- Treasuries are only starting to regain from their losses for the year on signs that inflation and the labour market are finally, actually cooling. The US labour market is showing signs of softening, with the US economy adding about 272,000 jobs in May. The unemployment rate increased to 4.0% in May from 3.9% in April, marking the first time it has hit 4.0% since January 2022. Most critically for the Fed, the labour force participation rate declined from 62.7% to 62.5%, indicating the share of people working or looking for work is shrinking. Average hourly earnings were +4.1% in May 2023 on a y/o/y basis. “Real" average hourly earnings (wages adjusted for inflation) were +0.8% from May 2023 to May 2024, up from April’s 0.5%. Wage growth within a range of 3.0% to 3.5% is generally considered consistent with the Fed's 2% inflation target. The inflation rate y/o/y was 3.3% in May, falling just below April’s 3.4%. This is the second month in a row that inflation has eased. The drop was partially due to declining gas prices. However, shelter prices rose 2.0%, the fourth straight month of increases.
- The Conference Board’s consumer confidence index fell to 100.4 in June from May’s 102.0. However, the University of Michigan's consumer sentiment fell for a third straight month to 65.6 in June 2024, the lowest since November, from 69.1 in May. The current conditions gauge declined to 62.5 from 69.6 and the expectations subindex fell to 67.6 from 68.8. The year-ahead inflation expectations were unchanged at 3.3% but the five-year one edged up to 3.1% from 3%.
- The flash Composite PMI Output Index edged up to 54.6 from May’s 54.5, a 26-month high. The increase was driven by the services sector, with the S&P Global flash index for service providers edging up 0.3 point to 55.1, the highest since April 2022. The manufacturing flash PMI came in at 51.7 from May’s 51.2, a 3-month high.
Yield curves
The Fed unanimously voted to keep overnight federal funds rate at the current range of 5.25% to 5.5% at its last meeting, marking the seventh consecutive meeting at which policymakers have opted to hold rates steady. The expectation is that the Fed will continue to keep rates on hold until September if not later. Fed policymakers, such as San Francisco Fed President Mary Daly are emphasising the need for caution while recognizing that “the bumpiness of inflation data so far this year has not inspired confidence.” Others, such as Chicago Fed President Austan Goolsbee have cited the need for further evidence of cooling inflation before adjusting policy. Although Fed Governor Lisa Cook expressed optimism that inflation will gradually improve this year, with more rapid progress expected in 2025, Fed Governor Michelle Bowman has insisted that the Fed needs to maintain elevated interest rates in the face of various upside risks to inflation. Although the Fed’s latest projection or dot plot indicated one cut this year, Bowman reaffirmed her expectation of no rate cuts this year and her openness to further tightening should inflation progress stall or reverse.
All eyes will be on the Fed’s preferred gauge of US inflation, the PCE deflator, due on Friday, to determine if a rate cut could happen before the November election..The yield on the 2-year Treasury note, which is highly sensitive to movement of the Fed Funds rate, has fallen from 4.94% in May to 4.74%. The benchmark 10-year US Treasury note yield has fallen to 4.31% from May’s 4.56% , while the yield on the 30-year bond has also fallen from May’s 4.70% to 4.44%.
Yield swings
US Treasury yields declined in June. Markets are now adjusting to the idea that rates may not only be higher for longer, but may not fall until 2025. Duration risk continues to be a concern with traders waiting on improving inflation data to determine when the first rate cut will take place.The gap between two- and 10-year yields remained deeply negative and it hit its widest since December at minus 51.6 basis points on the 25th of June. An inversion in that part of the yield curve, which occurs when shorter-dated Treasuries yield more than longer-dated ones, is closely watched by investors as it has historically signalled an oncoming recession.
Source: Factset
Source: Bloomberg 10:30 am EDT 26 June 2024
Global Economic and Market Review
In the UK, inflation continued to ease in May, with the headline rate at 2.0% year-on-year, down from 2.3% in April, marking the lowest rate since July 2021. Core inflation was 3.5%, while services prices remained high at 5.7%. Unemployment was up to 4.4% from 4.3% and average wages remained at 6.0% the same as for the previous three-month period; and annual growth in employees’ average total earnings (including bonuses) was 5.9%, the same as for the previous three-month period. In terms of growth, the S&P Global flash Composite PMI came in at 51.7, in June, down from May’s 53.0 and a 7-month low. The flash Services PMI fell to 51.2 from May’s 52.9, also a 7-month low. Nevertheless, consumer sentiment is improving, with the GfK Consumer Confidence Survey showing a rise in the confidence index to -14 in June, up three points from May. Three measures were up, one was down and one was unchanged in comparison to last month’s announcement. Retail sales volumes fell in the year to June, following a modest recovery in May (weighted balance of -24% from +8%).The Bank of England (BoE) held interest rates at 5.25%, stating the decision not to ease was “finely balanced” for some of the nine members on the Monetary Policy Committee. emphasising the need for restrictive monetary policy to control inflation. The MPC voted 7-2 in favour of no change for a second consecutive meeting, with Swati Dhingra and Deputy Governor Dave Ramsden both backing a rate cut. Markets are pricing in more than a 50% chance of a move in August as price pressures are cooling and inflation is falling. However, service sector prices remain high despite falling headline inflation.
As the UK now faces a general election on 4 July, the economy may be less of a worry with unemployment still remaining relatively low and wages have continued to outpace inflation. However, tax rises and spending cuts are expected regardless of whichever party wins the election.
In the eurozone, markets have already accounted for a June rate cut and are indecisive over the speed of the second cut. Money markets have priced in 58 basis points of ECB monetary easing in 2024. This implies two rate cuts and approximately a 30% chance of a third move by year-end. ECB officials, however, are mixed about the timing of further cuts. Olli Rehn, Governor of the Bank of Finland, has suggested that borrowing costs could go as low as 2.25%-2.50% in 2025. The ECB sees inflation oscillating above its 2% target for the rest of this year but sees a downward trend restarting next year, with price growth moving to 2% by the close of 2025. The problem remains the stickiness of wages. The eurozone Unemployment rate is at 6.40%, compared to 6.50% last month and 6.50% last year. The euro area annual inflation rate was 2.6% in May 2024, up from 2.4% in April. Markets will therefore be looking closely at eurozone inflation data to get a better understanding of how quickly the ECB’s second rate cut may take place.
German government bond yields have risen more than US yields, reducing the 10-year yield differential between the US and Germany to around 186.3 basis points in June from 191.9 basis points in May. 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, is now about 153.8 basis points from 131.9 basis points in May.
With the number of expected Fed rate cuts officially down to one projected it is clear that the divergence in central bank policy will affect markets. Global bond markets are just not happy as reflected in the rise in bond market volatility over the past few months, particularly as there are indications that the neutral rate may be higher than policymakers, particularly the Fed, have previously suggested. If this is indeed the case, then this does not give bond markets much room for manoeuvre in terms of recouping losses. Although we’ve seen cuts by the ECB, the SNB, and the Riksbank with expectations of a first cut by the BoE to take place in August, before any Fed moves, markets are still rattled by geopolitical factors appearing to worsen. Political uncertainties in Europe including the snap elections in France, the ongoing war in Ukraine, and fiscal worries related to the new EU parliamentary group, are weighing on investors’ minds. We are also seeing growing trade fragmentation with potentially deteriorating economic relations with China following on from the rise in EU and US tariffs against Chinese electric vehicles and other products. We also have the concerns related to structural demographic shifts affecting labour markets tightness and participation rates, and the consequent impact on wages, particularly in the services sector. In addition, existing regulation aligned to the low-carbon transition may result, in the short to medium term, in higher energy prices as OPEC+ tries to maintain a level of “stability” in the market by shifting supply. All of these factors are likely to make inflation more volatile in the medium term.
Given the continuing degree of volatility and the increasing, at least over the short term, divergence in policy rates, investors may consider adding duration to their portfolios to lock in yields. Investors may also wish to consider adding tactical exposure through yield-spread, targeting.
Key risks
- Inflation fails to fall in line with projections, weighing on asset prices. It is becoming apparent that there is a divergence in central bank policy rates following on from the Bank of Canada, the ECB, the Riksbank and the SNB all cutting rates in June while the Fed and the BoE held steady. Although inflation is falling, it may not fall in line with projections due to sticky services costs, particularly in Europe. Rising rents are also a problem in the US. There are also risks that headline inflation may rise due to commodity prices rising as global demand increases, particularly for materials used in the electric car industry. The euro has also depreciated against the dollar in June due not just to the first rate cut by the ECB, which was largely expected by markets, but by the results of the European parliamentary elections, the snap election by France, and the potential consequences of the parliamentary election on fiscal policies moving forward.
- Policymakers mistiming on credit loosening leads to recession or reinflation. ECB and UK policymakers in particular will need to be cautious about getting the balance between supporting their economies with future inflation risks. In addition the growing divergence in policy could cause currency volatility which is already likely to be higher than normal given elections in France and the UK.
- Geopolitical tensions and events. Tensions in the Middle East are rising, with Hezbollah threatening Israel as well as EU member Cyprus. There is also the continuing war in Ukraine, which may become more complicated following the European parliamentary elections and the future direction of EU expansion as well as direct support from member states. There are also increasing tensions in the South China Seas between the Philippines, China, and the US.
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