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Alaska’s giant grizzlies are in the limelight, but how far are the markets from a peak bear moment?

This week’s US CPI release surprised to the upside for a second consecutive month in a row, with headline and core at 8.2% and 6.6% respectively. In the case of the latter, this represents a new cycle high, meaning that any hope that the Fed can pivot away from an aggressive path on interest rates appears premature. However, with futures markets now discounting 5% Fed Funds next spring, we continue to think that Treasury yields have priced in much of the bad news and are now not far from fair value.

The more hawkish the path on US rates becomes, the darker the economic prospects for 2023 seem to appear. From that standpoint, policymakers will certainly be hoping for some better news on inflation soon. The economy appears to be cooling and with the housing market at a standstill, we would project that moderation in rental increases can temper price indicators in the months ahead. However, forecasting inflation remains difficult and persistent inflation appears to risk de-anchoring wage and price expectations.

Against this backdrop, risk assets came under further downward pressure and US stocks approached pre-pandemic and policy-easing levels, before a sharp late reversal. Should rates need to rise above 5% to quell inflation, this probably infers a more significant recession than has seemed likely, up to this point.

Recession fears may bear flatten the yield curve and should equities take a steeper leg lower, then flight to quality support may act as support to longer-dated government bonds. Consequently, we have pared a tactical long position in US rates in the wake of CPI data, but remain biased to be long rather than short, in duration.

Meanwhile, events in the UK continued to grab attention, with gilt yields gyrating against a backdrop of elevated volatility and impaired liquidity. An announcement by the Bank of England (BoE) that it would end its temporary support program for gilts saw long-dated yields return to their highs above 5.1%, having rallied as low as 3.6% in the immediate aftermath of the announcement of this initiative.

Subsequently, there was some suggestion that the BoE would backtrack on this position if market conditions warranted this, and coupled with suggestions that the government would be forced to row back on parts of its fiscal plan, this saw yields retrace lower once more.

At the same time, data suggested that the UK economy would contract during Q3, whilst a sharp drop in economic confidence post the “mini-budget” implied that the country is already in recession at this point. With markets pricing a sharp rise in UK interest rates, financial conditions have tightened and this poses a substantial threat to the housing market. In our estimates, some 2 million households are set to see mortgage costs double within the next 12 months, if the BoE delivers rate hikes, as discounted in futures pricing.

With housing costing around 40% of wages in the South East of the UK, such a move risks putting the majority of these mortgages into default. If this were to occur, then we would extrapolate a 40% decline in house prices, mirroring the price move in long-dated real fixed-income assets this year. In turn, this could trigger the risk of financial and economic collapse.

Consequently, we believe that the BoE will simply be unable to raise rates in this way and would be well advised to tighten rates much more modestly. In many respects, this seems justified, as arguably inflation expectations are now lower than they were before the “mini-budget”, thanks to moves in energy prices and concerns over economic prospects. Arguably, we believe that the UK will be forced into an outcome whereby inflation is allowed to remain higher for longer as a result. This infers a steeper UK yield curve and a weaker pound.

We also believe a political pivot in the UK is likely. The cost of the UK fiscal plans can be mitigated by the imposition of windfall taxes on the renewables sector, as the realization dawns that a marginal price model on energy support makes very little sense. This could save one-third of the total bill, which we have estimated at GBP150 billion over 18 months at prevailing gas prices. Paring support for higher-rate taxpayers and businesses could also reduce the cost, along with a greater push towards energy efficiency.

In this case, the GBP150 billion cost could be cut in half, and coupled with a few token reductions in tax cuts, it may be possible for Truss to survive with pro-growth agenda intact, as long as the BoE and OBR are prepared to help her. However, the prospects for Chancellor Kwarteng look much less promising and it seems unlikely that he will see out the month in his role. Arguably, if he hangs around much longer, the UK might risk becoming a Kwasi-emerging market.

With respect to LDI-related flows, we think that we have seen approximately 50% of assets sales completed at this point (though any guess here is a function of where 30-year rates settle). The UK rates market continues to exhibit massive negative convexity, which is contributing to volatility in both directions.

The unpredictable nature of these moves and the de-risking that is occurring makes it challenging to read what will happen next and with BoE support for the gilt market set to end today, so the next several sessions will be watched very closely. However, we are inclined to start paring a short in long-dated gilts close to 5%, whilst retaining a long position on short-term SONIA contracts and a short on the pound.

In relation to the UK, markets across the rest of Europe and beyond looked relatively dull by comparison in the run-up to the US CPI release. Meanwhile, moves in gilts have been dominating price action across other markets, given the direct correlation to the level of UK yields and the required asset sales that may take place as a result. A firesale of some assets has created technical dislocations across global credit markets.

In sterling credit, this has seen portfolio trades printing 10 or 20bp in yield away from mid-market levels. However, on a broad market basis, credit indices have generally proven somewhat more resilient than equities, with evidence of some cash being put to work, as outright yields reach levels of valuation that are triggering demand in IG and HY assets.
 

Looking ahead

Volatility in UK assets may continue to be a significant driver of short-term technical price action. However, it will be the outlook for US inflation and the rate hiking cycle which has much more lasting significance for global financial markets in the months and quarters to come. For the time being, it seems difficult to shake the macro narrative, which has held sway since the beginning of 2022. Yet investors are defensively positioned, as demonstrated by a relatively contained sell-off in the wake of the disappointing inflation release.

Generally speaking, we think there remain solid reasons to project a moderation in price data in months to come. This should occur, as long as wages do not start moving more discernibly to the upside, driving second-round inflation impacts. In time, this should make for a more constructive backdrop, but rate expectations will need to peak first.

We continue to think that adding exposure to assets that are oversold will prove the correct approach on a medium-term view, and so we are more inclined to add risk on weakness than we are inclined to sell existing positions.

Otherwise, rather than beating on Liz Truss and her band of merry men yet again this week, it seemed an entertaining distraction to observe that this is the annual ‘Fat Bear Week’. Noting the picture below, there certainly seem to be a few fatties gorging themselves silly for now. However, we know that bears will ultimately go into hibernation and we may come to realize that we are not too far from a peak bear moment.

[Ed. note - for gamblers out there, the winning Fat Bear for 2022 is 747.]

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