Yields Roar To New Highs

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US yields pushed to their cycle highs during the past week, with 2-year and 10-year Treasury notes breaching prior support levels at 5% and 4.25%, respectively.

Our meetings with US policymakers in the past week leave us with the impression that the Federal Reserve (Fed) is still concerned that the negative outcome if they fail to have tightened policy enough, is potentially more painful than an outcome where they tighten by too much and then need to correct their course.

There is nervousness that if inflation is stuck in a 3-4% range, expectations may de-anchor over time, and also, a risk of a shock which could lift inflation back towards 5%, could make life very uncomfortable. Some past Federal Open Market Committee (FOMC) veterans have also noted to us that in a hiking cycle, you only know when you have gone too far and should stop once the economy cracks.

However, for the time being, GDP growth continues around its trend, and it strikes us that little seems to be slowing the consumer. Low mortgage pre-payments mean that only a small sliver of borrowers are being impacted by higher rates at this point.

Meanwhile, lower turnover in the housing market means softer demand for durable goods, but in its place, we can see stronger demand for services and spending of an experiential nature. This is seen in hotel prices and ticket prices for live music.

In many respects, this has been the summer of Taylor Swift, and it seems wherever she has been touring, so she has managed to shake it up with respect to prices and the ground under her feet!

At the same time, we can see evidence of cooling inflation elsewhere, and as China slides into recessionary territory, weaker commodity prices can also lower input costs. Monetary policy is at levels deemed contractionary, with rates well above the estimated real neutral rate of interest that equilibrates the economy in the long run.

This may mean that the Fed leaves rates where they are and allows policy time to take its full effect. This may also become politically expedient heading into 2024, given a desire to avert a recession in an election year if possible.

However, even if rates have now peaked and stay where they are for an extended period, we continue to see little merit in taking a long-duration stance in an environment with a substantially inverted yield curve until we can plot a path to lower rates. For now, there are very few in Washington who can see this occurring any time in the next 6-9 months.

Absent a large drop in the equity market, we see this requiring a move in the unemployment rate to at least 4.5% and rising with inflation below 3% and on a path declining towards the 2% target. Consequently, we continue to adopt a neutral stance and wait for opportunities of a more tactical nature should prices overshoot in the coming days.

Discussions around US politics have highlighted an outside probability of neither Trump nor Biden contesting the next election. However, in the case of Republicans, this requires a narrowing of the field of candidates, given that only a plurality, not a majority, is required to win the nomination.

On the Democratic side, Biden is seen winning the Primaries but possibly then being persuaded to step aside next summer on health grounds. In the national elections, Trump is seen prevailing as the most likely victor with 3rd party candidates probably drawing votes away from Biden.

Foreign policy will not be the main focus of the US election, though, within Republican ranks, the one policy differentiator between Trump and others has been his stance on Ukraine. This can be a wedge issue within the party.

Consequently, other candidates seeking nomination may also be pushed to downplay support for Ukraine during the process. Meanwhile, our feedback from Moscow suggests a worrying desire to double down on the war, making the path ahead look a painful one in the region. Nevertheless, we expect EU support for Kyiv to be unwavering, and hopefully, this will see the nation emerge from its current struggles as an EU member in the years ahead.

Bund yields also rose to new highs over the week, and they continue to track Treasuries. Meanwhile, the Band of Japan has been under ongoing pressure to allow yields to rise as its policies continue to undermine the yen.

A big upside surprise in Japan’s GDP in the past quarter was driven by exports, though it is also striking to see how nominal growth is surging with inflation continuing to move higher. From this standpoint, continuing to retain a short position in Japanese government bonds continues to appear well-merited.

Elsewhere, China’s downside risks continue to build though it is not clear to us that there is much Beijing can do to support activity. Scrapping the publication of economic data is a worrying sign that speaks to the ongoing scope for policy missteps in the months ahead.

In many respects, we may see China's problems today mirroring those of Japan in the 1990s. From this point of view, we have added a short China renminbi stance expecting the currency to continue to weaken, having hit a 15-year low this week.

Meanwhile, an upside surprise in UK wage data is likely to add to ongoing problems for the Band of England. Recently, they have been more specific in communicating their reaction function over the coming meetings, homing in on how private sector wages, labor market tightness, and services inflation evolve in the near term to determine their next move.

This week’s data was mixed, but with another set of labor market and inflation data to come before the September Monetary Policy Committee (MPC) meeting, it is still too early to conclude whether another 25 basis points is warranted or whether a bigger move is needed. The latter has a higher bar now, given the MPC’s assumption that current rates are already in ‘restrictive’ territory.

Markets are now pricing rates moving toward 6% at year-end though we are inclined to see Bailey and colleagues take a more dovish stance as jobs growth and activity data all show signs of softening. We continue to believe the pound is overbought at this juncture.

Looking ahead

It strikes us that the market consensus is probably positioned net long in duration and long in terms of exposure to risk assets. A move to a new high in yields could see selling from technical-based accounts and could well weigh on sentiment. Consequently, we are happy to continue to retain a relatively cautious investment stance for the time being.

August is a month when markets are somewhat illiquid, and an overshoot in price action would not be difficult to imagine, giving better entry opportunities at more attractive market levels. For now, we can sit back and watch the Lionesses roar – Could a World Cup finally be ‘coming home’?

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