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• Hopes for an early rate cut dwindled further, as stronger-than-expected inflation pushed yields higher.

• Meanwhile, the UK has fallen into recession ahead of its national election.

• Elsewhere, markets have been relatively quiet, although Japanese GDP came in weaker than expected and the decision to normalise policy is still ahead for the BoJ.

• We may be heading towards a less volatile point in the calendar, at least until we hit a round of interesting central bank meetings in March.

A strong US CPI report saw yields move higher, as rate cut enthusiasm was (temporarily) placed onto the back burner. Arguably, the rally in rates since the end of October has been driven by a narrative that inflation is returning to target and this will pave the way for policy easing, inasmuch as activity data with respect to economic growth continues to remain very upbeat.

Over recent months we have seen how rate bulls have wanted to extrapolate short-term trends in inflation data in order to support their argument. However, in this context it is worth highlighting that – looking at core CPI – the annualised outcome over the latest 3-,6- and 12-month periods stands at 4.0%, 3.6% and 3.9% respectively.

It is true that the picture looking at PCE Core data, which is the Fed’s favoured measure, appears somewhat better and that CPI statistics have been boosted by strong gains in imputed rents, which should moderate going forward.

Nevertheless, we have stood by the view that the FOMC is unlikely to start lowering interest rates until inflation data is much closer to target, and from that standpoint, this appears to validate our long-held view, that rate cuts are only likely in the second half of 2024.

In the short term, with equities buoyant and bitcoin rampant, our own conversations with policymakers have focussed on the theme of US growth exceptionalism, at a time when data elsewhere in the global economy seems to be on a much softer trajectory. Positive US wealth effects have also prompted a sharp uptick in the number of individuals retiring in the US workforce, and it strikes us that a further uptick in wages is possible, at a time when the labour market remains very tight.

For much of last year, the notion that the US economy was at a late point in its cycle was not much questioned. Yet a recent acceleration in activity has seen some indicators build a case for a mid-cycle stance. That said, we continue to believe that the base case is for a moderation in activity as we move through the year, acknowledging that the full effects of past policy tightening are yet to be felt.

Nevertheless, a soft landing trajectory continues to suggest to us that the trajectory of a coming rate cycle will mirror the experience seen in the 1990s. This will be shallower and less pronounced than at times when the economy has experienced a much harder landing.

From this point of view, we continue to look to challenge pricing, where >100bps of rate cuts are discounted, on the premise that we will see a return to the valuation norms of the 2010s, in the absence of widespread evidence of a much more abrupt slowing in economic growth.

Across the Atlantic, UK GDP data showed the UK in recession in the second half of 2023. Recession headlines will only add to the determination from the Tory Party to deliver tax cuts to stimulate activity and buy votes ahead of an election later this year. It is likely that tax cuts are funded by reductions in spending, scheduled to occur in the period after the election, at which point the Conservatives most certainly won’t be in office. This approach may meet the statistical approval of the OBR, but markets may choose to look through this with a more sceptical lens.

Fiscal easing is also likely to lead to increased concerns with respect to the fiscal position, which an incoming Labour administration is likely to inherit. Nevertheless, a tax boost can give a temporary sugar rush to the economy in growth terms, and we would further note that activity data at the start of 2024 appear somewhat firmer that what we were recording at the end of 2023.

Although this week’s UK inflation data recorded a downside miss after surprising to the upside the month before, UK core CPI remains close to 5%. Consequently, with inflation well above target, ongoing inflationary wage settlement and fiscal easing incoming, we think it is going to be difficult for the Bank of England to lower interest rates in the months ahead.

With gilts outperforming over the past week, we have added to a short duration stance in the UK, on the view that 10-year gilts will struggle to move much below 4.0%. Waning enthusiasm for UK assets from overseas investors and building medium-term fiscal uncertainty both suggest a larger-term premium going forwards. In light of this, the UK yield curve on a 10/30 basis is historically steep at around 60bps. Nevertheless, we can see further underperformance from long-dated UK rates on a forward-looking basis.

Markets in the Eurozone were relatively quiet over the past week. Bunds outperformed on a relative basis, as Treasury yields moved higher. We believe that Eurozone duration is likely to continue to be more resilient in trends towards higher yields, with bunds looking cheap if we reach levels around 2.5% on 10-year maturities.

Sovereign spreads in the Eurozone have continued to grind quietly tighter, with Italy pushing below 150bps for the first time in the past two years, against a backdrop of muted volatility, which favours carry trades.

Elsewhere, we have recently become more constructive with respect to the Icelandic bond market. Inflation in Iceland had been problematic over the past couple of years due to excessive wage claims from labour unions. However, a new sensibility with respect to wage negotiations has been achieved, with unions just looking for around 3% gains in 2024. Against this backdrop, inflation and interest rates are likely to fall. Meanwhile the Icelandic economy remains robust, and we are inclined to look at Icelandic bonds as high-quality, high-yielding assets.

Japanese GDP data, which was released this week, was lower than we and the market had been expecting. Strong price gains, with the GDP deflator averaging 4.5% in the second half of the year, saw a slight contraction in real growth and serves to highlight that Japan’s issue of late has been with inflation, which is too high, rather than too low.

From this point of view, we believe that we are still on track for the government to acknowledge that deflation is over and that the objective of inflation being stable at around 2% has now been achieved. Meanwhile, a robust US economy and a yen trading above 150 also put pressure on the BoJ to commence normalisation without delay.

However, we have previously seen how Ueda is prone to adopting a cautious approach and may determine that headlines of recession mean that policy action can be deferred another month or two. Were this the case, then further pressure on the yen is likely to build, something which seems better understood by the Ministry of Finance and others in the Japanese government. In this context, the run-up to the March BoJ meeting remains very interesting.

Elsewhere, markets were relatively quiet over the past week. Credit spreads tracked movements in equity markets. Notwithstanding a sharp fall on the day of the US CPI release, it seems that the ‘buy the dip’ mentality in stocks continues to hold. Meanwhile in credit, cash bonds have continued to outperform versus CDS on basis.

Meanwhile in FX markets, recent data confirming a strong US labour market and firmer CPI has contrasted with weaker prints in many other economies. This has given an additional push to the theme of US growth exceptionalism and, in turn, led to a bid for the US dollar. The greenback is materially overvalued on mostly all valuation metrics. However, rate differentials and demand for US assets shows little sign of diminishing soon. These facets remain dollar supportive.

We have been adding steadily to long dollar positions since the start of the year and see scope for these trends to persist. We think there is more scope for the pound to weaken than the euro and we target a move below $1.20 on cable. Elsewhere, we are short EM currencies such as the Hungarian forint and Colombian peso, which may be vulnerable to an unwind of carry, with central banks in these countries committed to material rate cuts, as growth slows and inflation falls.

Looking ahead

We are moving into the quieter part of the month for economic data. US rates markets now discount four rate cuts from the Fed in 2024, which is not too far from what the Fed has projected. Recent strong data has led us to revise up our estimate for fair value in US 10-year yields from 4.25% towards 4.5%, but we don’t see much asymmetry in the return profile at current levels, and we feel that other markets offer a better risk/reward.

In the absence of much data or central bank commentary, we could see volatility subside over the next couple of weeks. With schools out for mid-term breaks, the week ahead may be a bit of a pause before we gear up for the March economic data round and a number of interesting central bank meetings to come.

Lower volatility can continue to favour spreads, and for the time being we are content running modestly long of beta in corporates and sovereigns, using CDS to help hedge directional risk. Market technicals in credit continue to remain favourable, and the price action of the past week has shown risk appetite remains relatively resilient for the time being.

Indeed there is plenty that looks pretty perky in the US economy for now… if only the same could be said of the leading presidential candidates. On the one hand, Biden seems to stumble from one gaffe to another, as commentators question the president’s age and command of his faculties.

Meanwhile Trump’s comments last weekend, seemingly encouraging Russia to attack NATO alliance members who are not paying up, will strike many as irresponsible at best, and very dangerous at worst. Certainly, the fear of Trump is present across European capitals we visit. There may have been a time when some Trump comments came across as funny.

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