.7% in July to September 2023, slightly down on the previous periods, but is still among the highest annual growth rates since comparable records began in 2001. Investors will be watching for today’s Autumn statement where finance minister Jeremy Hunt will unveil new tax and spending plans. Just over a year ago, then finance minister Kwasi Kwarteng sparked chaos in global bond markets with a package of large unfunded tax cuts. The BoE Governor Andrew Bailey has warned markets that they were underestimating the persistence of UK inflation.

Markets have determined that the ECB has reached the peak of its tightening cycle. Euro area yields touched 12-year highs in early October, but have since fallen as weaker US and Eurozone economic data has suggested inflation would slow quicker than previously thought. ECB President Christine Lagarde remains cautious about the inflation outlook, saying, "This is not the time to start declaring victory. We need to remain focused on bringing inflation back to our target." The Eurozone economy is slowing, with the European Commission Autumn Forecast projecting GDP growth in 2023 at 0.6% in both the EU and the euro area, 0.2% below the Commission's summer forecast.

There has also been a drop in yields across the Eurozone itself with the gap in yields between Eurozone countries also falling. The gap between Italy and Germany's 10-year yields, a gauge of investor sentiment towards the Eurozone's more indebted countries, hit a two-month low of 170 bps on Tuesday, 21 November. According to Worldgovernmentbond.com, the spread between Germany’s 10 year and Italy’s 10 year is 175.7 bp, down 31.5 basis points this month.

Despite the slowdown in inflation in Europe, the UK and the US, there are still downside risks that shouldn’t be ignored. There is still a possibility of further rises in oil and other energy resources as we head into the winter season which would also hit food prices. Add in political uncertainty in the US as we move closer into the election cycle and borrowing costs staying higher for longer, and the picture starts to look slightly less rosy.

It is clear that new and existing geopolitical risks, mounting concerns around developed countries debt levels and debt sustainability, growing recession risks in the Eurozone and UK economies, and potential differences in domestic interest rate paths will continue to drive spread differentials. Bond volatility has been at a much higher level than before the pandemic. However, with inflation falling while growth, at least in the US, managing to hold up for now, markets are likely to remain more positive on bonds although much will depend on any unexpected data which suggests that a softer landing is more or less likely. Volatility will remain a key feature for bond markets well into Q1 2024.

Key risks

• Inflation fails to fall in line with projections, weighing on asset prices. It is highly anticipated that the Fed, the ECB and the BoE will continue to hold rates at their current level for an extended period, most likely well into Q2 2024.There may also be a rise in headline inflation as energy prices and food prices are expected to rise in Q4 2023 and into Q1 2024. This may contribute to further wage rises, thereby increasing inflationary pressures. Although tech stocks have been rising on expectations that the Fed will begin cuts by Q2 2024, any potential tightening or the volatility that often accompanies higher for longer interest rates, may cause interest-sensitive stocks in the technology sector, financials, telecommunications, and infrastructure to decline further.
• Policymakers actions lead to over tightening credit conditions. Growing concerns over the slowdown in Europe could cause the Euro to fall further against the USD and Sterling. Another factor for concern will be bond issuance levels. With the US in particular poised to issue more, investors are struggling to absorb the bond supply, resulting in weaker demand and higher yields.
• Geopolitical events and climate change. Although the threat of the conflict in Gaza widening to include other players in the Middle East appears to have diminished following Israel’s tentative agreement with Hamas over a five day ceasefire and the meeting between US President Joe Biden and Chinese Premier Xi in November yielding no major breakthroughs, but potentially preventing further deterioration in bilateral ties, there are still other geopolitical risks that will continue to impact markets. These include the ongoing war in Ukraine and the tensions between NATO and Russia, and the direction the new President of Argentina may take with its trading partners and neighbours. 

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